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Q: Our children won't be in
college for ten years. Why should we think about saving for college
now?
A: Whether
you are married or divorced, your children are likely to look to the two
of you to help finance their college education. Saving for college
will be even harder after a divorce than before. So if you want your
children to go to college, you have to think about it now and make firm
plans.
Q: What can I do about
it now?
A: You can
agree now whose responsibility it will be to pay for college (or how the
two of you will share that cost). You can even agree on regular
payments into a college fund as part of child support.
There are a number of provisions of the tax law that make it easier to save for Education expenses:
Q: What is the Best Way to Save for College?
The best way to save right now may be 529 savings plans.
529 plans are a wonderful way to have income accumulate for your child's college education, tax-free. The catch is that, for now, the best feature of the plans -- freedom from taxation even when the money is distributed out -- is due to expire after 2010.
If your child is going to college after that, 529 plans are still great savings vehicles, but there is a measure of uncertainty as to how beneficial these plans will be.
529 named after the tax-code section (Section 529) that authorizes them.
You can establish a separate 529 plan for each child, and you contribute separately to each child's plan.
Contributions to the account are not tax-deductible on your federal income tax return. They may be tax-deductible on your state income tax return, depending on the plan and the state. In any case, funds invested in the plan grow without incurring taxes on the gains.
Then, when you sell the securities and spend the money in the plan on qualified education expenses during 2002 through 2010, you don't have to pay any tax on the gains. For expenditures from 529 plans during these years, this is also one of the best and rarest benefits the tax law has to offer: income that is never taxed.
For expenditures during 2011 and later years, each withdrawal is considered to be part income and part return of the principle investment. The income portion is taxed to the student (not the parent). The return of principle portion is not taxed at all.
Expenses do not qualify if they were paid with cash for which the Hope Credit or Lifetime Learning Credit (see below) were claimed.
For upper-income taxpayers, 529 plans can be a real boon. This is because parents may make contributions into a 529 plan no matter how high their income.
Money saved in a 529 plan may be used to pay tuition and most, if not all, room and board.
You may transfer funds from one child's account to another. You would do this if one child does not need them.
After a divorce, the parents may each fund a separate 529 account for a given child. Similarly, parents and grandparents may fund separate 529 accounts for the same child.
If you hit hard economic times and have to take the money out of the account, though, you pay not only taxes on any gains, but a penalty equal to 10% of any gain in value of the account over the amount contributed.
The plans are sponsored by individual states. In some states, you can contribute as much as $250,000 over your lifetime.
Also, the treatment of 529 plans may be more favorable than pre-paid tuition plans (see below) with respect to financial aid you may receive.
A note about bad economic times: Losses that you incur from investments in 529 plans are not tax-deductible. If you believe that your investments are going to lose money, you might want to hold off investing in a 529 plan until that belief changes.
The plans are owned by the beneficiary. Thus, a deposit into a 529 plan account is a gift to the beneficiary. In general, for gifts from one person to another of up to $10,000 per year, there is no gift tax to pay. (Thus, two parents can give a combined total of $20,000 to a child without having to pay a gift tax.)
But with 529 plans, there's a little extra benefit. An individual can give up to $50,000 to a child's 529 plan and be treated as having given $10,000 per year for five years. So a family can "front load" its gift without paying gift tax. A mother and father can give a combined gift of $100,000 without triggering a gift tax.
One difference between a 529 plan and an Education Savings Account is that with a 529 plan you have a limited ability to choose the investments. You can set a target amount to be invested in stocks versus bonds, but that's all. (You can also choose for the amount to start out in stocks and gradually sift to bonds.) The IRS lets you shift the investment strategy once a year. But the fund manager, not you, chooses which specific stocks, bonds, or mutual funds to invest in.
Also, pay attention to any fees that the fund management company may be charging. While the fees will not be enough to offset the tax benefits, you might want to set up with a company that charges relatively lower fees.
At the independent web site www.savingforcollege.com, you can compare various 529 plans.
Q: What are Prepaid Tuition Plans?
Prepaid tuition plans are taxed similarly to 529 plans.
The difference is in how the money is applied. In prepaid tuition plans, you are guaranteed that if you invest an amount equal to today's tuition at a state school, the fund will pay your child's tuition when the child attends, regardless of what tuition costs at that time.
If the child attends private college, or an out-of-state college, the fund will contribute the same amount, that is, the cost of the state school in the year your child attends college.
Q: What about Education Savings Accounts (formerly Education IRAs)?
You can now contribute up to $2,000 per year to an Education Savings Account for any child of yours (or other qualified beneficiary) who is under age 18.
If you have three children, you may set up three accounts, and contribute a total of up to $6,000 per year.
The contributions to the account are NOT tax-deductible.
However, funds invested in the plan grow without paying taxes each year, just as they do in an IRA or 401(k) plan.
Then, when the funds are withdrawn from the account, they can come out tax-free -- as long as they are used for qualified education expenses. Funds may be used for tuition, fees, books, supplies, equipment, computers and educational software, and, for half-time or full-time students, most room and board.
Expenses do not qualify if they were paid with cash for which the Hope Credit or Lifetime Learning Credit (see below) were claimed.
Where expenses do qualify, Education Savings Accounts offer one of the best and rarest benefits the tax law has to offer: income that is never taxed. The income on the money in these accounts is never taxed, as long as it is used by a qualified beneficiary for qualified education expenses.
The money can be used to pay qualified expenses at elementary schools, middle schools, high schools, and colleges. The schools may be public, private, or religious.
The ability to use the funds for religious private schools is controversial. We might point out that, in most cases, the children will be so young that the investments will not have had time to generate much tax benefit before being spent on tuition.
If the child does not use the funds at all, you may transfer the funds to another qualified beneficiary's account (for example, that of a younger child).
If the funds just stay in the account, the child can take them out when he or she turns 30 -- but at that time the child will have to pay taxes and penalties.
Upper-income taxpayers see their ability to use this benefit gradually phased out as income rises. For taxpayers who are not "married filing jointly," the phase-out starts at a modified adjusted gross income level of $95,000 per year. Taxpayers who are not filing jointly and who have modified adjusted gross income of more than $110,000 in a given year may not make a contribution at all in that year. (For couples who are married filing jointly, the numbers are $190,000 and $220,000.)
Thus, two parents who earn equal incomes are in the same situation whether married or divorced.
Divorce Tip: If one parent earns the bulk of the family income when the couple is married, and that income is over $220,000, the divorce actually frees up the other parent to make contributions to an Education Savings Account, where he or she could not do so before.
A note about bad economic times: Losses that you incur from investments in Education Savings Accounts are not tax-deductible. If you believe that your investments are going to lose money, you might want to hold off investing in an Education Savings Account until that belief changes. Or, invest, but keep the investment in safe income-producing securities, such as money-market funds.
Q: My Parents Saved Using Uniform Gifts to Minors Accounts. Is this still worthwhile?
It is not as tax-advantaged as the other ways of saving. But for relatively small amounts (under $5,000 total), it's fine, and it's easy to set up.
A Uniform Gift to Minors Account allows you to give gifts to your children, up to $10,000 per year per child. (Father and mother may give a combined total of $20,000 per year per child, whether or not they are married to each other at the time.) Amounts beyond this limit are subject to gift tax when the gifts are made.
Income on funds in these accounts are NOT tax free. However, a portion of the income is taxed at the child's rate, which typically is lower than the parent's rate.
For children under age 14, the first $750 of income is tax-free. (If the investment is yielding a 10% return, for example, that would mean that returns on the first $7,500 invested is tax-free.)
For children under age 14, the next $750 is taxed at the child's tax rate (which is typically the lowest tax bracket, now 10%).
Income of children under age 14 that exceeds $1,500 is taxed at the parent's tax rate. (That is, it is taxed as if it were the parent's income.) If the parents are divorced, the parent taxed is the one who claims the exemption.
If your children have income from investments (such as stocks, bonds, or mutual funds), this income is a factor to consider in deciding which parent claims the exemption for the child.
This factor rubs in the other direction from the usual consideration. Usually, you want the child to be claimed by the parent with the higher income, because that parent gets more tax benefit from the exemption. But if the child has investment income over $1,500, that income imposes more of a tax burden on the parent with the higher income. Parents in this situation need to weigh these two factors against each other to figure out which arrangement has the greater tax benefit on balance.
For children age 14 or older, all income is taxed at the child's own rate.
Q: If I'm Paying Tuition, What Tax Deductions and Other Tax Benefits Are Available?
There is now an array of tax deductions and other benefits for people who are attending college or graduate school.
One or more of these may be of interest to the divorcing spouse who is returning to school himself or herself.
- The student loan interest deduction allows the deduction of up to $2,500 of interest paid on student loans. There is a phase-out at upper income levels.
- The deduction for higher education expenses will apply only for the years 2002 through 2005. It allows a deduction of up to $3,000 in 2002 and 2003, $4,000 in 2004 and 2005. There is a phase-out at upper income levels.
- The Hope Scholarship Credit gives you a dollar-for-dollar tax reduction of up to $1,500 for tuition for the first two years of college. The person claiming the credit must be the one who claims the child as a dependent.
- The Lifetime Learning Credit reduces your tax 20 cents for every dollar spent on tuition, for up to $5,000 of tuition. In 2003, this will cover up to the first $10,000 of tuition. The person claiming the credit must be the one who claims the child as a dependent.
- An exclusion for education paid by your employer. If you employer pays for your qualified education, you don't have to report that benefit as taxable income.
- An exclusion from income for certain qualified scholarships. If you receive certain qualified scholarships from your college or university, you do not have to report that income as taxable.
- The exclusion of certain income derived from the forgiveness of student loans allows that imputed income to be excluded.
- An exclusion of interest earned on U.S. savings bonds that are used to pay for higher education allows that interest to be earned tax-free.
- The allowance of IRA money to be used for education expenses without paying a penalty on an early distribution lets you use money from your own IRA, in certain circumstances, to fund your child's education, without paying the 10% penalty normally paid on an early withdrawal from your IRA.
Q: For what other major
expenses should we plan?
A: The big
ones are orthodontia (braces), summer camp, and private school. In
some states, the judges are very sympathetic to suggestions that amounts
to cover these things should be added on to child support amounts -- as
long as the child would have had these things within the marriage.
Q: Can the Family Law Software Planner help?
A: Yes. the Family Law Software Planner can help you by quickly showing how much income each of
you will have with a given set of proposed expenses.
You can then negotiate from a position of
knowledge, not ignorance.
Also, with respect to those tax credits
that depend on claiming the exemption, the Planner will point those credits
out as it walks you through your plan. You can arrange things so
that the person who pays the tuition is also the one who claims the tax
exemption.
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