The Best Way to Save for College

The majority of the tax news, as reported by the media and TV, has been about the many major measures included in the Tax Relief Act, such as income tax rate cuts, increases in the adoption, child, and dependent care credits, pension reforms, and estate tax relief. These are all very important items. Certainly the media proclaimed "Tax Rebate" gathered wide attention, although this is not a "tax rebate" at all but an advance payment of a tax credit against 2001 taxes. (Read - Congress pulls a "used car salesman" maneuver on the public.)

But hiding quietly in the Tax Relief Act changes, is the topic for our discussion today. These are the items that are tax incentives for education that are in the new law.

There are tax breaks for paying for higher education costs and there are tax breaks for saving for future education expenses. These new tax breaks begin in 2002 and later years.

Current law permits contributions to a state sanctioned account established to meet qualified higher education expenses of a designated beneficiary (a "savings account plan" known as " Section 529 " plans) or to purchase tuition credits on behalf of a designated beneficiary to be used for subsequent payment of qualified higher education expenses for that designated beneficiary. Currently the earnings portion of the distributions from such "savings account plans" for qualified higher education expenses are taxable to the beneficiary.

The Tax Relief Act eliminates these distributions from the definition of taxable income, so beginning January 1, 2002, qualified withdrawals from Section 529 plans become completely exempt from federal income taxes (and probably avoid state income taxes in many states as well). This applies only to state sanctioned plans but does apply to both the "savings plan" and the tuition credit plan.

The new act still allows the taxpayer to take either the Hope or Lifelong Learning education credits on qualified higher education expenses not paid for by funds distributed from a Section 529 plan. The new law states that only the earnings from Section 529 plans cannot be used for purposes of calculating the educations credit.

Section 529 plans, unlike Education IRAs, do not have phaseout rules relating to the contributor's adjusted gross income and are not restricted to beneficiaries under the age of 18. You can establish a Section 529 plan to benefit any member of your extended family, including yourself.

The Tax Relief Act includes another substantial change to the Section 529 plan. Beginning in 2002, you may do a same-beneficiary rollover as often as once every 12 months. This is not the same as once a year. So be aware, moving the account from one plan to another incorrectly timed could have very negative tax implications. Before attempting any rollover, you should check with your tax advisor. This new feature is interesting, since now it allows you as the account owner to easily change the way you account is invested, despite the general prohibition against participant investment direction that remains in the law.

Also, while considering the Section 529 plan, we now must pay more attention to the Education IRA. It is much more useful, thanks to the Tax Relief Act. Starting in 2002, the annual contribution cap is lifted from $500 to $2000 per year. Tax-free withdrawals will no longer prevent claiming any Hope or Lifetime Learning Credits. And, you will be able to make contributions to the Education IRA and a Section 529 plan in the same year for the same beneficiary without creating a penalty tax.

Several other education savings and payment provisions are in the Tax Relief Act. Here they are:

• Tax-free withdrawals from an Education IRA can be used to pay for qualifying elementary and secondary school expenses, including the expenses for private schools.
• Tax-free withdrawals from a Section 529 plan have to be coordinated with the Hope and Lifetime Learning Credits so that both benefits are not claimed on the same expenses.
• A new above-the-line (pre-AGI) deduction for the payment of college tuition is provided for families with incomes below a certain level. The deduction is offered as an alternative to the Hope and Lifetime Learning Credits, and requires coordination with any Education IRA and Section 529 plan withdrawals taken in the same year.

In fact, good planning is the key to create the best tax advantaged methods of saving and spending for education expenses. You should consult with your tax advisor early, before making any committments, so that they can guide you to the best structure and assist you with the timing involved. Tax preparers, advisors, and financial consultants are studying and learning these new measures with tax savings for you in mind.

While the Tax Relief Act is very helpful in the area of saving for college, it is certainly complex. The various existing education incentives, and the rules surrounding them, are already confusing. The new provisions will increase the amount of confusion. The IRS has a formidable task in developing the necessary guidance for taxpayers and their professional advisers.

And finally, a warning. Be aware that all of the changes made by the Tax Relief Act are set to expire after December 31, 2010. If Congress does not extend or otherwise amend them, things will revert back to the way they work now. So, there is an element of uncertainty in any tax planning that we do now.

Federal & General Information	Complete information and comparisons of Section 529 plans Saving for college using a Section 529 plan Strong suggestion: All professional Tax Preparers, Advisors and Financial Consultants should purchase this excellent book and consider subscribing to "The 529 Plan Report" newsletter. Comparison Ratings and Links to every existing state fund are located here.
North Carolina	College Vision Fund - College Foundation of NC
Virgina	Virginia College Saving Fund

For more information, eMail: taxinfo@electrofile.com