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Bring balance to your education planning

By Anthony J. Gambacorta

With the stock market in its third year of decline and economic uncertainty weighing on the minds of many investors, paying for college seems like an impossible dream. Given today’s intense economic pressures, many parents view education costs as a tradeoff between funding their children’s education needs and their own retirement. This is because parents plan on saving money for their children to go to college, and then promptly pay their tuition in four years. This process often leaves parents feeling cash poor, just as they begin to focus on their own retirement.

As an alternative, parents should consider treating education costs as a capital investment, rather than as an expense. As with other capital expenses, payment for your child’s education can be designed to match the length of time it is expected to be used.

While 529 Plans and Coverdell IRAs can be excellent vehicles for reducing taxes to pay for education, the primary goal each plan is to save for college as an expense. We will explore the 529 plan’s features and compare them to an additional option: creating a Special Purpose Investment Account.

Special Purpose Accounts

A Special Purpose Investment account is a flexible planning concept which recognizes the fact that paying for a child’s education and making assumptions about your financial future 15 to 20 years ahead of time is very difficult. While the account is designated to fund your child’s education, it can also be used to meet additional objectives, once the education goal is reached.

The Special Purpose Investment account offers families a number of benefits. First, since the account is titled in the names of parents or relatives, it is controlled by them. In addition, there are no strings attached to this type of savings. They are personal funds in all respects, to be used at the owner’s discretion.

The account can be used to repay student loans and spread the investment in a college education over 10 to 15 years. For example, assume a student borrowed $125,000 to pay for college expenses. At a 7.00 percent interest rate, the loan payment would be $1,451 per month for ten years. Also assume that $7,500 per year was saved and invested at an eight percent return in the 15 years prior beginning loan payments. For tax purposes, assume that one-half of the return will be taxed at a capital gains rate of 20 percent and one half of the return will be taxed at an ordinary income rate of 39.6 percent. Given these assumptions, the portfolio would be worth $178,826 when the account begins to make student loan payments.

In this scenario, with payments beginning at graduation, the Special Purpose Account would still have a balance of $83,130 after the loans are paid in full. This balance can be used by the parents to supplement their own retirement or to meet other obligations. It can also be used to assist children with a down payment on a new home, or for gifting over the years.

The Special Purpose concept is fully taxed as it is earned. As a result, investments in the account would be negatively impacted by taxation.

Section 529 Basics

Section 529 plans allow the contributions to grow tax-free and, if used for “qualified education expenses,” there is no tax imposed on the income that is earned and used to pay for those expenses. These qualified expenses include tuition, room and board, books or personal computers required for college.

However, if not used for qualified education expenses, the income is taxed and a 10 percent penalty is imposed on withdrawals. The tax and penalty rules are waived if the beneficiary dies or becomes disabled.

The tax advantages of the 529 plan are excellent. Being able to contribute to a plan, have the funds grow and withdraw them tax free to pay for expenses can be a tremendous asset. For example, a parent saving $7,500 per year for 15 years and earning an eight percent return can expect to accumulate $219,132 in the 529 plan. In addition, beneficiaries can be changed, so if one child decides not to go to college, the account beneficiary can be changed to preserve the tax advantages and pay for his or her education. The new beneficiary must be related to the old beneficiary by blood or marriage.

The primary disadvantage of the 529 plan is that you lose some flexibility in order to gain tax advantages. Take note of the term “qualified education expenses.” This term only applies to college or graduate school expenses. So, if you are saving for college and your child decides not to go to college, or the plan is overfunded, then tax is due on income earned, plus a 10 percent penalty. In addition, this income is taxed as if it is ordinary earned income and does not benefit from more favorable capital gains treatment.

In the case of 529 plan overfunding, let us assume that the family spent $125,000 for college, had no other children going to college and had no other educational expenses. The $94,132 surplus ($219,132 less $125,000 cost) would be subject to ordinary income tax, plus a 10 percent penalty when withdrawn. For illustration purposes, the $94,132 would be taxed at a Federal rate of 31 percent, plus a 10 percent penalty. As a result, the net amount taken out of the 529 would be $55,537 at the end of the child’s education. Therefore, it is important that you reasonably fund the 529 plan or you will forgo capital gains tax treatment and potentially have to pay an additional 10 percent penalty on top of ordinary income rates.

Coverdell IRAs

Coverdell Education Savings Accounts were expanded on January 1, 2002, to allow taxpayers to contribute up to $2,000 per year if their adjusted gross income was $95,000 or less in the case of a single filer, or $190,000 if filing jointly in the year in which the contribution was made.

The primary features of the Coverdell are similar to the 529 plan; however, there are some provisions that make them particularly attractive.

There is no deduction for contributions for the Coverdell. However, the earnings can grow tax free within the account and be withdrawn without taxation, as long as the purpose is for “qualified education expenses.” These qualified expenses are much broader than just the college and graduate costs in the 529.

The Coverdell will terminate when the beneficiary reaches age 30, and unlike 529s, the funds cannot come back to the donor, so once the money is given to the child it cannot be taken back.

The primary advantage of the Coverdell IRA is that it can be used for elementary and secondary school education. While there are a wide number of loan programs, student aid and grants for college, getting kids through elementary school and high school can also be very expensive. Given the wide range of potential eduation expenses, Coverdell accounts can make an important contribution to a child’s elementary education.

The Best Solution?

As with all things in life, moderation appears to be the best course. Rather than rushing out and funding a 529 plan with all of your savings, consider a balance between the tax advantages of a 529 plan and the flexibility that comes with a Special Purpose investment account. In addition, the Coverdell IRA can offer significant benefits to those who expect to use funds to pay for elementary and secondary school education.

Anthony J. Gambacorta is Chief Investment Officer of Preswick Capital Management, LLC in Media. Pa.

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