CFP Notes: Education Planning

Credits and Tax Planning

Needs Analysis
When a client wants to establish an appropriate saving schedule to fund his or her child’s college education, a financial planner needs to learn the child’s age, the age at which the child will enter college, the after-tax earnings rate of the parents, the inflation-adjusted interest rate, and the current cost of tuition, as well as the rate of increase.

American Opportunity Tax Credit
The American Opportunity Tax Credit (AOTC) is a tax credit available for the first four years of undergraduate study. The credit is worth up to $2,500 per student per year, calculated as 100% of the first $2,000 in “qualifying educational expenses” plus 25% of the next $2,000, with $1,000 of the credit being refundable. Qualifying educational expenses include not only tuition but also books, supplies, equipment, and student fees. Further, the student must be enrolled on at least a half-time basis for his educational expenses to qualify.
This credit phases out for MFJ taxpayers over the AGI range of $160,000 through $180,000, and for single taxpayers over the AGI range of $80,000 through $90,000.

Lifetime Learning Credit and Student Loan Interest
The Lifetime Learning Credit is a tax credit that, unlike the American Opportunity Tax Credit, is available for all the years of undergraduate and graduate study. Tuition is a qualified expense, though books and supplies are not if they are not bought from the school directly. The credit is good for 20% of the first $10,000 paid for all eligible students; the maximum amount per family, then, is $2,000. None of this credit is refundable.
Taxpayers are also allowed to deduct up to $2,500 of interest on qualified education loans as an adjustment to income. This deduction phases out as the modified adjusted gross income reaches a certain level. Any voluntary payments of interest are also deductible. Any nontaxable education benefits, such as distributions from an ESA, will reduce the amount of the deduction.

Qualified Tuition Programs
Qualified tuition programs, also known as QTP or 529 plans, are state-sponsored, tax-advantaged plans that can be used to pay for education, especially undergraduate and graduate education. The Tax Cuts and Jobs Act expanded 529 plans to permissibly fund K-12 education, not merely college expenses. The owner of the account selects the beneficiary, though the contributor will stay in control and will have the freedom to withdraw funds at any time. If the designated beneficiary does not attend college, the owner may select a new beneficiary from the same family. There is a tax-free growth of earnings if funds are withdrawn for qualified educational expenses, which include tuition, room and board, and books and supplies. The SECURE Act of 2019 also permits 529 funds to be used on up to $10,000 of student loan debt. The funds are treated as a gift of present interest, qualifying for the $15,000/$30,000 gift-tax exclusion (as of 2020). Contribution limits vary by state. These plans will have some effect on the amount of financial aid the student is likely to receive. These plans are only successful when they are begun while the child is very young.

Education IRAs

Part One
An education IRA, also known as a Coverdell ESA, is an education savings plan used for undergraduate and graduate-level expenses. The owner of the account will select the beneficiary. Typically, a parent or guardian will establish the account and can elect to maintain control of the account for educational purposes. Withdrawals are paid to the beneficiary and are not refunded to the person who started the account. If the beneficiary does not attend college, the beneficiary may be changed to a member of the beneficiary’s family under the age of 30. Any withdrawals are tax-free as long as they are not greater than the beneficiary’s qualified education expenses for the year.

Part Two
Contributions to an education IRA can be made after the beneficiary reaches the age of 18 only if the beneficiary is a special needs beneficiary. Contributions are not deductible from taxes and can be made to more than one IRA as long as total contributions do not exceed the contribution limit. Withdrawals may be made for tuition, room and board, books, and supplies without penalty. Any earnings are taxed as ordinary income and are subject to a 10% penalty for nonqualified use. The parent or guardian will have a broad choice of investment vehicles for the IRA. An individual may claim the American Opportunity, Hope and Lifetime Learning Credit in the same year that he or she receives a tax-free distribution, so long as the distribution is not used to cover the same expenses for which the credit is claimed.

Savings Bonds
Savings bonds are sold at a discount and pay no annual interest. The interest earned on savings bonds is not taxable at the state and local levels, but it is subject to federal tax. Interest will be excluded from federal income tax if it is used for higher education expenses in the same year that bonds are redeemed. For this to happen, though, the person must be at least 24 years old at the time of issuance and the bond must be registered in the name of the purchaser or the child (if it is intended for the child’s education). The qualified educational expenses for a savings bond include and fees; the cost of books and lodging, however, is not considered a qualified expense. Exclusion is phased out with a high AGI and is not available for married taxpayers filing separately.

CollegeSure CD
A CollegeSure CD can be purchased from the College Savings
Bank and is sold in both whole and fractional units. The annual interest for a
CD of this kind is calculated on the basis of the Independent College 500 Index.
There is no ceiling on how much a CollegeSure CD can earn, and it is guaranteed to keep up with the cost of college. Even if the cost of college does not go up in a given year, the CD will earn a minimum of 4%. The FDIC insures CollegeSure
CDs for up to $250,000, and investors who hold them will pay no fees or commissions. If the student should earn a scholarship or choose not to go to college, the parents will get back all of the money invested plus the accumulated interest.

Other Educational Funding

Government Grants and Scholarships, Perkins Loan
Pell Grants are distributed on the basis of financial need; the greatest amount that can be distributed in a given year is $6,195 for the 2020-21 school year. These grants are available only to undergraduates. Federal Supplemental Educational Opportunity Grants (FSEOGs) are distributed on the basis of financial need, with the maximum amount that a student can receive in a year being $4,000 as of 2020. These grants are available to both full- and part-time students, though the grants are reduced for part-time students.
Perkins Loans are funded by the federal government but administered by the schools. They are distributed on the basis of financial need, with the limit being $5,500 for undergraduates and $8,000 for graduate students. The loans have a 5% rate of interest, and there is a 9-month grace period after graduation before payment is due.

Stafford Loans, PLUS, and SLS
Stafford Loans are available to part- and full-time undergraduates and graduate students. These loans are based on financial need, though there are limits on how much an individual may receive both in a single year and cumulatively. Loans can be either subsidized, meaning the student will not be charged interest until repayment begins, or unsubsidized, where repayment begins at the inception of the loan. The interest rate on any unsubsidized Stafford Loan and a subsidized graduate school Stafford Loan is currently fixed at 6.8%; subsidized undergraduate Stafford Loans have a fixed interest rate of 7.9%. The Parent Loan to Undergraduate Students (PLUS) allows parents to borrow money for college; like the Supplemental Loans to Students (SLS), they are not tax-based and are not available to part-time students.

College Work Study, UGMA, and UTMA
College work-study programs are funded by the federal government and administered by individual schools. Eligibility for these programs is based on financial need, and they are available to both graduates and undergraduates. Students in work-study programs are provided with employment at which they can earn a maximum amount of money while attending school. The Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors
Act (UTMA) were both established to allow parents to set up custodial accounts in a child’s name to help pay for the child’s education. Parents may want to transfer assets to their children in order to reduce the income taxes on the earnings. The money transferred to such an account is an irrevocable gift, and the child may choose to use it for something other than education.

Section 2503(c) Minor’s Trust and Zero-Coupon Bonds
A Section 2503(c) Minor’s Trust allows the transferred trust property to be treated as if it were a gift of a present interest to a child.
For this reason, it qualifies for annual gift tax exclusion. A trust like this is used either when the grantor’s income tax bracket is high and the recipient’s tax bracket is low, or when the grantor doesn’t want an appreciating asset included in the gross estate. If income from the trust is distributed every year, it is taxable to the recipient; if income accumulates, it is taxed to the trust. Another way of funding education is through zero-coupon bonds, which offer no interest during the life of the bond, but the payment of the principal at maturity. These bonds are sold at a discount. Zero coupon bonds are made somewhat less attractive by the fact that the IRS taxes the accrued interest even before the investor receives the funds.

Ownership of Assets
The ownership of assets will affect the amount of financial aid a student is offered. The firm that evaluates a student’s financial aid will use a methodology formula known as the expected family contribution.
Parents can use as much as 47% of after-tax income to pay for college, but no more than 5.6% of assets; capital gains are treated as income. The family will be expected to contribute less to the cost of education if the family saves money in the parents’ rather than the child’s name, as the formula asks students to contribute 35% of their assets to the cost of college. Also, parents can minimize their expected contribution by investing in a 401(k) or other tax-sheltered retirement plan; investments in these plans are excluded when calculating the total value of the assets owned by the parents.