People have long used Irrevocable Life Insurance Trusts (so-called “Crummey” Trusts), UTMA and UGMA accounts and direct paid State and Federal Tuition programs to help prepare for and pay for educational expenses and as a way to transfer wealth to the next generation. The Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRAA) greatly enhances the use of Section 529 plans and Coverdale Education Savings Accounts (ESAs) as additional strategies to consider in this same vein.
Parents and grandparents can employ wealth transfer strategies to younger generations both to help with higher education costs and to accomplish their own estate planning and wealth transfer objectives in as tax-advantaged manner as possible. Clients now have several options to accomplish this including:
- irrevocable demand (Crummey) trusts for minors;
- direct payment of tuition under Section 2503(e) of the Internal Revenue Code;
- UTMA/UGMA custodial accounts;
- Prepaid tuition plans and college savings accounts under Section 529; and
- Coverdell ESAs (formerly known as Education IRAs).
This article first concentrates on the changes the Economic Growth and Tax Relief and Recovery Act (EGTRRA) makes to 529 plans and Coverdale ESAs, and then compares how these strategies fare next to others.
Based on EGTRRA’s changes to 529 plans and Coverdale ESAs, these options may often outstrip other techniques for college savings and wealth transfer. This give your financial advisor a golden opportunity to help you compare plans and strategies in order to decide what is best in your particular set of circumstances.
SIGNIFICANT CHANGES TO SECTION 529 PLANS
Section 529 plans exist as either prepaid tuition plans or savings accounts. By March of 2002, 47 states (including Michigan) offered some type of 529 plan. EGTRRA introduced at least five major changes to 529 plans that your advisor should consider in helping you compare this strategy to others.
- Beginning in 2002, not only is growth in a 529 account tax-deferred, but now distributions for qualified higher education expenses are income tax free.
- The definition of qualified higher education expenses was already very broad under Section 529. nbsp; nbsp;EGTRRA expands the definition to include all annual room and board when the student lives in institution owned or operated housing, and $1,500 per year when the student lives at home.
- In addition, expenses to enable a special needs beneficiary to attend college are now considered qualified as well.
- EGTRRA expands the definition of “family members” (those beneficiaries to whom a donor may change an account to income tax free) from siblings to include first cousins.
- EGTRRA also now allows private educational institutions to create tuition plans, but not nbsp; nbsp;savings plans under Section 529. nbsp; nbsp;Distributions from tuition plans created by private institutions will be tax free beginning January 1, 2004.
- Donors may now roll a 529 account over to a new account, either in the same state or in another state, once every 12 moths. nbsp; nbsp;This change tempers the lack of investment choices with 59 plans to a degree.
Under EGTRRA, Educational IRAs are now Covedell ESAs, with the following changes:
- The annual contribution limit increases from $500 to $2,000.
- As with 529 plans, distributions from Coverdell ESAs are tax free if used for qualified higher education expenses.
- Coverdell ESAs now also include the same broadened list of qualified education expenses as do 529 plans, plus the addition of K-12 expenses.
- Like 529 plans, Coverdell ESAs now include first cousins as permissible family members to whom ESAs can be rolled over income tax free.
- Significantly, a donor can now contribute to both a Coverdell ESA and a 529 plan for the same beneficiary in the same year.
- A student can now receive nbsp; nbsp;qualified distributions from a 529 plan or Coverdell ESA, and the taxpayer can still claim a HOPE or Lifetime Learning Credit for the same student in the same year. nbsp; nbsp;The only limitation is that the distribution and the credit cannot be for the same expenses.
- The law now exempts special needs beneficiaries from the restrictions on contributions to a Coverdell ESA after age 18, and from the requirement to remove funds from the account or designate a new beneficiary by age 30.
These plans vary from state to state regarding investment options and fees, minimum and maximum contributions limits, holding periods prior to qualifying contributions, state residency requirements, income tax requirements and more.
Bottom line….MAKE AN APPOINTMENT WITH YOUR FINANCIAL ADVISOR TO EXPOLRE THE OPTIONS before making a decision as to how this all fits into your overall personal financial and estate succession plan.