Education Savings Made Easier

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ESAs and 529 plans can help your clients meet rising tuition costs.

By Kirk Okumura

With increasing tuition rates, higher education has become one of the largest financial expenses confronting today's families. However, the federal government has created two tax-advantaged funding vehicles to assist in saving for higher education costs: the Qualified Tuition Program, or 529 plan, and the Education IRA (now known as the Coverdell Education Savings Account or ESA).

529 plan
The 529 plan encompasses prepaid tuition programs and college savings accounts sponsored by individual states. The Economic Growth and Tax Relief Reconciliation Act (EGTRRA) of 2001 stipulates that, effective 2002, 529 plans will include prepaid tuition programs sponsored by an eligible educational institution.

In a prepaid program, you pay future tuition for specified schools at the current price. Most programs now allow you to apply the value of the account toward the tuition of other schools that are not specified in the contract, but will not cover any difference in tuition costs if the selected school is more expensive.

The second type of 529 plan, the state-sponsored college savings account, has more flexibility. Forty states provide for college savings accounts, and most are open to nonresidents, although higher fees sometimes apply. Contributions are allocated either to preset age-based mutual fund portfolios or a small selection of other mutual fund choices. You can apply distributions to any eligible educational institution to pay for qualified education expenses including tuition, fees, room and board (must be at least a half-time student), books and so forth.

With either type of 529 plan, contributions are made with after-tax dollars. Thanks to EGTRRA, the withdrawals for qualified education expenses as of Jan. 1, 2002, are generally received without federal income tax. In addition, 529 plans may be transferred to another member of the beneficiary's immediate family, including the beneficiary's first cousins.

Use an ESA to help pay the costs of private grammar school and secondary education.

Coverdell ESA
The Coverdell ESA works like a Roth IRA. Contributions are made with after-tax dollars to a custodial account funded by mutual funds, stocks, bonds, CDs and other investment options. A cumulative contribution limit is set at $2,000 per beneficiary per year, an increase courtesy of the new rules under EGTRRA. Unfortunately, like the Roth IRA, there are income eligibility limits. For someone filing a single return, the contribution limit begins to phase out at $95,000 and is completely phased out at $110,000. For those filing a joint return, EGTRRA has increased the income eligibility so that the phase out begins at $190,000 and is completely phased out at $220,000. In addition, contributions can only be made until the beneficiary turns 18.

Like the 529 plan, withdrawals from an ESA to pay for qualified education expenses are received without federal income tax. However, funds must be completely withdrawn or transferred to another eligible beneficiary within 30 days of the beneficiary's 30th birthday, or income tax and penalties will apply to the earnings.

Making a choice
The 529 plan has no income eligibility limits; anyone can contribute regardless of his or her income level and can receive contributions until the account value reaches from $100,000 to $250,000, depending on the state. The $2,000 per-year contribution for an ESA pales in comparison.

Moreover, 529 plans allow those saving for education to contribute up to five times the annual gift exclusion without incurring a gift tax-as long as they don't gift any more money to that beneficiary for the subsequent five-year period. For 2002, that amount is $55,000 for an individual and $110,000 for a married couple. This makes the 529 plan an important and valuable estate-planning tool.

As far as funding post-secondary education, an ESA gives you more control over the investment options. If this type of control is important to your clients or prospects, their first $2,000 could go into an ESA.

EGTRRA benefits
EGTRRA may have extended ESAs' shelf life by liberalizing the definition of qualified education expenses to include those associated with kindergarten through grade 12. An ESA now can be used to help pay the costs of private grammar school and secondary education. In this respect, an ESA has no competitor.

Fortunately, those who would like to use an ESA for either of these reasons can still contribute to a 529 plan, since EGTRRA has also eliminated the penalty for making contributions to an ESA and a 529 plan in the same year.

No matter which option clients choose, it's important to protect these goals from the loss of income through death or disability. Show your clients the benefits of protecting their plan against that possibility. Any financial goal of that size is one worth insuring.

Kirk Okumura is an LUTC author and editor. You can reach him at kirko@amercoll.edu.

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