Pomp, Circumstance and Tax Shelters
By: Susan Garland Source: AARP.org Date Posted: 2006-06-08 11:02:20.249597-04:00
Ask teachers what they most value, and they'll likely name education and family. Starting a college-savings plan is a good way of addressing both priorities. Retired teachers can help with their grandchildren's college costs while also leaving a legacy of learning-and they may also reap some tax benefits for themselves. The following are the top plan choices:
Option 1: A 529 plan
Grandparents looking for the best tax advantages, especially in the current bear market, should consider a 529 college investment plan. Every state has set up its own 529. Earnings on contributions are exempt from federal income tax, though there is no federal deduction for contributions.
Grandparents can set up an account in any state but should check the plan in their home state first. Many states now allow residents to take a state deduction for their contributions-up to $5,000, for example, for an individual ($10,000 for joint filers) under plans in both New York and Michigan. A state tax deduction only applies if you set up the account in your state and your state offers such as deduction. An excellent website, www.savingforcollege.com, offers comparisons of all state plans and links to each plan's site.
A 529 plan also is ideal for grandparents with large savings who want to reduce the taxable portion of their estate. Each grandparent can contribute $55,000 in one year for each grandchild without paying taxes on gifts over $11,000.
Another advantage is that grandparents can choose to take back the money, paying taxes and a 10 percent penalty only on the accrued earnings. Also, they can change the beneficiary at any time. For example, if a retiree decides to continue her own education, she can make herself the beneficiary. In short, a retired teacher can set up a 529 for herself.
Option 2: A Coverdell Education Savings Account
A Coverdell, formerly known as the Education IRA, may be the right choice for grandparents who have limited funds. With a Coverdell, a single filer with less than $95,000 in adjusted gross income can contribute up to $2,000 for each grandchild. Like a 529, earnings are usually not subject to federal income tax. Unlike a 529, however, a Coverdell is not tax-deductible in any state.
One advantage is that the grandparent controls how the money is invested. State 529 plans are usually managed by firms such as Fidelity or TIAA-CREF and thus offer limited investment options. A Coverdell allows a grandparent to invest in a favorite stock or low-fee index fund. However, a grandparent cannot get his money back once the account is opened, as he can with a 529.
With the Coverdell, the maximum annual contribution for each beneficiary is $2,000 a year. If a parent also has contributed $2,000 to a Coverdell, the grandchild will pay a 6 percent excise tax on excess contributions, so grandparents need to coordinate with their children.
Option 3: Uniform Transfer to Minors Act (UTMA)
Establishing a custodial account-a type of trust-under the UTMA offers some tax breaks. The first $750 in earnings is tax-free and the next $750 is taxed at the child's lower rate. But once the money is deposited, it belongs to the grandchild. And the money does not need to be spent on education. If the child wants to blow it on a car, there's nothing a grandparent can do about it.
Option 4: Just Pay Up
You may find that your best bet is to just pay the bills at the time they're due. Assets and earnings in a 529, Coverdell, or UTMA could reduce the student's chances for aid, though 529 rules are still up in the air. This is why grandparents need to coordinate their plans with their children. Philip Johnson, a certified financial planner in Clifton Park, New York, says the family could opt for a grandparent to simply pay part of the tuition.
"Make sure the grandparent sends the check directly to the college," he says. "Otherwise it becomes part of the parents' assets for financial aid calculation."
No matter which plan a grandparent chooses, warns Dean Knepper, a planner at Lifetime Financial Planning in Leesburg, Virginia. "I would advise them to have, at most, 60 percent in stocks during the early years and no more than 20 percent in stocks as the child nears college."
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