If you're wondering how you're going to save enough for your children's education, you may want to hit the books and learn about the expanded choices to be available next year to help pay the tuition and other schooling expenses.
The new legislation increases the annual contribution limit to Education IRAs from $500 to $2,000 per child or four times the annual amount allowed in 2001. Also, you can now use the balance in these accounts to pay for elementary and secondary school tuition including expenses such as tutoring, after-school latchkey programs, room and board and computer equipment, in addition to college expenses. Current law allows coverage for college expenses only.
Assuming you would save the full $2,000 each year for 18 years and received an 8 percent rate of return, you could save almost $81,000 for education needs under the Education IRA. In comparison, if you were to contribute only $500 annually under the current limits, you would end up with only $20,223. Keep in mind this example is for illustrative purposes only and does not reflect the performance of any particular investment.
In addition, key provisions in the new legislation affect 529 plans, also known as Qualified State Tuition Plans. The most significant improvement is a provision that makes qualified withdrawals from 529 plans federal-income-tax-free starting in 2002. In some cases, withdrawals may be exempt from state taxes as well. In addition, the new law allows one tax-free transfer within a 12-month period from one qualified tuition program to another beginning in 2002 for the benefit of the same designated beneficiary. Currently, the beneficiary must be changed for a transfer to be permitted.
529 plans are especially beneficial for wealthy investors for a couple of reasons. One reason is that the plans allow contributions up to $50,000 per beneficiary in a single year without federal gift-tax consequences. Ordinarily, donors would not be allowed to contribute such a large amount without incurring a gift tax. No other gifts may be made to the same beneficiary for a five-year period.
Beneficiaries also benefit because qualified withdrawals are federally tax free, allowing them to pocket more of the cash for school expenses. Under current rules, withdrawals are taxed at the beneficiary's tax bracket, typically 15 percent.
For example, a withdrawal that includes $5,000 of earnings under current rules would mean a beneficiary in the 15 percent bracket would only receive $4,250, losing $750 to federal income taxes.
But how do you decide which plan to use for your college-savings plan? Savers should maximize their contributions by using both plans, if they can afford it. Current law prohibits investors from contributing to both plans in the same year, but the new law does allow dual contributions.
However, if you are limited to how much you can contribute to a college-savings plan, you should be aware that Education IRAs may offer more flexibility in investment choices while 529 plan investment options are more restricted. However, 529 plans offer important estate-planning benefits as well as higher annual contribution limits and no age or income limitations.
Finally, investors should be aware of the sunset clause in 2011. If a new law is not passed between now and then, all laws revert back to what they were before this new law was passed. So if your child is only two years old now, by the time they reach college age, distributions for the 529 plan may no longer be tax free. Proper planning for this possibility will be critical.
Enrique Montoya, Accredited Asset Management Specialist firstname.lastname@example.org