College Aid and Tax Planning Part 2: Hierarchy of Long-Term Savings

FINANCE

Personal Financial lanning

College Aid and Tax Planning Part 2: Hierarchy of Long-Term Savings

By Alan R. Sumutka

A solid long-term savings strategy for college aid and tax planning should maximize both financial aid and tax savings. Part 1 of this article, which appeared in the February 2004 CPA Journal, focused on financial aid eligibility and planning. Part 2 focuses on financial planning and assets. A prioritized, four-tier approach presented in the Exhibit analyzes assets, considering both college aid and tax implications.

Tier 1: Sheltered Assets

Assets in the first savings priority category provide for specific necessities, are generally sheltered for aid purposes, generate cash and borrowing ability, and offer favorable tax consequences.

401(k), 403(b), and Simple IRAs. Because there are many sources for funding education but few for retirement, retirement saving should take precedence over college saving. Financial aid qualifiers should fund a 401(k), 403(b), or Savings Incentive Match Plan for Employees (Simple) IRA at least up to the amount required to obtain any employer match funds. This match represents additional savings; regular contributions provide a savings discipline; and together they benefit from long-term compounding.

Although they are noncountable under both the federal methodology (FM) and the institutional methodology (IM), plan assets are difficult to access. Generally, Simple IRA assets are not accessible until retirement, and 401(k) or 403(b) funds are available only via hardship withdrawals or plan loans, which impede compounding benefits. Furthermore, hardship withdrawals generate taxable and countable income, loan interest is not deductible, and loans may have to be repaid promptly if employment is terminated.

For low-income financial aid qualifiers, a contribution of 5% to gain an employer match may exhaust discretionary savings. Even high-income individuals that maximize contributions may deplete their reserves. If insufficient aid is available, these individuals may suspend their potentially substantial retirement contributions during the college years [$30,000 if both spouses maximize 401(k) or 403(b) contributions in 2006] and use the cash to fund education. Despite the negative tax consequences of this strategy, aid eligibility does not change, because elective deferrals are counted as untaxed benefits.

Roth IRAs. Roth IRAs may be the best savings vehicle available. They bolster retirement savings, are aid-sheltered (FM and IM), can most likely be funded without concern for adjusted gross income (AGI) phase-outs ($150,000 for married taxpayers filing jointly; $95,000 for single taxpayers), and, if needed to pay for education, contributions can be withdrawn tax-free anytime, but they are countable.

With the current $3,000 contribution maximum (for those under age 50) increasing to $4,000 in 2005 and to $5,000 in 2008, financial aid qualifiers can contribute $33,000 to one IRA for the eight-year period from 2003 through 2010, when sunset provisions may limit contributions to $2,000. If a spousal IRA is funded as well, a couple can contribute $66,000. For a child born in 2003, 18 years of contributions by one person amount to $53,000 (assuming a cutback to the $2,000 limit in 2011) or $83,000 (assuming the $5,000 contribution limit is extended beyond 2010). Spousal contributions double these amounts to $106,000 or $166,000, respectively.

These calculations consider contributions only; earnings could swell these balances. If withdrawn before age 59 As, however, earnings are taxable and countable income, but are not subject to the 10% premature withdrawal penalty if used for higher education expenses. If withdrawn after age 59 As and held for five years, earnings are tax- and penalty-free.

Principal residence. A principal residence is noncountable under FM, but is counted under IM, which is why it is ranked below retirement assets. A mortgaged residence provides tax-deductible interest (on up to a $1 million mortgage), and its equity provides a source of liquidity via a tax-deductible home equity line of credit (of up to $100,000).

At the current low interest rates, financial aid qualifiers that are purchasing a home should consider a 30-year mortgage and enjoy the leverage. Some homeowners should evaluate whether to refinance an outstanding mortgage over its remaining term or consider a term that ends before a child enters college. The eliminated mortgage payments provide immediate cash flow and eligibility for a substantial home equity line of credit.

Financial aid qualifiers with low-interest-rate mortgages should not accelerate mortgage payments to pay off the mortgage prior to college. They should use the excess cash to fund retirement because the expected long-term, after-tax return of these investments will very likely exceed the low, after-tax mortgage interest rate.

Permanent life insurance. This insurance is a noncountable asset (FM and IM), which provides liquidity, tax-deductible student loan interest on policy loans (if below the phase-out limit), and life insurance. When compared to term insurance, however, these favorable features come at a price: It is much more expensive, and may be unaffordable if the previous assets are funded.

Tier 2: Potentially Shelterable Assets

Although Tier 2 assets and most of their income are countable, they have the potential to be sheltered if a financial aid qualifier possesses noncountable debt (e.g., personal debt) before base year one (BY1). Absent such debt, they are countable and no better than Tier 3 assets.

By borrowing against Tier 2-1 assets (i.e., bank certificates of deposits or savings accounts and certain bonds) and using the proceeds to pay noncountable debt, the countable (after-debt) value of Tier 2-1 assets can be reduced. Tier 2-2 assets (i.e., CESAs, municipal bonds, stocks, U.S. savings bonds) possess less flexibility because, generally, they must be liquidated to be sheltered. Ideally, with sufficient noncountable debt, Tier 2-2 assets can be liquidated and Tier 2-1 assets can be collateralized before BY1.

Tier 2-1 assets appear to be more favorable than Tier 2-2 assets, but there are trade-offs. Tier 2-1 assets are very conservative long-term investments and generate ordinary income. Some Tier 2-2 assets are more aggressive and better suited for long-term investing (e.g., stocks) and generally offer more favorable tax treatment during accumulation and upon liquidation.

Tier 2-1 Potentially Shelterable Assets, by Borrowing or Liquidation

Bank certificates of deposit and savings accounts. These assets can be used as collateral to obtain a bank loan and generate deductible investment interest expense (up to investment income). Although they generate ordinary income, they create no taxable event on withdrawal, which is why they are potentially more desirable than bonds. These assets are best suited for very conservative investors that set a predetermined education savings target and seek to guarantee the principal.

Corporate and other nonmunicipal bonds and bond funds. When held in a brokerage account, these assets are marginable and also generate deductible investment interest expense. When sold, however, they can generate losses or long-term capital gains (LTCG). Laddering bond (including zero-coupon) maturities to coincide with the expected payment dates of education expenses has been an effective strategy for conservative investors that set a predetermined education savings target and want to guarantee principal (subject to credit risk) and eliminate a taxable event upon disposition. Financial aid qualifiers, however, may need to shelter assets and liquidate their positions prematurely, thus creating a taxable event.

Tier 2-2 Potentially Shelterable Assets, Usually by Liquidation

CESAs. Regardless of who opens a Coverdell Education Savings Account (CESA), it is counted as a student asset and as student income upon withdrawal, a particularly devastating combination. If spent before BY1, however, it can be a powerful savings tool, even surpassing a Roth IRA.

Annual nondeductible contributions cannot exceed $2,000 per child, a purported disadvantage, and must be made before the beneficiary reaches age 18. When considering the higher priority of other savings options, however, some individuals may be unable to fund more in a year. Full contributions can be made if modified AGI (MAGI) is below $190,000 (M-J) or $95,000 (single). (Some commentators suggest that it is possible to circumvent this threshold by having someone with qualifying AGI, such as a grandparent, make the contribution.)

CESA tax advantages are unique and compelling. Like some other (Tier 3) assets, contributions and their earnings can be distributed tax-free when used to pay for most college expenses. Yet they can also fund qualified elementary and secondary expenses, which include a variety of kindergarten through 12th-grade education expenses (e.g., tuition, fees, books, supplies, equipment, room and board, uniforms, transportation, extended day programs, computer technology and equipment, Internet access, and services used not only by the beneficiary but also by the beneficiary’s family). Because CESAs permit the tax-free expenditure of contributions and earnings before BY1, they are potentially shelterable by depleting them. After 2010, however, K–12 expenses no longer qualify for the exclusion, annual contributions are reduced to $500, and the phase-out threshold is reduced, unless Congress reauthorizes provisions that would otherwise sunset.

When CESAs are not spent for precollege expenses, they rank in Tier 3. They are not shelterable (i.e., cannot be collateralized), and their assets and income are attributed to the student. Also, when used for college expenses, CESAs reduce the amount of college expenses eligible for the Hope scholarship credit, lifetime learning credit, or college tuition and fees deduction. All CESA assets must be distributed before the beneficiary reaches age 30 (if the child does not attend college) or rolled over within 60 days of reaching age 30 to another beneficiary in the same family who is also under 30; otherwise, the earnings are taxable.

Municipal bonds and bond funds. Because these assets are marginable in a brokerage account, they would normally be Tier 2-1 assets. Yet because the loan interest expense is nondeductible (i.e., it generates tax-free income), few individuals are apt to borrow against them. Thus, to shelter the principal and income (remember that tax-exempt income is added to compute available income), one must liquidate them and either spend the proceeds to pay noncountable debt or invest in Tier 2-1 assets to be used as loan collateral. Generally, the interest is tax-exempt (which makes it a more favorable Tier 2 asset than stocks or U.S. savings bonds), and favorable LTCG treatment can result upon liquidation. As with corporate bonds, laddering bond (including zero-coupon) maturities can be an effective conservative strategy.

Stock and stock funds. Like municipal bonds, these assets would normally be in Tier 2-1, because they, too, are marginable when held in a brokerage account. Most investors would eschew borrowing, because dividends earned in a margin account are ineligible for the new 15% dividend tax rate. Therefore, to shelter these historically high-return assets, they must be liquidated (with a probable tax consequence) to pay noncountable debt or to invest in Tier 2-1 assets to be used as loan collateral.

U.S. savings bonds (EE/I). When these bonds are used for nontuition purposes, they are the least advantageous Tier 2-2 asset. They cannot be used as loan collateral, liquidation is necessary to shelter them, and although interest is deferred during accumulation, it is all taxable as ordinary income on redemption. Of course, they potentially yield tax-exempt income when used to pay for college tuition or fees, but because payment usually occurs in a BY, they are then Tier 3 assets.

Tier 3: Nonshelterable Assets

Most Tier 3 assets (i.e., college savings plans, qualified U.S. savings bonds, CESAs, and prepaid tuition plans) have significant tax advantages (e.g., tax-deferred earnings and potentially tax-free distributions). When used to pay for college expenses, however, they cannot be sheltered for aid purposes and afford no borrowing opportunities, making them a poor savings option.

IRC section 529 college savings plans. Although these assets are countable, the tax-free income generated to pay for college expenses is not counted as untaxed income, which—along with its superior tax advantages—give it priority over other Tier 3 assets. (Some commentators suggest that these plans should be funded by grandparents so that they are not counted as parent or student assets. But financial aid professionals review college payment checks and will consider them as financial resources. If the assets are used to pay for post-BY4 expenses, however, they can be valuable.)

The many benefits of these state-sponsored plans are well documented. They offer parental control of assets, high contribution levels with no phase-out provisions, a variety of professionally managed, static or age-based tax-deferred investments of different risks, tax-free transfer opportunities, tax-free distribution of earnings for college expenses at any qualified institution, and possible state benefits. If the primary beneficiary does not attend college, the funds can be distributed (but the earnings are subject to income tax and a 10% penalty), they can remain in the account for the beneficiary’s future education or the education of her child, or the beneficiary can be changed to another person in the family. For estate purposes, contributions are a completed gift and excluded from the estate, even though the donor can manage the assets, use them for the donor’s education, change the beneficiary, or take a taxable distribution to oneself.

Section 529 plans also have disadvantages. Some states charge high fees. Once an investment is selected, it cannot change unless funds are rolled over to another state plan, and some states tax rollovers. Age-based savings plans reduce stock allocations as a child ages, reducing the market risk near college but eliminating the long-term investment horizon often needed to generate stock gains. Any stock losses are not deductible. Although distributions are usually tax-free (though scheduled to sunset after 2010), expenses paid with them do not qualify for the Hope or lifetime learning credits or tuition and fees deduction.

Qualified U.S. savings bonds (EE/I). When used to pay for noncollege expenses, these bonds are classified as Tier 2 assets. But in Tier 3, they rank below college savings plans because although their income can be tax-free upon distribution, it is countable as untaxed income.

IRC section 529 prepaid tuition plans. Despite the apparent attractiveness of these state-sponsored plans to a low-income financial aid qualifier—the tax-free plan locks in today’s tuition rate for future college education, eliminating the risk associated with other savings options—they are the least appealing Tier 3 asset, because distributions are counted as resources. Other shortcomings include the scheduled sunset (after 2010) of the tax-free distribution provision, forfeiture of other education tax benefits, potential residency requirements in the sponsoring state, possible penalties if the participant selects an out-of-state institution, the unavailability of the funds for nontuition expenses, and poor investment performance in some states (encouraging these states to eliminate the plans, temporarily halt enrollments, charge fees, or set higher prepaid tuition rates).

Tier 4: Undesirable Assets

Although both Tier 4 assets (annuities and traditional IRAs) are sheltered, they are undesirable for long-term education savings.

Annuities. Although unlimited amounts can be invested in these aid and income-tax-sheltered assets, they must be withdrawn to pay for education (i.e., they cannot be collateralized), and are then subject to a 10%, under age 59 As premature distribution penalty, making them fully countable as benefits. Also, with current low income, dividend, and LTCG tax rates, they make questionable long-term investments. They can shelter assets, however, so they are best purchased during BY planning.

Traditional IRAs. Because individuals are permitted to fully fund only one IRA, the Roth IRA is preferable over the traditional IRA.

Asset titling. Most commentators suggest that financial aid qualifiers title assets in the lower-assessed parents’ names, not the child’s name. If assets held in the child’s name can be spent for the benefit of the child before BY1, however, such titling is not detrimental to aid and the family may enjoy tax benefits related to the sheltering of income at a lower child bracket.

Alan R. Sumutka, CPA, is an associate professor of accounting at Rider University, Lawrenceville, N.J.