A child or grandchild might go to college - start a 529 college savings plan. While this is probably good advice for most, it's not the only option. For many, it's not the best option. If you're a physician, business owner or anyone worried about estate tax or asset protection, there may be better approaches. Let's review many of the options for funding college costs:
529 College Savings Plans: Contributions to these well known plans, named after the tax code section that creates them, are not tax deductible, but the earnings escape all income tax if the funds are used for college costs (tuition, room and board, books). You can gift $12,000/year and even front load 5 years' of contributions at one time. If you withdraw funds for non-qualified expenses you'll pay income tax on the gain and a 10% penalty. Many states offer tax breaks for contributions to 529 plans. The recent extension of the Kiddie Tax (taxes kids under a certain age at their parent's tax rate) to age 18 enhances the advantages of 529 plans over other options.
Coverdell Education Savings Accounts: You can contribute $2,000 per child under age 18. While you don't get a deduction, and the maximum contributions are limited, these funds can be used for any type of educational costs, including K-12 grades. 529 plans cannot. The ability to use this benefit is phased out when your income reaches $220,000 (MFJ).
Direct Tuition Payments: Benefactors can pay unlimited amounts for tuition costs if paid directly to the institutions. For wealthy families already giving the maximum $12,000/year/donee gifts, this is a great planning step as it doesn't count against these annual gifts. Grandparents looking to shrink their estates can simply pay tuition as part of their gift program. If you have a durable power of attorney be sure to authorize gifts in the precise manner you wish them to be permitted. Name the permissible donees, the maximum annual gifts, and whether direct tuition payments should be permitted. Permitting non-GST exempt trusts to make distributions for grandchildren's tuition (and medical) won't trigger GST tax. This can be a powerful addition to a child's trust, by pass trust, or other family trust.
Save in Your Name: This non-plan can actually be a great plan. You have total control over the investments and distributions. Funds you hold may be counted less harshly for financial aid then funds in the students name. While you can't get the income tax break of a 529 plan, you can use tried and true investment strategies (harvesting gains and losses, growth stocks with negligible current dividends, etc.) to minimize income taxes. This provides no asset protection or estate tax benefits.
IRA: You can withdraw money from your IRA account without penalty if the funds are used to pay for college and graduate school. This is probably the last option a student should consider. It undermines a key savings plan for future retirement. The withdrawals may constitute income that adversely affects your financial aid efforts.
Get a Job-Employer Pays: A great way to pay for graduate school is to get a job with an employer that pays for tuition. A qualified employer educational assistance program can lets you receive up to $5,250 tax free for tuition and other costs.
Save in Your Child's Name: This is typically in a custodial account. Recent tax law changes make this costly for income taxes since income of a child under 18 is taxed at your highest tax rate. Also, assets in a custodial account if you're the donor and custodian will be taxed in your estate. There is no control over the child's misuse of the funds.
Trusts: Instead of putting assets in a child's name where you might loose control, setting up a trust to own the gift money for future education costs is a great way to protect the assets. However, trusts create some complexity and are taxed at higher tax rates faster than individual taxpayers. Trusts can own 529 Plans. Trusts as part of an overall plan, however, might be the best option. See below.
FLP/LLC: If you're setting up an FLP/LLC to consolidate family investments, protect assets, minimize estate tax, coordinate investments, etc. instead of creating 529 Plans consider setting up a trust for your children which will instead invest the funds in your FLP/LLC. This can further support the validity of the FLP/LLC as a family investment vehicle, fractionalize ownership, reduce your ownership, and contribute to the entity being a more efficient family investment vehicle. You won't achieve the tax benefits afforded by a 529 Plan, but you may achieve much broader and more important family goals.
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