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Back to school: following the PATH for higher education funding.

Higher education costs are escalating and families are trying their best to keep up with them. This article will discuss various strategies to help fund this important expenditure. The Protecting Americans against Tax Hikes (PATH) legislation extended and made permanent some of the education tax strategies, which also are available for adults who want to increase their educational credentials.

Qualified Tuition Plans (Sec. 529)

These plans have become a popular method for putting away college funds. The basic idea is that funds are contributed to a prepaid plan or a savings plan that will be available when the child is ready for college. Initially, all of the plans were sponsored by a state, but colleges and universities can now sponsor their own plans.

Each plan has a maximum funding amount that can be met by contributions. For example, the California ScholarShare College Savings Plan has a maximum of $371,000 per beneficiary (the potential college student). In Alaska, $400,000 can be invested and Arizona allows $419,000 per beneficiary, but the Georgia plan will only accept $235,000. While the designated beneficiary is the individual to whom funds are being accumulated for, there is some flexibility if the owner wants to transfer funds to another beneficiary with higher college expenses.

Parents, grandparents or the child can make contributions. Lump sums are typically contributed, but payroll deductions and automatic investment plans are also available in many states. The donor stays in control of the account. Funds can be withdrawn for any purpose, but if they're not used for higher education, the earnings portion will incur a 10 percent penalty tax and be subject to income tax. The beneficiary can be changed with no tax consequences if the new beneficiary is a member of the family.

The PATH change is that a computer will qualify as a higher education expense for 529 Plan purposes.

The California ScholarShare Plan is managed by TIAA-CREF and other investment advisers manage the plans of other states. The beneficiary need not attend college in the state sponsoring the plan as a general rule, though some states have more restrictive requirements.

You can compare funds, performance and fees online at

Contributions to a 529 Plan are taxable gifts and generally qualify for the annual exclusion for gift tax purposes. In fact, five years' worth of exclusion can be used for one gift. For example, a couple can contribute $140,000 to a 529 Plan without affecting their individual lifetime estate and gift tax exemptions. They do this by completing Form 709 and checking a box on Page 2 to indicate an election to treat the current year gift as covering the following four years as well. If they contribute more than the current exclusion ($14,000 per donee) for five years, the excess gifts are taxable in the first year.

Although the donor retains control of the 529 Plan, it's not an asset in the individual's estate--with one exception. If the gift was made and the donor dies before five years elapses, the unused exclusions of $14,000 per year would be included in the estate. The amount is not increased by any growth in the 529 fund.

Trusts for Education

The Internal Revenue Code [Sec. 2503(c)] provides for a Minor's Trust that is often used for education. The gift to the trust qualifies for the annual exclusion if all of the income is distributed annually once the beneficiary is no longer a minor. These trusts generally terminate when the child reaches age 25.

Another trust used for education that qualifies for the annual exclusion is defined in Sec. 2503(b). This type of trust allows no accumulation, so the income must be paid out annually, but the principal remains intact for education purposes.

Accounts for Minors

Every state has either a Uniform Gifts to Minors Act or a Uniform Transfers to Minors Act. Ownership of the account established pursuant to such an act is vested in the minor. Control of the account is turned over at majority--which may not be the best thing. In addition, these accounts are not recommended if the student will be applying for financial aid as they count against the child more than other types of education funding sources.

Coverdell Education Savings Accounts

These accounts were formerly known as Education IRAs. Contributions can be made to the accounts before the beneficiary reaches age 18, but must be fully distributed by age 30. Like an IRA, the contribution is due by April 15 of the following year, but are not deductible. The maximum contribution is 12,000 per beneficiary. There is an income phase-out so wealthier parents or grandparents may be precluded from participating. Modified adjusted gross income is capped at $110,000 per taxpayer to contribute each year.

The Coverdell ESA features tax-free earnings and funds can be used for elementary, secondary and college education expenses. Like the 529 Plan, a designated beneficiary is the individual named to receive the benefit of the funds. Funds may be used for academic tutoring for beneficiaries in elementary or secondary school, as well as acquiring technology, equipment and Internet access.

The 12,000 annual limit is for all contributions for a beneficiary--so if one grandparent contributes the full $2,000, other relatives are precluded from making an allowable contribution that year. A beneficiary can benefit from contributions made to a 529 Plan in the same year as a Coverdell contribution.

Individual Retirement Accounts

Withdrawals from individual retirement accounts are taxable in full unless the owner has made nondeductible contributions. Distributions before age 59.5 are subject to a 10 percent federal penalty (California imposes a 2.5 percent penalty). But distributions used for higher education of the account owner, spouse or descendent of the owner or spouse are exempt from the 10 percent penalty. The exemption from penalty also applies when a Roth IRA is used for higher education.

Tax Credits and Education-related Deductions

There are two basic credits available in connection with higher education:

American Opportunity Credit: This is the most valuable. A credit of up to $2,500 is available for qualified education expense against the tax and is available for four tax years per eligible student; the tax years elapse even if the previous Hope credit was claimed for one or income limitations preclude usage. The student may be able to claim the credit if the parent doesn't qualify; an adjusted gross income of more than $90,000 per taxpayer ($180,000 on a joint return) prevents usage of the credit; and 40 percent of the credit may be refundable. A degree program or a program leading to another recognized education credential is required, and the student must be enrolled at least half the time during an academic period within the tax year for which the credit is claimed. The credit is 100 percent of the first $2,000 of qualified education expenses for an eligible student and 25 percent of the next $2,000 of qualified expenses.

Lifetime Learning Credit: This is available for any year that no other education credit is claimed. It can be used for higher education expenses that are not part of a degree program. The maximum credit is $2,000 per return and nonrefundable. The limit on modified adjusted gross income was $65,000 per taxpayer ($130,000 per couple) for 2015. The credit is 20 percent of qualified expenses up to $2,000 credit.

PATH extended the above-the-line education deduction through 2016, which allows eligible parents to deduct up to $4,000 in tuition and fees per student. Taxpayers can chose a deduction if it's more beneficial than a credit. Personal interest is generally not deductible, but you can deduct student loan interest if you meet the income and other requirements. The maximum deduction is $2,500, which is phased out for taxpayers with modified adjusted gross income of $80,000 per person ($160,000 on a joint return). You must receive Form 1098-E to support the deduction and the interest must be taken out solely to pay qualified education expenses for a student enrolled at least half-time in a degree program.

FAFSA Reporting

The Free Application for Federal Student Aid is used to determine need for purposes of college scholarships. Student income is assessed at 50 percent--meaning $5,000 of student income will reduce a student's aid eligibility by $2,500.

Withdrawals front UTMA and IRA accounts for college are counted as student income on the following year's FAFSA. The value of a parent or dependent student owned 529 account has a minimal effect on financial aid eligibility. The value of the account is considered a parental asset on the FAFSA, so the maximum effect on aid eligibility is 5.64 percent of its value ($5,000 in a 529 Plan would only reduce aid eligibility by $282). Nothing needs to be reported on the FAFSA when the funds are withdrawn for college.

Assets owned by the student (UTMA, IRA or Roth IRA) and the student's income are weighted most heavily in determining whether federal benefits are available. The parents' assets (but not retirement accounts) are considered and the number of children in the family that may need to share in those assets for higher education. Funds owned by others (529 Plan established by grandparents for example) are not part of the formula.

Other sources of education funding include scholarships, fellowships, grants and employer tuition programs. With so many options, families need to be aware of the income tax and financial ramifications of choices.


Mary Kay Foss, CPA is a director at Sweeney Kovar LLP and CalCPA Estate Planning Committee member. You can reach her at
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Title Annotation:financial planning
Author:Foss, Mary Kay
Publication:California CPA
Date:Mar 1, 2016
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