College Planning
in the Wake of New Tax Laws
Planning for college
has never been easy. But such planning became a bit easier when President
Bush signed the TIPRA and DRA into law earlier this year. Among other
things, DRA and TIPRA changed the treatment of pre-paid tuition plans and
529 plans, two popular vehicles Americans use to save for and pay for
college.
Chief among the
changes are those that pertain to the so-called "kiddie tax."
Effective in 2006, the new law calls for the "kiddie tax" to
remain in effect until a child turns 18. Previously, unearned income
attributable to children age 14 and older was usually taxed at the child's
tax rate. The new tax law, however, raises the age to 18 effective January
1, 2006. Exceptions apply for minor children who are married and file a
joint tax return, and distributions from certain qualified disability
trusts.
This change affects
parents and grandparents who were or continue to use custodial accounts
such as UTMAs (Uniform Transfer to Minors Act) or UGMAs (Uniform Gift to
Minors Act) for college savings instead of 529 college savings plans. At
present, UTMA and UGMA dollars are considering the child’s asset in the
financial aid formula. But selling funds, or at least selling funds that
have appreciated in value, in an UTMA or UGMA prior to a child turning 18,
could create a significant tax bill. What’s more, assets in UGMA and
UTMA accounts become the child’s at the age of maturity, which varies by
state.
For many parents and
grandparents, the new law makes 529 plans a more viable savings vehicle.
With a 529 plan, contributions will grow tax-free and withdrawals are
tax-free through 2010 as long as they are used for qualified education
expenses. In addition, financial planners note that with 529 plans, the
parent or grandparent controls the money.
Of course, parents
and grandparents who established UTMA and UGMA accounts to pay for college
education do have options. Under the act, UTMA or UGMA assets can be
invested in a 529 plan, although assets have to be liquidated and cash
invested in the plan. Doing so may create a tax burden, but financial
planners note that it may be more than offset by preferential treatment of
529 plans in the financial aid formula. A tax analysis should be performed
to determine the impact.
According to
SavingforCollege.com, 529 plans do indeed receive preferential treatment.
Sometimes referred to as the "529 loophole," the new law removes
student-owned 529 plans and Coverdell education savings accounts from the
expected family contribution ("EFC") in the federal financial
aid formula. A 529 account or Coverdell ESA is considered an asset of the
account owner; however, 529 accounts or Coverdell ESAs owned by a
dependent student are excluded from the Free Application for Federal
Student Aid or FAFSA. Most undergraduates are dependents for FAFSA
purposes.
This is exceptional
treatment, reports SavingforCollege.com. Under the federal financial aid
rules, college savings plans are counted as an asset of the parent (if the
parent is the account owner) and assessed at a rate of 5.6 percent. This
means that 5.6 percent of the funds are deemed available for college
expenses in the year a student applies for aid. By contrast, 35 percent of
assets owned by the student are used to calculate the EFC.
In addition, parents
and grandparents who have been using prepaid tuition plans to save for
their children's college education received some good news on July 1, 2006
when the federal government began treating 529 prepaid tuition plans the
same as 529 college savings plans for financial aid purposes.
Distributions
(withdrawals) from a college savings plan that are used to pay the
beneficiary's education expenses are not counted as either parent or
student income. Prepaid tuition plans will now be treated the same way.
By way of background, prepaid
tuition plans prior to July 1, 2006 were treated differently than college
savings plans under the government's financial aid formula. A prepaid
tuition plan wasn't counted as an asset of either parent or student, but
any distributions from the plan were considered a "resource"
that reduced the cost of attendance at any given college. And that
resulted in a corresponding dollar-for-dollar reduction in financial aid.
That is, every dollar that flowed out of a prepaid tuition plan reduced
the beneficiary's aid award by one dollar. The new financial aid rules
ensure that both types of 529 plans will be treated equally.
August 2006— This column is
produced by the Financial Planning Association, the membership
organization for the financial planning community, and is provided by
McGuire & Co., LLC, a local member of the FPA.
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