A primer: Section 529 plans, Coverdell Education Savings Accounts , and other tax-smart ways to save for college - Education IRAs - individual retirement accounts

Army Lawyer, April, 2004 by Craig D. Bell, Maureen C. Ackerly

Introduction

Benjamin Franklin once observed, "An investment in knowledge always pays the best interest." (2) As legal assistance attorneys, clients frequently ask: What is the best way to save or pay for education, especially college education for children and grandchildren? There really is no one "best" answer or resolution to this question. Many more options are available today than ever before. Traditionally, we have counseled clients on the use of custodial accounts such as the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA). (3) These standby methods are quite appealing now that Congress has lowered the capital-gains tax rate that effectively reduces the tax rate most children will pay on any gains in their stock portfolio to between eight and ten percent. (4)

We have also counseled clients on the use of U.S. Savings Bonds, such as Series EE bonds issued after 1989 and all Series I (inflation adjusted) bonds. (5) For married taxpayers with adjusted incomes of $117,750 or less ($73,500 for single tax return filers), some or all of the interest earned on these bonds is tax-free if used for higher education expenses. (6) Consumers' main complaint about them is their low interest rate.

In addition to the traditional savings techniques discussed above, Congress has recently introduced tax incentives to promote education savings, including prepaid tuition and education investment plans commonly referred to as 529 Plans (after Section 529 of the Internal Revenue Code which governs them), Coverdell Education Savings Accounts (formerly called Education IRAs), Hope Scholarships, and Lifetime Learning Credits. (7) This article focuses on 529 Plans and Coverdell Education Savings Accounts. The appendices provide supplemental statutory guidance.

Background

Increasing Cost of Higher Education

The College Board compiled data from 2001-2002, which shows an increase of 9.6% in college tuition and fees at four-year public institutions, and 5.8% at four-year private institutions, as compared with a 1.2% annual increase in the Consumer Price Index. (8) The increase in tuition and fees from 2000-2001 was 4.4% and 5.2%, respectively. (9) College costs increased an average of 7.7% per year during the period 1971-2001, in comparison to an average 5.1% annual increase in the Consumer Price Index over the same period) (10) From 1989 to 1999, college costs increased at more than twice the rate of the Consumer Price Index (5.6% versus 2.3%). (11)

The economic importance of higher education has also increased. United States Census Bureau statistics show the annual income for a person with a college degree is more than eighty percent higher than for a high school graduate. (12)

In 2020, the College Board projects average college costs for four years of tuition and fees, books and supplies, room and board, transportation and other expenses, as $271,698 for private institutions, and $123,487 for public institutions. (13) Using present costs of actual institutions and projecting to 2020 (assuming five percent inflation rate in college costs), the "in-state" cost for four years of attendance at SUNY-Albany (a four-year public college) will be $130,272, the "out-of-state" costs for Michigan State University (a four-year public college) will be $204,676, and the cost for Columbia University (a four-year private college) will be $358,547. (14)

Predominant Financial Concern

According to the College Savings Plans Network, a non-profit affiliate of the National Association of State Treasurers, public opinion polls indicate the greatest financial concern of most American families has shifted from the ability to save sufficient retirement assets to the ability to pay for children's college education). (15)

In August 1995, the United States General Accounting Office (GAO) published a report on state tuition programs in existence at that time. (16) According to the GAO report:

   When asked on Alabama's program application
   how they would save for college costs
   without the tuition prepayment program,
   about 52% of purchasers in 1991-1994
   checked "savings account," about 17%
   checked "savings bonds," about 15%
   checked "life insurance," and only about 6%
   checked "stocks." With passbook savings
   accounts currently offering less than 3%, it
   appears that a large percentage of Alabama's
   participants would be putting their money in
   investments that would be expected to provide
   a lower return than the anticipated rate
   of tuition inflation, about 7-8% per year. (17)

According to an Alliance/Harris College Savings Poll (August 2001), families expect to save only $20,000 for college costs, but expect to pay more than $80,000. (18)

Traditional Education Savings Techniques

Traditional education savings techniques include gifts to a student or for the student's benefit, and tuition payments made directly to the educational organization. Girls of up to $11,000 per year or $22,000 if the donor is married (19) to a beneficiary outright, a custodial account for a beneficiary, or certain types of trusts for a beneficiary, qualify for an annual exclusion from gift tax. (20) They are treated as nontaxable gifts" for purposes of generation-skipping transfer (GST) tax. (21)