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U.S. Savings Bonds - Are they a Good Way to Save for College Education Costs?

During much of September I had discussed investing for higher education.  In particular, I went over some common ways to achieve this goal including regular investments, Coverdell savings (Education IRAs), and the popular 529 plan.  I briefly touched on how some of these investments can affect financial aid received.  This week, I will go over using savings bonds.

U.S. savings bonds are issued by the U.S. Treasury department and are backed by the full faith and credit of the United States Government.  While these bonds offer advantages, they also have some restrictions that you should be aware of.  With so many ways to save for college savings, it's very important to choose the option that suits your goals!

Savings bonds are seen as desirable by some because in certain cases, interest that would otherwise be taxable for federal purposes can be excluded if used for qualified education expenses.  Not all savings bonds qualify however.  All series I and series EE bonds issued after 1989 are eligible.  Another very important criterion is that the bond owner must be at least 24 years old before the bond's issue date!  Many people are not aware of this restriction and are therefore not able to take the exclusion on interest even if used for proper qualified education expenses.

A good example of this is when a grandparent buys bond(s) and puts it in their grandchild's name.  Unless that grandchild is 24 years old at the issue date of the bond, the interest would NOT be excludable from income, even if used for the child's education.  I should also note that even if the grandparents were named as the owner instead of the grandchild, they still would NOT be able to exclude the interest UNLESS they claim the grandchild as a dependent on their tax return.

In other words, if you use savings bond proceeds to pay for qualified education expenses on yourself, your spouse, or any dependent you claim as exemptions on your tax return, you are able to exclude interest earned on these bonds.  This is much more restrictive than people think.

Finally, in order to exclude interest used to pay for qualified education expense, your modified adjusted gross income must fall below certain limits.  For 2005, the exclusion begins to be phased out when MAGI reaches $61,200 for single filers ($91,850 for joint) and is eliminated completely at $76,200 ($121,850 for joint).

Historically, U.S. Savings bonds simply do not produce higher investment returns.  With education costs increasing more than the general rate of inflation, this means you would most likely have to invest much more in savings bonds than you would with another investment that historically produces higher returns.

As a general rule, I do not recommend U.S. Savings bonds as a viable mean for saving for my clients' future college education costs.

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The 529 Plan:  A Popular Choice for College Savings     Back to top

This is the forth in a series of articles about saving for higher education expenses.  Last week we discussed the Coverdell account (Education IRA) along with its advantages and restrictions.

This week, we will discuss a very popular savings vehicle known as the 529 plan.  529 plans are also known as qualified tuition programs.  They are very much like a Coverdell account that I discussed last week with some important differences.  Here are some of those differences:

1) 529 plans are established and maintained by the States.  Each State has its own 529 plan.  However, it is important to note that you do not have to contribute to a 529 plan for the state in which you are a resident.  For example, a NY resident could choose another State plan if he/she feels the plan is a better fit.
2) Contribution Limits - The only limitation set forth by the IRS is that one cannot contribute more than the amount necessary to provide for the qualified education expenses of the beneficiary.  However most State plans will set limits as to the maximum amount one can invest.  For example, a plan may have a stipulation that once an account size equals $250,000 or more, then future contributions are not allowed.
3) Income Restrictions - Unlike an education IRA, there are no restrictions based on your income for making contributions into a 529 plan.  A very wealthy individual for example, can make contributions for each of his grandchildren no matter what his modified adjusted gross income might be.
4) Qualified Education expenses for purposes of a 529 plan do not include grades k-12 like an Education IRA.  529 qualified expenses are for those education expenses incurred in an “Eligible educational institution”.  This means any college, university, vocational school, or other postsecondary educational institution that is eligible to participate in a student aid program administered by the Department of Education.
5) Changing beneficiaries - With a 529 plan you ARE able to change beneficiaries as long as the new beneficiary is a member of the original beneficiary's family.  The definition of beneficiary's family is quite liberal.  This gives the account owner a bit more control over the asset compared to the Coverdell account.

For federal income tax purposes, 529 plans and Coverdell accounts are essentially similar.  There is no federal deduction for contributions made but growth is never taxed if proceeds are used for qualified education expenses and these expenses don't “clash” with other financial aid.

Regarding State tax deductions, most States will allow their residences to take a State tax deduction if they use their State's 529 plan.  New York for example allows a maximum State tax deduction of $385 and $770 for single and joint filers respectively.  The $385 would be the maximum deduction based on a contribution of $5,000 and the $770 would be based on a $10,000 contribution. 

As a general rule, the State tax deduction should not be a deciding factor on whether to use that State's plan.  This is particularly true when the deductions are somewhat minimal like they are in NY.  Other very important items to look at are yearly expenses and investment returns!

The 529 plan may be an attractive alternative to some people if you need to save for future college expenses.  As always, remember that there is no “one size fits all” approach.  The best solution for you depends on your financial situation, goals, risk tolerance, how you feel about giving up control of certain assets, your tax situation, among many others.


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TAX BENEFITS FOR EDUCATION:     Back to top

This week, I'd like to update for 2007, tax breaks for qualified higher education expenses.  Education credits and deductions are discussed in much more detail in IRS Publication 970 (Tax Benefits for Education).  This publication is pretty lengthy and full of details that I am not able to discuss in this article.  I'll go over the basics to make sure that you know what to look for if this area applies to you.

Tax benefits are for “qualified education expenses” - Generally this means tuition and fees required for admission to a qualified institution of higher learning.  Room and board for example is NOT considered a qualified expense.  Colleges report the relevant information including qualified expenses, scholarships and grants, and whether the student is a half-time student on form 1098-T (Tuition Statement).

The main tax breaks are the education credits.  Education credits are reported on form 8863.  There are two education credits available, the Hope Credit and the Lifetime Learning Credit.  Both are “Non-Refundable” meaning that your credit is limited to the lesser of the maximum credit amount or the extent of your federal tax liability. 

Hope Credit - This credit is calculated based on the first $2,200 of qualified education expenses.  The credit is calculated at 100% of the first $1,100 and 50% of the next $1,100 for a maximum of $1,650.  This credit can only be used for the student's first two years of higher education.  The student must also be considered at least half-time and have no prior drug convictions.

Lifetime Learning Credit - This credit is calculated at 20% of eligible expenses of up to $10,000.  The maximum Lifetime Learning credit is therefore $2,000.  This credit is available for an unlimited number of years (not just the first two years as in the Hope credit).  Also, the felony drug conviction rule does NOT apply for the Lifetime Learning Credit.

There are income limits to the Hope and Lifetime Learning Credits.  Generally the benefit for these credits is phased out beginning at a modified adjusted gross income (MAGI) of $47,000 and ending at $57,000 (Between $94,000 and $114,000 for married filing jointly).  As common sense would dictate, you can only take one of the education credits in each year for each eligible student.

Tuition and Fees Deduction - Those who have education expenses and do not qualify for the Hope or Lifetime Credit may still be able to qualify for the tuition and fees deduction.  The maximum deduction is $4,000 for (Single and MAGI < $65,000 or Married Filing Jointly and MAGI < $130,000).  The deduction is limited to $2,000 for (Single and MAGI > $65,000 but not more than $80,000 or Married Filing Jointly and MAGI > $130,000 but not more than $160,000).  The tuition and fees deduction will be reported this year on form 8917.  Unfortunately, there is no relief for education expenses for taxpayers with modified adjusted gross incomes above these levels.

Student Loan Interest Deduction - This is essentially for students (or their parents if they are legally obligated to repay the loan) after the student graduates.  This deduction can be taken for as long as the loan is outstanding and interest is paid.  The maximum deduction is the smaller of $2,500 or actual amount of student loan interest.  This deduction is phased out for filers with a modified adjusted gross income between $55,000 and $70,000 ($110,000 and $140,000 for married filing jointly).

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Education Planning     Back to top

Well it's that time of year again to send the kids back to school.  Therefore, I thought it would be timely to write a series of articles relating to education planning.  This week I'll give an overview of this area by introducing some general guidelines and considerations to think about as well as the education investment options that are available.

The fist major consideration to think about is whether or not you should invest for your child's education in the first place!  I say this because for many people of modest means, investing for your child's education can actually work AGAINST you.  How can this be you ask?

Well for starters, if you haven't adequately prepared for retirement, it makes much more sense to invest in your 401(k) plan at work or an IRA.  This is because these investments are EXCLUDED from “available assets” in the financial aid formula used in calculating financial aid!  That's right, IRAs, Retirement plans, certain life insurance, etc. are considered “restricted assets”.

If on the other hand, you had invested in a college education plan; these assets would be considered “free” or “unrestricted” assets and would be expected to be contributed towards the child's education.  As a result, the child might very well receive less financial aid than he/she otherwise would have.  In essence you run the risk of obtaining less financial aid PLUS you haven't saved for retirement!

So remember, if your income is modest, it would make much more sense to contribute to your retirement needs first before even considering education planning!  Keep this in mind…..it's much easier to go to a bank and help finance your child's education than it is for you to go to a bank and ask for a loan to finance your retirement 10 or 20 years down the road!

There are other factors as well regarding the amount of financial aid you may receive, including income, types of assets, etc.  For example, many business owners have assets that are “tied up” in their business.  This also makes a difference in determining assets you are expected to contribute towards your child's education.

With that said most parents in the middle to upper income areas are in fact expected to contribute towards their child's education.  Luckily, there are several options available.  Among them:  Regular investment accounts, Savings Bonds, UTMA (Uniform Transfer to Minors Act) accounts, Coverdell (Education IRA) accounts, and 529 plans.  In the next few weeks, I will go into detail on the advantages and disadvantages of each type of plan taking into consideration such things as tax benefits, flexibility, income limits, asset control, and allowable uses.

As in many areas of financial planning, there is no “one size fits all” approach.  The solution that is best for you depends on your financial situation, risk tolerance, how you feel about giving up control of certain assets, your tax situation, and other important considerations.


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“Regular” Investments for Future Education Expenses?     Back to top

Last week I provided a general overview of education planning and discussed why it is important for parents (especially low income) to take care of their retirement needs first.  I explained how certain assets are excluded from the financial aid formula in determining amounts you are expected to contribute towards your child's education.  This week, I will go over some of the common people can invest for future education expenses.

The first thing I would like to highlight is the difference between a “Regular” investment and an Investment that is legally designated for some other purpose.  By Regular investments I mean those that are not legally designated (and specifically earmarked) for some specific purpose.  Keep in mind that investments such as IRAs, 401(k)s, UTMA accounts, Education IRAs etc. ARE designated for purposes such as retirement or education.  These investments generally have strings tied to them in some way because you receive favorable tax treatment.  In the case of a traditional IRA or 401(k) for example, you make a “deal” with the government by agreeing to use future proceeds from the investment for retirement purposes.  You also agree that you will wait until at least age 59 ½ before you start taking proceeds for retirement.  As part of the deal you receive a tax deduction for the amount you contribute and tax deferred growth (no payment of taxes on the growth while it's still invested).  If you break your end of the bargain (by accessing your IRA investment for example before age 59 ½), you are penalized.

A regular investment then is one where you simply invest and receive no favorable tax treatment.  This can be an attractive way to invest for college education planning for some people because there are “no strings attached”.  You maintain control over the investment and can use it for any purpose you would like.  So if some unexpected financial event comes up and you need to access your money, you can do so without penalties.  Note:  There are certain investments (CDs for example) that carry their own penalties for early withdrawal but this is a condition of the individual investment.  It is NOT due to the investment being legally designated for a specific purpose.

So, some people choose to invest in a regular type investment for future education expense.  This provides the most flexibility since the investment can be used for any purpose at any time.  The major drawback is that there are no tax advantages for you in this type of investment.  This means that you receive no deduction for any investment you make and are taxed on interest, dividends and certain capital gains each year as your investment grows.

A “regular” investment may be the best choice for someone saving for future education expenses if they wish to maintain as much flexibility and control as possible.  (As I will explain in a future article, there is one type of investment where control is given to the child at age 21).  It may also be the best choice for those who may have to tap into the investment in the future.  So if you think you might need to access funds from your investment, a “regular” investment is most likely the best option for you.

Next week, I'll discuss the Coverdell account (Education IRA), including its advantages and disadvantages.  Remember the decision on which investment option to take for education planning purposes will depend on your financial situation, risk tolerance, how you feel about giving up control of certain assets, and your tax situation among other reasons.

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The Coverdell (Education IRA)     Back to top

Last week I briefly touched on the difference between a “Regular” investment and an investment that is legally designated for some special purpose (retirement, future education expenses, etc.).  I went over the advantages to the Regular investment, and how this can be an effective way for some people to invest for education expenses.

This week, I'll focus on the Coverdell education account (also known as the Education IRA).

Overview - Coverdell savings account investments are invested and the proceeds are used for purposes of higher education expenses.  There is no current tax deduction for contributions made to a Coverdell account.  However, the investment grows tax deferred and proceeds, if used for qualified higher education expenses, are tax-free.  This works much like a Roth IRA in the sense that the growth of the investment is not taxed if used for the purpose it was intended for.

Qualified Higher Education Expenses for purposes of the Coverdell account include tuition and fees, books, supplies, and equipment.  Room and board is an allowable expense if the student attends at least half-time.  For a Coverdell account, these same expenses for an elementary or secondary school are acceptable (not just college expenses as is the case with other college investment vehicles).  This is noteworthy for those parents or grandparents who want the flexibility of being able to use proceeds for private school expenses, not just for college!

Restrictions:  Here are some restrictions to be aware of:
1) The yearly maximum for any one individual cannot exceed $2,000 per year.  This means that if a parent decides to contribute $1,500 into an education IRA and a grandparent also wanted to contribute for the same child, the grandparent could only contribute $500.
2) You cannot add further contributions once the account beneficiary reaches age 18
3) If the beneficiary does NOT use proceeds for qualified education expenses, the proceeds must go to him or her within 30 days after reaching age 30.  This is important for people who would like to maintain control over assets to make sure that proceeds are used for the intended purpose.
4) You may not contribute to an education Ira if your modified adjusted gross income is over $110,000.  ($220,000 for married filing jointly).
5) There is a possibility that after the year 2010, k-12 expenses will no longer qualify.  If current law is not renewed after this date, the contribution limit would also go back to its former $500 per year.
6) Distributions for education expenses may be taxable if such things as tax-free scholarships, Pell grants, etc. are greater than qualified education expenses.
7) Performing the calculation as to how much you can take out in a given year can be difficult.  An example of this would be coordinating withdrawals with the Hope or Lifetime Learning credits.

IRS Publication 970 covers the topic of tax benefits for education.  Like most other IRS publications, it is lengthy and detailed.  I am only highlighting some of the major benefits and restrictions of a Coverdell account.  Remember, most investments that are designed for a specific purpose have strings attached to them.  It is important to work with a professional who can guide you through the various choices so you can be comfortable for the choice that's right for you.

Next week, I'll discuss another investment designed for education expenses; the 529 plan.

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Saving for Education and Financial Aid - A Tricky Combination?     Back to top

Well it's hard to believe that it's already October!  Normally in the late August/early September timeframe, I write a little overview on College education planning.  This year I'm a little late!  Anyway, here is some general information that any parent should think about regarding saving for college education and financial aid planning. 

The fist major consideration to think about is whether or not you should invest for your child's education in the first place!  I say this because for many people of modest means, investing for your child's education can actually work AGAINST you.  How can this be you ask?

Well for starters, if you haven't adequately prepared for retirement, it makes much more sense to invest in your retirement plan at work and/or an IRA.  This is because these investments are EXCLUDED from “available assets” in the financial aid formula used in calculating financial aid!  That's right, IRAs, Retirement plans, certain life insurance, etc. are considered “restricted assets”.

If on the other hand, you had invested in a college education plan; these assets would be considered “free” or “unrestricted” assets and are therefore expected to be contributed towards the child's education.  As a result, the child might very well receive less financial aid than he/she otherwise would have.  In essence you run the risk of obtaining less financial aid PLUS you haven't saved for retirement!  It's a lose/lose situation for you and your child!

So remember, if your income is low to moderate, it would make much more sense to contribute to your retirement needs first before even considering education planning!  Keep this in mind…..it's much easier to go to a bank and help finance your child's education than it is for you to go to a bank and ask for a loan to finance your retirement 10 or 20 years down the road!

There are other factors as well regarding the amount of financial aid you may receive, including income, types of assets, etc.  For example, many business owners have assets that are “tied up” in their business.  This also makes a difference in determining assets you are expected to contribute towards your child's education.  For instance a farmer may have significant assets but these assets (like your retirement investments) may not be considered to be “available” for paying education expenses.

Now lets talk about middle to upper income people.  These parents ARE in fact expected to contribute towards their child's education.  Luckily, there are several options available.  Among them:  Regular investment accounts, Savings Bonds, UTMA (Uniform Transfer to Minors Act) accounts, Coverdell (Education IRA) accounts, and 529 plans.  I have written on each of these in detail in prior articles and would be happy to answer any questions you might have.

As in many areas of financial planning, there is no “one size fits all” approach.  The solution that is best for you depends on your financial situation, risk tolerance, how you feel about giving up control of certain assets, your tax situation, and other important considerations.
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Bob Tackabury is owner of Robert L. Tackabury, CPA 2556 Rt. 12B, Hamilton, NY 315-825-0255 and is an Investment Registered Representative.  Securities offered through IBN Financial Services, Inc., 8035 Oswego Rd., Liverpool, NY 13089.  315-652-4426. 
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