Money Matters

Pending changes would alter college savings options

August 11, 2012 

Q. We have set up Education Savings Accounts for our three children and wanted to begin one for our new baby. When I went to the website of the no-load mutual fund family to get the required forms, they had a statement posted that they were no longer offering ESAs and were no longer accepting contributions to existing ESAs. Should we look elsewhere for an ESA or start some other type of education savings plan? What should we do with the funds we already have in our existing ESAs? Should we establish custodial accounts?

A. Unless Congress acts to extend the attractive benefits of the Coverdell Education Savings Accounts (ESA), they may expire at the end of 2012. Due to this possibility, some providers will no longer accept new assets nor open new ESAs. If there is no extension, contributions for a beneficiary will be reduced from $2,000 to $500, expenses for kindergarten through the 12th grade may no longer be covered, and a contribution to both a 529 plan and ESAs for the same beneficiary will no longer be allowed in the same year.

Tax changes have made custodial accounts such as the Uniform Gift to Minor Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts very unattractive. Custodian accounts no longer allow unearned income of children age 14 or over to be taxed at the typically lower children’s tax rate. Under current tax law, unearned income of more than $1,900 of children under age 18 will be taxed at the parent’s rate. Once a son or daughter turns 18, the investment income will be taxed at the child’s rate, but full-time students age 23 and younger will have to pay taxes owed from these accounts at their parent’s tax rate. Students age 19 to 23 will be exempt from this requirement if they are earning income totaling more than half of their support.

If the goal is to help with college, a 529 plan offers tax-advantaged savings, and depending upon the state in which you live it may provide tax incentives for contributions. The NC plan offers a tax deduction for contributions up to $5,000 ($2,500 if a single taxpayer) and can be used to pay qualified education expenses at colleges and universities throughout the United States (cfnc.org). You can roll over money from an ESA to a 529 plan without incurring any tax penalties as long as the 529 plan has the same beneficiary as the ESA. Unlike ESAs, there is no income limitation for making contributions to a 529 plan. Also, the amount a person can contribute is much greater than the current $2,000 per beneficiary to an ESA; over $300,000 may be contributed to a 529 plan. In one year $13,000, or $65,000 once every five years can be contributed per donor per child without filing a gift tax return.

With four children, cash flow might be a challenge and I encourage you to make sure you are saving for your retirement before you begin saving for college. Student loans, grants, scholarships and working while attending college are options for your children but not for you in retirement. Contributing the maximum to a Roth IRA before making contributions to education accounts would be a good plan. Contributions are made with after-tax money so you can withdraw these at any time without a tax penalty. Earnings can also be withdrawn penalty-free if used for qualifying higher education expenses. When your children begin college, if you determine you don’t need your Roth IRAs to meet retirement expenses these can be tapped to meet college expenses.

Holly Nicholson is a certified financial planner in Raleigh. She cannot answer every question. Reach her at askholly.com or P.O. Box 99466, Raleigh, NC 27624

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