Credits

There are two different kinds of tax credits currently available in tax year 2010:

American Opportunity Credit – This credit is available for students (and parents of students) that are in their first four years in a degree program at college.  The credit is a maximum of $2,500, and is calculated as:  100% of the first $2,000, and 25% of the next $2,000 of Qualified Higher Education Expenses (QHEE) paid for that student.  QHEE is limited to tuition, fees, books, supplies, and other equipment required for the course of education at an accredited institution of higher learning.

Up to 40% of the credit can be refundable – meaning that, even if you don’t pay any tax at all, you may be eligible to receive as much as $1,000 in refunded credit.  (Note:  if you’ve been around the college tax credits block in recent years, this credit has replaced – or rather expanded – the old Hope Credit.)

Lifetime Learning Credit – This credit can help you to pay for any level of postsecondary education, including professional degree courses, graduate courses, and courses to improve job skills.  The credit is equal to 20% of the first $10,000 of QHEE paid for all students on the tax return, for a maximum of $2,000 in credit for the family.  There is no limit to the number of years that this credit can be applied to.

Deductions

There are two types of deductions available for education-related expenses as well:

A tuition and fees deduction is available for parents and students – which is a reduction to your Adjusted Gross Income (AGI).  Depending upon your income, you may be eligible to deduct as much as $4,000 in QHEE.

In addition, a Student Loan Interest Deduction is also available to help ease the pain of those student loans after college.  This deduction also reduces your AGI – and it doesn’t just have to be for a qualified student loan.  If you’ve used a home equity loan, a credit card, or other personal loan that was used exclusively for QHEE, the interest can also be deducted.  But be careful, the exclusive use provision can catch you – if any part of the non-qualified loan is used for a purpose other than QHEE, the interest is not deductible.

College Savings Plan Benefits

There are also two types of college savings plans that can be used on a tax-benefited basis, to help you pay college expenses.

Section 529 Qualified Tuition Programs – These programs, often referred to as 529 plans or QTPs, provide a vehicle for families to save up for college expenses on a tax-favored basis.  With a 529 plan, families can contribute amounts to the savings plan, and the account is invested – as the account grows, if the distributed funds are used for QHEE (in this case, including room and board), there is no tax on the growth.  The only limit to the amount of contributions is in relation to gift tax limitations – for most folks this isn’t a problem, but consult your advisor if you have questions.

Coverdell Education Savings Accounts (ESA) – ESAs are similar to 529 plans, with a few differences.  ESAs can also be used for private elementary or high school expenses, in addition to QHEE.  In addition, there is a specific limit of $2,000 in contributions per student per year.  The same tax treatment as the 529 plans applies to ESAs – as long as the distributions are used for education expenses, there is no tax on growth in the account.

Coordination of Benefits

The Lifetime Learning Credit and the American Opportunity Credit cannot be claimed for the same student in the same year.  Likewise, neither credit can be applied to the same student in the same year as a tuition and fees deduction.  You also cannot claim the same expenses as the offset for distributions from a 529 or an Education Savings Account.  As you might have guessed, the same holds true for coordination between the tuition and fees deduction and a 529 or ESA – the costs used for either cannot be used for the others.

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Among the options for Section 529 plans are two types of account:  savings and prepaid tuition.  Following is a brief explanation of the two types of account.

Savings-Type 529 Plan

The savings type of 529 plan works much like an IRA or 401(k): contributions are made and the amounts contributed to the plan are allocated among various sorts of investment options, mostly mutual funds or derivatives of mutual funds.  Over time, assuming that you’ve made appropriate allocation choices and the investments grow, the balance of the account will in turn grow, increasing the amount of funds available to pay for college expenses.  Growth in the account is tax-free when used for qualified higher education expenses (QHEE).

As with any investing activity there are risks to investing in these plans – similar to the risks you face in your IRA or 401(k) plan.  It’s possible that your account could lose value at any given point in time (like late 2008, for example) but prudent investment choices, appropriate time-orientation, and risk management can help to assure that your account will grow over time – but there are no guarantees.

Prepaid Tuition 529 Plan

On the other hand, the prepaid tuition type of plan is set up quite differently from any other type of account.  Instead of a savings account, in this case you’re purchasing discounted “units” or semesters of education – which, backed by the sponsoring state, are guaranteed to be traded for equivalent semesters of public college education (in the sponsoring state) when the student reaches college age.

If the student chooses to attend a non-public school or a school in another state, the programs guarantee that the equivalent of the then-current tuition cost will be available to pay the college of choice, even though the cost at that school will be different from the state universities in the sponsoring state.

Just as with the savings-type of plan, growth in the account is tax-free if used for QHEE – and in either type of plan if you choose not to use the account proceeds for education, you can withdraw the value and pay tax and a penalty on the growth.

The Downside to Prepaid Tuition

So, with all the market volatility, you’d think that the prepaid plan is the way to go – after all, this type is guaranteed!  Unfortunately, that guarantee by the sponsoring state is only as good as the state’s finances; these days, for many states, finances are currently listed under the heading of “Deplorable”.  When you couple the finances of the state with the dramatic increases in tuition costs we’ve seen in recent years, someone is bound to take a hit.  Guess who “someone” is?

Many prepaid tuition plans were forced to bar adding new participants to their plans after the dot-com bubble burst several years ago, since poor market returns and higher tuition rates were causing the plans to lose money far too quickly to make up reserve balances.  Now, similar situations abound, and the states backing the plans may or may not have the funds to help shore things up.  As a result, new fees have sprouted for many plans – along with large increases in the discounted costs for new credits being purchased, which chokes off the new money coming into the plans.

According to a recent article in the Wall Street Journal, all across the nation prepaid tuition plans are operating in the red – seems that the market volatility does have an impact on these plans after all, just a little more subtle and after the fact.  And it’s up to the state to determine if their promises are worth keeping… and here in Illinois we don’t have that much faith in our state government. Your mileage may vary.

For my money, it just makes far more sense to use the savings-type of 529 plan: a plan that you can understand, can follow the balance, and perceive how and why fluctuations occur.  With those plans, you know what you have in the account, day in and day out.  With the prepaid plans, especially given the poor fiscal conditions of the states guaranteeing things, it’s all in question, in my opinion.

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Keep in mind as you read this, the questions are one individual’s specific concerns about his situation.  The person asking the question has simply put this list of questions out on a public bulletin board hoping for responses – that’s part of why some of the questions aren’t fully answered or clarified, since the original poster didn’t come back to clarify his questions or respond to my responses…

The original questions are numbered, and my response is italicized.

1. Is there any income limit for parents to be able to qualify/ participate in the 529 plan.

No

2. We are thinking about initiating the plan with Iowa/ Virginia (as we heard from some our contacts have done it) – Even if we move out of CA to another state – can it still be used?

Yes

3. Is it possible to roll over from 1 state 529 plan to another state – any charges/ fees?

Yes, it is possible. Fees will depend upon the plan chosen.

4. Assume that the child does not get educated here in the USA, can the funds be used for International education – Canada, France, Singapore, India ?

The funds could be used for international education, but if the school is not accredited in the US, you’ll pay a penalty and taxes on the growth of the fund if you withdraw funds for this purpose, which is not considered a Qualified Higher Education Expense (QHEE).

5. What are the annual contribution limits – per child/ couple/ family?

In general, this is up to the plan, most have a limit of somewhere around $235,000. In order to maintain simplicity, most folks limit their annual contribution to the annual gift exclusion limit ($13,000 per child per parent in 2010), while some utilize the special 5-year front-load gift limit ($65,000 per child per parent in 2010).

Having said this, though – many states limit tax benefits to $10,000 per child per year. This will be different on a plan/state basis. If you’re investing in an out-of-state plan, this won’t matter to you.

6. What is the process to take out the funds in the middle? Would there be any penalties?

You contact the plan to make a distribution from the plan. There would be penalties and taxes due on the growth in the account. Depending upon state tax benefits (and the plan you’re using), there may be state taxes and/or penalties involved as well, since some states require recapture of any deduction benefit that was provided for contributions.

7. Is it possible to have a 529 in more than 1 state? Are there any restrictions?

Yes, you may have 529 plans in more than one state. Primary restriction that I can think of would be the gift tax exclusions noted earlier. Otherwise there is no reason you couldn’t have several states’ plans.

8. Is it possible to move $ across funds? Are there any restrictions/ charges?

Again, this depends upon the plan. If your question is “can I move money around to other funds/allocations within the same 529 plan?”, then the answer is yes, but depending upon the plan, there are likely restrictions, such as rebalancing can only be done once every 12 months.

If your question is “can I move money around to other 529 plans?”, the answer is yes, but I believe you need to move the entire account (roll over) when you do this, and I believe you are limited to one such rollover in twelve months.

9. What happens if I loose the $ in account? Are there chances of loosing?

You have a smaller balance at the end of the month than you did at the beginning of the month.

Of course there are chances of losing money – just the same as any investing activity. This of course will depend upon your investment allocation decisions. The more risky your choices, the more likely you are to lose (and gain) money.

Also, I suppose it’s possible that you could take a miscellaneous deduction for a major loss in a 529 account.  Since there is basis in the account and tax could be owed on a non-qualified distribution above that basis, there’s no reason to doubt that you couldn’t take a miscellaneous deduction for the loss.  This would be subject to a 2% floor, and you’d likely have to close the account to recognize the loss.

10. Who holds control in a 529? What happens if a beneficiary is no longer part of the family (God Forbid !!)? Etc or something happens to the contributor?

The owner of the account (you, your spouse, etc.) has control over the beneficiary of the account, and so you can change the beneficiary as you see fit. If something happens to the contributor (and by this I assume you mean the owner – yourself), hopefully you’ve chosen an appropriate contingent owner to manage the funds in your absence. Otherwise it is probably up to state statutes to determine management.

11. Is there any age restrictions in using this 529 $ for the beneficiary or can it be used at any age?

No restriction on the age of the beneficiary.

12. What happens if there is left over’s & I am not able to use it?

This partly depends upon why there is left over money: if this is due to the fact that the student received scholarships, then you are allowed to distribute an offsetting amount (same as the scholarship) from the 529 account, to the extent that the scholarship monies are used for QHEE. This distribution must take place in the same year that the expenses are paid.

If there are funds remaining in the account due to the death or disability of the primary beneficiary, you are allowed to remove the funds from the account without penalty, however you must pay tax on the growth of the account, but no penalty.

If there are funds remaining in the account because the cost of school for that beneficiary was less than you anticipated, you have two choices: roll the funds over to a new beneficiary, or take a distribution and pay the tax/penalty. The rollover can be done to anyone you wish (doesn’t have to be your child, can be anyone).

13. Can I pass this to my brothers / sisters children? & is there any limitations? Can the funds be used for self/ spouse?

Yes – no limitation other than the gift limits mentioned above.

14. Can the 529 funds or any left over’s be used by the next generation?

Yes.

15. Does having a 529 account mean, one cannot initiate a UTMA/ UGMA, Coverdall etc?

No, a 529 account does not exclude eligibility to utilize those vehicles.

16. I was reading an article & vaguely recall a # $239,000 (Is this the total $ contribution or the $ balance on the account (attributed due to appreciation/ dividends etc).

I don’t know – I don’t vaguely recall reading that article. The limits are going to be different for each plan.

17. Are (qualified/ nonqualified) withdrawals exempt from state taxes?

Depends upon the plan. Most qualified withdrawals are exempt for most states’ tax. Nonqualified withdrawals may or may not be exempt from state taxes – look at your state’s tax laws and the plan information.

18. How does the process work? Should I prepay for the university & give a receipt to the 529 plan? or will the 529 pay the university directly? Will it cover only University fees/ registration/ dorm/ living? Clothing, Books?

Again, take this up with your specific plan. In general, you can either pre-pay or make a withdrawal to pay the amount(s). Just keep good records. In general your QHEE will include tuition, fees and books. Room/board may also be covered, depending upon the plan in question.

19. Is the 529 applicable for school also? or Undergraduate/ Graduate/ PhD?

Okay, what are you asking here? 529 plans are for post-high school education expenses, which includes undergrad, grad, and PhD studies, as well as non-degree pursuing education.

20. Is anyone aware of any state tax inventives for the state of CA?

No

Hope this was of some help to you.  If you have more questions please leave them in the comments section below.

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Yet another expiring tax provision at the end of tax year 2010 is the expansion of the Coverdell Education Savings Account (ESA) that came into effect with EGTRRA 2001.

Through 2010

Until the end of 2010, you are eligible to make non-deductible contributions to a Coverdell ESA of up to $2,000 per beneficiary per year.  These contributions are phased out ratably when your Modified Adjusted Gross Income (MAGI) is between $95,000 and $110,000 for single filers; the phaseout occurs between $190,000 and $220,000 for married persons filing jointly (MFJ).

The earnings from these ESAs can be withdrawn tax-free to cover qualified expenses for elementary school, middle school, high school, or college.  This is the only significant benefit to an ESA over a 529 plan – that the account can be used for schooling prior to college.  ESAs must also be distributed within 30 days of the beneficiary’s reaching age 30.

Beginning in 2011

Unless something is changed, beginning in 2011 the non-deductible contributions are limited to $500 per beneficiary per year, and the phaseout is the same as listed above for single filers.  The phaseout for MFJ filers is reduced to between $150,000 and $160,000.  In addition to the change to the limit and phaseout range, the ESA will only be allowed for qualified post-secondary (college) education expenses.

It’s not clear at present if existing Coverdell ESAs will be allowed for funding elementary, middle school and high school on a grandfathered basis, or if the funds will no longer be allowed for these purposes.  If I had to put a bet on it, I’d wager that the current law will be extended indefinitely – with perhaps no new contributions will be allowed, effectively sentencing the Coverdell ESA to death at some point in the future.

Who Cares?

The reason I mentioned that this might go in the “who cares?” file is because, other than the ability to pay for elementary, middle, and high school, the ESA has no benefit over the much more popular 529 plans.  And if Congress allows the current provision to lapse, I doubt seriously if there would be any participation in the plans at all, due to the restrictive limits on the plans, plus the age 30 distribution requirement, which doesn’t exist for 529 plans.

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Since contributions to the Roth IRA are “after tax”, the first $5,000 earned (for 2009 and 2010) and the future earnings on that income will never be taxed if contributed to a Roth IRA.  And since as a parent you’re paying for most everything else that the child needs anyhow, why not encourage him to make a contribution of his first $5,000 of income into a Roth IRA?

One downside (or maybe it’s an upside?) to this strategy is that the contributions will be available (without tax or penalty) for college expenses, down payment on a home, or whatever.  However, if the money is left in the account it can provide a tax-free source of income for retirement in the future.  This can be a good time to introduce the concept of saving for something far into the future to your child.

An added benefit of putting the money into a Roth IRA account is that money in retirement accounts (such as a Roth IRA) is not included in the FAFSA calculations for student financial aid.  If this money was put into a savings account, the savings account would be counted as a source of funds to pay for college expenses (on the FAFSA).

Two key factors to remember are:

1. The child must have earned the income.  This means that the income was reported to them on a W2 or 1099, or possibly the child was self-employed.  The income must be reported on an income tax return in order to account for the income, even if no tax was owed on the earnings. (Note: don’t get carried away with this idea and “invent” income for your child.  Allowance for mowing the yard or cleaning her room does not count as income.)
2. The Roth IRA contribution must be made before the tax return is filed for the year in question.  For the 2009 tax year, for example, the contribution to the Roth account must generally be made by April 15, 2010.

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The ability to deduct interest on student loans is not going away entirely, but rather the old restrictions are being reapplied, making it more difficult to use this deduction.  For a large number of folks, this is going to cause an unexpected increase in taxes beginning in tax year 2011 (on top of everything else that’s changing!).

Through Tax Year 2010

The present law allows you to deduct up to $2,500 of interest for student loans for all years that interest payments are required.  This deduction is an above-the-line deduction, taken on line 33 of the 1040 form, which reduces your Adjusted Gross Income (AGI).  Reducing AGI is important because so many other taxes and deductions are tied to the level of the AGI or Modified AGI.

The deduction is phased out starting at Modified AGI of $60,000 and is completely phased out at a Modified AGI of $75,000 for single filers.  For Married Filing Jointly (MFJ), the phase-out range is between $120,000 and $150,000 of MAGI.

Beginning in 2011

With the expiration of the more liberal provision, the old rules come back into effect – which means that beginning with tax year 2011, you’re still allowed to deduct up to $2,500 of interest on student loans, but only during the first 60 months of the loan payment period.  After the first 60 months, interest is no longer deductible.  (Note:  Of course, this is in place because most everyone has their student loans paid off in five years, right?  Especially if your MAGI is in the range to take advantage of the provision… geez.)

The deduction phase-out range is much more restricted, as well:  between $40,000 and $55,000 MAGI for singles and between $60,000 and $75,000 MAGI for MFJ.

Of course, this and all the other expiring provisions could be extended or a new provision put in place.  We’ll just have to wait and see how things pan out between now and the end of 2010.

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However (and there’s always a however in life, right?) – as suspected, the economic slowdown has begun to impact these prepaid plans across the country, as reported in the Sound Mind Investing blog recently, with the article Prepaid college tuition: it seemed like a good idea at the time.  Essentially, the plans have made promises that supposed a certain level of return on investments; a level that has been subverted with the downturn of the economy.  As a result, in some cases the plans are being propped up by state funds (that are continually running in short supply), or imposing additional “fees” to participants in order to make up the difference.  In some cases, the plans are putting forth the concept that they may come up short of funds altogether…

I have not heard of any actions by the state of Illinois on these problems, but the article in the New York Times (referenced by Sound Mind Investing) indicates that 16 of the 18 prepaid tuition plans across the country are facing difficulties… which leads you to believe that the remaining two can’t be far behind.

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Kirk’s primary beef is with the Illinois-based BrightStart 529 plan – which is mostly a swipe at one of his main opponents in the Senate race, Illinois’ Treasurer Alexi Giannoulias, since BrightStart falls under Giannoulias’ responsibility.  Last year, one of the funds in the BrightStart plan, managed by Oppenheimer, was severely impacted by the fallout in the bond market due to overexposure in the derivatives market.  Negotiations between Oppenheimer and Giannoulias’ office are continuing, and investors are expected to receive some sort of remuneration soon.

So anyhow, as is often the case, in the heat of the moment during the economic fallout of last year, this 401(kids) plan was recommended.  It’s my contention that this plan is nothing new – the Coverdell ESA is pretty much exactly the same thing.  Let’s do a quick comparison between the proposed plan and the existing Coverdell ESA:

So, other than the provision that these funds might also be used for a first-time home purchase, there’s no difference.  And consumers have already voted with their actions:  the Coverdell ESA is too little, too late.  With the miniscule annual funding amount (in comparison to the costs of college), paired together with the fact that there is no up-front tax benefit (as is available with the BrightStart plan for example), it seems that this proposed legislation is another example of unnecessary posturing-based law, with no or extremely low perceived benefit.

In fact, if the investor in a Coverdell or the new 401(kids) plan were to experience a similar issue as BrightStart investors did with Oppenheimer – how successful do you think the individual investors would be in negotiating remuneration on their own?  Don’t get me wrong, I’m in favor of less governmental involvement in most cases, but in this case I think the 529 plan wins out.

What do you think?

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The six facts reported in the IRS notice are as follows:

1. The American Opportunity Tax Credit, which expands and renames the existing Hope Credit, can be claimed for qualified tuition and related expenses that you pay for higher education in 2009 and 2010.  Qualified tuition and related expenses include tuition, related fees, books and other required course materials.
2. The credit is equal to 100% of the first $2,000 spend and 25% of the next $2,000 per student each year.  Therefore, the full $2,500 credit may be available to a taxpayer who pays $4,000 or more in qualifying expenses for an eligible student.
3. The full credit is generally available to eligible taxpayers who make less than $80,000 (single taxpayers) or $160,000 (married taxpayers filing jointly).  The credit is phased out gradually for taxpayers with incomes above these levels.
4. 40% of the credit is refundable, so even if the taxpayer owes no tax he can receive up to $1,000 of the credit for each eligible student as a refund.
5. The credit can be claimed for qualified expenses paid for any of the first four years of post-secondary education. (The previous Hope Credit was available only to students in the first two years of post-secondary education.)
6. You cannot claim the tuition and fees deduction in the same year that you claim the American Opportunity Tax Credit or the Lifetime Learning Credit.  You must choose to either take the credit or the deduction, whichever is more beneficial to you.

Of course this changes the landscape of available tax credits and therefore the affordability of college for lots of folks.  If your situation is such that tax credits could make the difference between going to college or not, you should probably talk your situation over with your tax advisor.

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Under today’s rules, taxpayers may deduct up to $4,000 of the cost of tuition and fees at those eligible institutions, but beginning next year this deduction will no longer be allowed (as long as the tax law doesn’t change between now and the end of the year).  This deduction phases out to a maximum of $2,000 if the MAGI is greater than $130,000 for married couples filing jointly ($65,000 for singles).  The deduction completely phases out for if the taxpayer’s MAGI is greater than $160,000 for couples and $80,000 for singles.

What this means is that families with college students (of any age) will be relegated to using either the Lifetime Learning credit or the new American Opportunity credit.

Briefly, the American Opportunity credit is for students in the first four years of post-secondary education (as determined by the institution, primarily by number of credits earned).  The credit is equal to 100% of the first $2,000 of qualified expenses, and 25% of the next $2,000 of expenses.  This credit is refundable up to 25% of qualified expenses, or $1,000.

The Lifetime Learning credit is equal to 20% of the first $10,000 of qualified expenses, but is not limited to the first two years of school.  This credit is also not refundable.

For the Lifetime Learning credit, phaseout begins at $96,000 and is completely phased out at $116,000 of MAGI (for marrieds).  For singles, the phaseout is between $48,000 and $58,000.  For the American Opportunity credit, phaseout begins at $80,000 for singles and $160,000 for married folks filing a joint return.

You’ll want to keep this in mind as you plan your 2010 taxes and how to pay for junior’s college next semester, because it just got more expensive…

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