California Bar Journal
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California Bar Journal

The State Bar of California


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Front Page - November 2001
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News / News Briefs
Applicants sought to oversee bar's diversion program
Let's have another cup of - legal advice
Foundation leads students to capital
Six honored for professional service
Warwick, six others named to California Judicial Council
Several thousand lawyers suspended for failing to pay dues, certify MCLE
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Trials Digest
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From the President - Remembering the fallen
The rule of law is our strongest weapon
Pro bono work is lawyers' duty
Letters to the Editor
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Law Practice - Success: The top eight requirements
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You Need to Know
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MCLE Self-Study
Planning for education expenses
Self-Assessment Test
MCLE Calendar of Events
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Ethics Byte - Lawyers move on in usual way despite disaster
Former city councilman spent his son's settlement
Attorney Discipline
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Public Comment


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This month’s article and test provided by
Taxation Law Section
West Group

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Planning For Education Expenses

Don't wait until a child is in college to answer tax and financial questions that come with the tuition bill

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J. Timothy MaximoffThe joy of raising a child can be tempered by the surprisingly complex task of planning for future education. Al-though the problem of funding education expenses is often left to clients and their financial advisors, providing for education expenses is one of the most common reasons clients engage in lifetime gifting and estate planning. A basic awareness of various education funding alternatives can be helpful to attorneys responding to clients' questions.

Attorneys familiar with "traditional" planning solutions for education needs, such as irrevocable trusts and CUTMA accounts, may not be as aware of tax-favored solutions for reducing the impact of providing for current and future education expenses. Some alternatives will be much more attractive in light of the recently enacted Economic Growth and Tax Relief Reconciliation Act of 2001 (the "2001 Act").

Selecting the best solution from the many possibilities is complicated by tax and family considerations and the variety of investment vehicles available. Given the complex tax and investment issues, attorneys may suggest that a CPA and competent financial advisor be consulted as an important part of the client's planning team.

Current funding

Parents paying a child's education expenses in 2001 without advanced planning are faced with a difficult situation. For lower income parents, two income tax credits may be available under IRC §25A. The "Hope Scholarship Credit" allows for a maximum credit of $1,500 per student per year for the first two years of post-secondary tuition and fees. The "Lifetime Learning Credit" can be claimed each year for 20 percent of up to $5,000 of qualified tuition and fees paid that year ($10,000 after 2002) and for which the Hope Scholarship Credit is not claimed.

Both credits are phased out for taxpayers with "modified adjusted gross income" over $40,000 for single filers and $80,000 for joint filers, and neither is available for married taxpayers filing separately. Additional limitations can also apply (see discussion below) [IRC §25A(e)(2)].

A new deduction of up to $3,000 for qualified higher education expenses will be available in 2002 as an alternative to the Hope and Life-time Learning Credit for a beneficiary [IRC §222]. The deduction is phased out for taxpayers with adjusted gross income ("AGI") of $65,000 or less ($130,000 for joint filers). The deduction limit rises to $4,000 in 2004 and 2005 ($2,000 for taxpayers with AGI above these limits but below $80,000 for single filers and $160,000 for joint filers).

Some clients consider using IRA distributions to pay education costs.  Although the withdrawal will be taxable under current IRA distribution rules, distributions for "qualified higher education expenses" (including tuition, books, fees, equipment and supplies of the IRA owner, or his spouse, child or grandchild) are exempt from early IRA withdrawal penalties [IRC §72(t)(2)(E)].

Payment of education expenses can have gift tax implications. How-ever, the client may be able to use the $10,000 annual gift tax exclusion for a present interest gift by a donor to a donee ("annual exclusion") or the gift tax exclusion for tuition paid directly to a qualified educational institution [IRC §2503(b), (e)].

As another alternative, a student might obtain financial aid and use the limited deduction for interest on qualified student loans under IRC §211 in the future. In any case, waiting until a child is in college will be a costly planning alternative.

Trusts and custodianships

Clients who plan ahead may use annual exclusion gifts to an irrevocable education trust which offers control of investments (by the trustee) and can contain clients' specific parameters regarding distribution of funds for education purposes. Trust assets can be excluded from the donor's estate at death and the trust may offer substantial protection of the education funds from the claims of creditors.

The expense and complexity of a formal trust can be avoided by making gift transfers to a custodianship account for a child under the Calif-ornia Uniform Transfers to Minors Act ("CUTMA" - Probate Code §§3900 et. seq.). CUTMA accounts are managed by the named custodian, who is frequently the parent/donor.  Account income is attributed to the minor and taxed at the minor's tax rates unless the IRC §1(g) "kiddie tax" applies in the case of a minor under age 14.  CUTMA accounts often yield a reasonable long term result due to very low administration costs.

Individuals placing education funds in custodianship accounts may not understand the custodianship account rules, which may differ depending on the state laws under which the account is created. Most parents forget that account balances generally pass to the beneficiary at age 18 (or in the case of lifetime gifts up to age 21 if so designated upon the transfer to the CUTMA account), so there is a risk the funds will be diverted from education following distribution.

Custodians may also make distributions for other purposes [Probate Code §3920]. Finally, a donor acting as custodian risks inclusion of the account balance in her taxable estate under IRC §§2036 and 2038 if she dies before the account is distributed.

The Education IRA

An individual may irrevocably transfer funds to an Education IRA for a designated beneficiary and manage the account. Education IRA assets grow on a tax-deferred basis.  Distributions are not taxed to the extent of the beneficiary's "qualified higher education expenses" (such as tuition, fees, books and in some cases, room and board) [IRC §§530(b)(2) (d)(2)].

In 2002, qualified education expenses will also include primary and secondary school expenses, making Education IRAs attractive tools for funding pre-college expenses.

Final distributions of an Education IRA must be made within 30 days of the designated beneficiary reaching age 30 or dying [IRC §520(b)(1)(E)].  Distributions for purposes other than qualified education expenses are subject to a penalty of 10 percent of the amount of the distribution included in income, although limited exceptions apply in the case of distributions following the death or disability of the beneficiary or in the case the beneficiary receives a scholarship [IRC §530(d)(4)].

Finally, Education IRA balances may be included in the beneficiary's estate on his death [IRC §§530(d)(3) and 529(c)(4)(B)].

Education IRAs have flexible rollover provisions that permit transfers to another Education IRA for a beneficiary's "family member" (including the beneficiary's spouse, children and siblings). However, additional transfer taxes can apply if the rollover is to a beneficiary one or more generations below the original beneficiary. [IRC §530(d)(5) and (6)].

Contributions to Education IRAs are not deductible for income tax purposes, but are completed gifts for gift tax purposes and qualify for annual gift tax exclusions [IRC §§530(d)(3)].

Contributions must be made before the beneficiary reaches 18 and are capped at $500 annually per designated beneficiary (increasing to $2000 in 2002) and contributions are phased out for single taxpayers between $95,000 and $110,000 of modified AGI and for joint filers between $150,000 and $160,000 ($190,000 and $220,000 in 2002) [IRC§530(b)(1)


The exclusion from income for distributions from an Education IRA for a specific beneficiary's education expenses must be coordinated with the use of Hope and Lifetime Learning Credits, which will not be available for expenses considered in calculating Education IRA distribution exemptions (no credit is allowed in 2001 if Education IRA distributions are excluded from income) [IRC §§25A(e) and 530(d)(2)(D)].

Qualified tuition programs

Qualified tuition programs authorized under IRC §529 offer substantial tax benefits to clients funding education expenses, irrespective of income. These programs have been implemented by most states.

Qualified tuition credit programs are offered by some states and may be created under the 2001 Act by eligible educational institutions. Under these programs, tuition credits or certificates are purchased for a designated beneficiary and redeemed at specific educational institutions. Tax rules are similar to those for the more flexible college savings programs discussed below.

College savings programs

College savings programs allow a person to create an account for a designated beneficiary within a state- sponsored program (referred to in this article as a "CSP account") to hold funds for higher education expenses. Other individuals may be able to contribute to the account.  Unlike IRA balances, account funds are managed by the state program manager and not the account owner.  Each state college savings program offers different investment options and terms.

Many state programs are marketed or have asset management provided by major financial institutions [TIAA-CREF manages California's Golden State ScholarShare College Savings Trust (]. Clients should be encouraged to compare state programs.

A substantial benefit arises in 2002, when distributions from CSP accounts for "qualified higher educational expenses" are excludable from taxable income. Qualified education expenses include tuition, fees, supplies, equipment and, in some cases, room and board [IRC §529(e)(3)].  Like IRAs, CSP accounts also offer the leverage of tax-free accumulations.

The CSP account owner retains control over account distributions, including the power to withdraw account funds. Annual gift tax exclusions can be used when funding CSP accounts. Individual contributions up to $50,000 can be prorated for purposes of using annual exclusions for the current and following four years, encouraging high initial contributions and increased growth potential [IRC §529(c)(2)(B)].

Account balances are not included for estate tax purposes except on the death of a donor within the 5-year period of deemed annual exclusion use (part of the balance is included in the donor's estate) or where distribution occurs on account of the beneficiary's death (included in her estate) [IRC §529(c)(4); Prop. Reg. §§1.529-5(d)(3)].

CSP accounts have no annual contribution limits although total contributions are limited under state programs to projected higher education costs (limits can be very high and depend on the program).

Finally, under the 2001 Act, family members can contribute to CSP accounts to fund Education IRAs for a beneficiary.

Currently state programs must assess penalties on CSP account distributions not applied to qualified higher education expenses. In 2002, a 10 percent penalty identical to the penalty on unqualified Education IRA distributions will replace the current penalty requirement.

Clients should determine if state plans will assess penalties when no longer required to do so. The 10 percent penalty does not apply to qualified rollovers of §529 accounts to another §529 account for the beneficiary's "family member" (see the discussion under Education IRAs above).

Liberal rollover rules in 2002 will allow clients to move funds between college savings programs, mitigating the owner's lack of control over investments. One transfer of balances between qualified programs will be allowed every 12 months with respect to each designated beneficiary. In addition, the IRS released Notice 2001-55, allowing a qualified program to permit a change in investment strategy once per calendar year.

If multiple CSP accounts and Education IRAs exist for a beneficiary, care must be taken to coordinate distributions and rollovers. Complex rules also apply to coordinate the available income exemptions, credits and deductions (to prevent taking multiple tax benefits from the same expenses).

Even so, using some or all of the above benefits could reap substantial benefits to most families.

Education funding vehicles may impact a student's qualification for need-based financial aid (consider whether accounts are treated as assets of the student or parent and whether distributions are counted in a student's resources). Each funding vehicle has different creditor protection attributes (for example, a CSP account may not be pledged as security for a loan).

Some planning uncertainty also exists, since the above tax favored tools are relatively new. The 2001 Act provisions are due to expire in 2011, unless reenacted. In addition, many unanswered questions remain concerning qualified tuition plans and other programs which require further regulatory guidance. 

Even so, the message is clear - start planning as soon as possible.

Timothy Maximoff is a shareholder at Hoge, Fenton, Jones & Appel Inc. in San Jose and Pleasanton. His practice includes estate planning, business and tax matters. He is a member of the executive committee of the Taxation Section of the State Bar.