There are many ways to prepare for elementary, secondary, and college expenses for your children or grandchildren. One of the most popular education savings vehicles is the use of a qualified tuition program, often referred to as a Section 529 plan, but there are other vehicles that should also be considered. Below is a brief description of how you can incorporate each vehicle into an effective educational and other needs funding plan for your child or grandchild. The best results come from using a combination of these options.
1. ESTABLISH A COVERDELL EDUCATION SAVINGS ACCOUNT (ESA)
Contribute up to $2,000 per year to a Coverdell ESA established for a child or grandchild. This account should usually be established by the parents. This tax-advantaged savings vehicle lets you save money for the qualified education expenses of
a named beneficiary, such as a child or grandchild. Qualified education expenses include college expenses and certain elementary and secondary school expenses. ESA’s can provide more flexible investing options compared to 529 college savings plans. The donor to the ESA must meet the modified adjusted gross income limits (MAGI). Married couples filling jointly with a MAGI of less than $190,000 ($95,000 for single filers) can contribute up to the full amount. Meanwhile, married couples filing jointly are completely passed out with a MAGI of $220,000 ($110,000 for single filers).
2. ESTABLISH A GIFT TO MINOR ACCOUNT (REFERRED TO AS UNIFORM TRANSFERS TO MINORS ACT [UTMA])
UTMA accounts are a simple way for a minor to own securities without requiring the services of an attorney to prepare trust documents or the court appointment of a trustee or guardian. Contributions can be made by anyone to UTMA accounts, which are usually established by a parent. There may be other lifetime expenses related to education or other needs that are not eligible to be paid by an ESA or 529 plan. Therefore, establishing a UTMA account could meet those additional needs.
However, parents should be mindful of the “kiddie tax” if they choose this option. The ‘kiddie tax” applies to children who are under 18 years and full-time students under 24 years. . If the child’s unearned income “investment income” is more than the kiddie tax threshold which is $2600 for 2024, then the child’s unearned income in excess of the threshold is subject to the kiddie tax and gets taxed at the parents’ marginal tax rate rather than the child’s tax rate. The kiddie tax threshold is adjusted for inflation each year. Under the “kiddie tax, the child’s first $1,300 of unearned income if tax free. The next $1,300 is subject to the child’s tax rate of 10%. Any additional unearned income above $2,600 is tax at the parents’ marginal tax rate. “Investment income” includes – capital gains, dividends, and interest income
Kiddie tax does not apply to the child’s salary or wages from working. That income is taxed at the child’s rate and qualifies for a larger exemption from tax. However, if the requirements are met, the kiddie tax will still apply to the child’s unearned income.
FOR EXAMPLE: Assume your child’s investment portfolio generates $2,600 of investment income, and has no other income. The first $1,300 would be tax free, the next $1,300 would be subject to a 10% tax or $130. This means the tax burden is only 5 % of the income generated, probably much less than your tax bracket.
3. ESTABLISH A 529 PLAN ACCOUNT
A 529 Plan may be established by a parent, but anyone can contribute to it. This education savings plan is designed to help set aside funds for future college costs. Also, up to $10,000 a year can be used for elementary and secondary tuition (but not other qualified education expenses). Named after Section 529 of the Internal Revenue Code, contributions to the 529 plan are treated as a gift to the beneficiary and are subject to gift tax annual exclusion limits ($18,000 for each donor or $36,000 for a married couple). Special rules allow you to use up to five years of the annual exclusion amount for a gift to a 529 Plan ($90,000 for each donor and $180,000 for a married couple). Some states allow an income tax deduction for contributing to a 529 plan.
4. ESTABLISH A GIFT TRUST
Families that have more complex situations may want to have an attorney draft a gift trust. Trust can continue beyond age 21 for the child’s benefit and be used for a wide variety of needs. Income is taxable to the trust and/or beneficiary.
5. ABLE ACCOUNT FOR CHILDREN WITH A DISABILITY
As a result of the passage of the Achieving a Better Life Experience Act of 2014, or better known as the ABLE Act, ABLE Accounts, can be created for your child or grandchild with disability. ABLE account is a tax-advantaged savings account to which contributions can be made to meet the qualified disability expenses of the owner, or designated beneficiary.
The beneficiary of the account is the account owner, and income earned from the accounts will not be taxed. Contributions to the account made by any person (the account beneficiary, family members, or friends) will be made using post-tax dollars and will not be tax deductible. Some states may allow for state income tax deductions for contributions made to an ABLE account.
A “qualified disability expense” means any expense related to the designated beneficiary as a result of living a life with disabilities. These may include education, housing, transportation, employment training and support, assistive technology, personal support services, health care expenses, financial management, administrative services, and other expenses which help improve health, independence, and quality of life. Individuals needing greater funds should also explore a special needs trust in lieu of or in addition to an ABLE account.
For more information visit: https://www.ablenrc.org/
6. DIRECT PAYMENT OF MEDICAL AND TUITION EXPENSES (not a gift for tax purposes so no dollar limit)
The gift tax rules under IRS Section 2503(e)(2) exclude gift payments of tuition made directly to an educational organization or directly to any person or organization who provides medical care for the benefit of another person such as a child or grandchild.
Annual gifts to the above strategies cannot exceed $18,000 per year by any one individual (between all of above strategies) for any one donor or that donor may have a gift tax liability. However, the direct payment of medical and tuition has no dollar limit as it is not a gift.
About the author: Robert Scharar is President of FCA Corp, a registered investment advisory firm located in Houston, TX and President of the Commonwealth International Series Trust mutual funds. He is also an attorney and a CPA.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.