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
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),
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)
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
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
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
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 (www.scholarshare.com)].
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
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
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.
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
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.