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College Planning in the Wake of New Tax
Laws
Planning for college has never been easy. But such planning
became a bit easier when President Bush signed the TIPRA and DRA
into law earlier this year. Among other things, DRA and TIPRA
changed the treatment of pre-paid tuition plans and 529 plans,
two popular vehicles Americans use to save for and pay for
college.
Chief among the changes are those that pertain to the
so-called "kiddie tax." Effective in 2006, the new law
calls for the "kiddie tax" to remain in effect until a
child turns 18. Previously, unearned income attributable to
children age 14 and older was usually taxed at the child's tax
rate. The new tax law, however, raises the age to 18 effective
January 1, 2006. Exceptions apply for minor children who are
married and file a joint tax return, and distributions from
certain qualified disability trusts.
This change affects parents
and grandparents who were or continue to use custodial accounts
such as UTMAs (Uniform Transfer to Minors Act) or UGMAs (Uniform
Gift to Minors Act) for college savings instead of 529 college
savings plans. At present, UTMA and UGMA dollars are considered
the child's asset in the financial aid formula. But selling
funds, or at least selling funds that have appreciated in value,
in an UTMA or UGMA prior to a child turning 18, could create a
significant tax bill. What's more, assets in UGMA and UTMA
accounts become the child's at the age of maturity, which varies
by state.
For many parents and grandparents, the new law makes
529 plans a more viable savings vehicle. With a 529 plan,
contributions will grow tax-free and withdrawals are tax-free
through 2010 as long as they are used for qualified education
expenses. In addition, financial planners note that with 529
plans, the parent or grandparent controls the money.
Of course,
parents and grandparents who established UTMA and UGMA accounts
to pay for college education do have options. Under the act,
UTMA or UGMA assets can be invested in a 529 plan, although
assets have to be liquidated and cash invested in the plan.
Doing so may create a tax burden, but financial planners note
that it may be more than offset by preferential treatment of 529
plans in the financial aid formula. A tax analysis should be
performed to determine the impact.
According to SavingforCollege.com, 529 plans do indeed receive preferential
treatment. Sometimes referred to as the "529
loophole," the new law removes student-owned 529 plans and
Coverdell education savings accounts from the expected family
contribution ("EFC") in the federal financial aid
formula. A 529 account or Coverdell ESA is considered an asset
of the account owner; however, 529 accounts or Coverdell ESAs
owned by a dependent student are excluded from the Free
Application for Federal Student Aid or FAFSA. Most
undergraduates are dependents for FAFSA purposes.
This is
exceptional treatment, reports SavingforCollege.com. Under the
federal financial aid rules, college savings plans are counted
as an asset of the parent (if the parent is the account owner)
and assessed at a rate of 5.6 percent. This means that 5.6
percent of the funds are deemed available for college expenses
in the year a student applies for aid. By contrast, 35 percent
of assets owned by the student are used to calculate the EFC.
In addition,
parents and grandparents who have been using prepaid tuition
plans to save for their children's college education received
some good news on July 1, 2006 when the federal government began
treating 529 prepaid tuition plans the same as 529 college
savings plans for financial aid purposes.
Distributions
(withdrawals) from a college savings plan that are used to pay
the beneficiary's education expenses are not counted as either
parent or student income. Prepaid tuition plans will now be
treated the same way.
By way of background, prepaid tuition
plans prior to July 1, 2006 were treated differently than
college savings plans under the government's financial aid
formula. A prepaid tuition plan wasn't counted as an asset of
either parent or student, but any distributions from the plan
were considered a "resource" that reduced the cost of
attendance at any given college. And that resulted in a
corresponding dollar-for-dollar reduction in financial aid. That
is, every dollar that flowed out of a prepaid tuition plan
reduced the beneficiary's aid award by one dollar. The new
financial aid rules ensure that both types of 529 plans will be
treated equally.
August 2006 — This column is produced by the Financial
Planning Association, the membership organization for the
financial planning community, and is provided by Don McCarty of
Financial Decision Partners, a local member of the FPA.
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