In this issue we would like to address methods of paying college expenses with maximum tax advantage. Caution: These suggestions are strictly related to income tax benefits, effects on financial and estate planning, and financial aid qualifications should be considered and are beyond the scope of these articles.

Custodial Accounts. In many cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $22,000 a year (2002) to each child with no gift tax consequences. For children over 13, the income from the assets is taxed entirely to them at their lower tax rates (as low as 10% in 2002). For children under 14, however, income above $1,500 (in 2002) is taxed at your rates. A variety of trusts or custodial arrangements can be used to place assets in your children's names. The transfer must be irrevocable and there is no guarantee the child will use the funds for education.

Series EE U.S. Savings Bonds offer two tax-savings opportunities when used to finance your child's college expenses: first, you don't have to report the interest on the bonds for federal tax purposes until the bonds are actually cashed in; and second, interest on "qualified" Series EE (and Series I) bonds may be exempt from federal tax if the bond proceeds are used for qualified college expenses. To qualify for the tax exemption for college use, the bonds must be purchased by you in your name (not the child's) or jointly with your spouse. The proceeds must be used for tuition, fees, etc. (not room and board). If only part of the proceeds are used for qualified expenses, then only that part of the interest is exempt. But if your adjusted gross income (AGI) is too high, the exemption is phased out. For bonds cashed in during 2002, the exemption starts to "disappear" when your AGI hits $86,400 for joint return filers ($57,600 for singles) and is gone entirely if your AGI is at $116,400 ($72,600 for singles). (These figures are adjusted annually for inflation.)

Qualified tuition programs. A qualified tuition program allows you to make contributions to an account set up to meet a child's future higher education expenses. These are commonly referred to as "Section 125 Plans". As these have become the college savings vehicle of choice, an entire article has been devoted to them on the third page.

Coverdell education savings accounts. You can establish education savings accounts (formerly called education IRAs) and make contributions of up to $2,000 per child. The ability to make these contributions begin to phase out once your income is over $190,000 on a joint return ($95,000 for singles). The contributions are not deductible, but fund earnings are tax free if spent on higher education expenses.

Deduction for college costs. In 2002 through 2005, certain taxpayers are permitted to take a deduction (whether they itemize or not) for college tuition and related expenses that they pay. In 2002 and 2003, for taxpayers with AGI of up to $65,000 for singles and $130,000 for joint return filers, the maximum deduction will be $3,000, The deduction can't be taken in the same year that a Hope or Lifetime Learning credit is claimed for the same student. However, it can be claimed in the same year as an exclusion is available for distributions from a Coverdell education savings account or qualified tuition plan or for interest on education savings bonds, as long as the deduction and exclusion aren't claimed for the same expenses.

Scholarships are generally exempt from income tax. For this exemption to apply, certain conditions must be satisfied. The most important are that the scholarship must not be compensation for services (except under health professions programs), and it must be used for tuition, fees, books, supplies and similar items (and not for room and board). Although a scholarship is tax-free, it will reduce the amount of expenses that may be taken into account in computing the Hope and Lifetime Learning credits, above, and may therefore reduce or eliminate those credits.

Employer educational assistance programs. If your employer pays your child's college expenses, the payment is a fringe benefit to you, and is taxable to you as compensation, unless the payment is part of a scholarship program that's "outside of the pattern of employment". Then the payment will be treated as a scholarship.

College expense payments by grandparents and others. If someone other than you pays your child's college expenses, the person making the payments is generally subject to the gift tax, to the extent the payments and other gifts to the child by that person exceed the regular annual (per donee) gift tax exclusion of $11,000 ($22,000 in the case of married donors who consent to split gifts). If the other person pays your child's school tuition directly to an educational institution, however, there's an unlimited exclusion from the gift tax for the payment. The relationship between the person paying the tuition and the person on whose behalf the payments are made is irrelevant, but the payer would typically be a grandparent. The unlimited gift tax exclusion applies only to direct tuition costs.

Student loans. You can deduct interest on loans used to pay for your child's education at a post-secondary school, including some vocational and graduate schools. (This is an exception to the general rule that interest on student loans is personal interest and, therefore, not deductible.) The deduction is an above-the-line deduction (meaning that it's available even to taxpayers who don't itemize). The maximum deduction is $2,500. However, the deduction phases out for taxpayers who are married filing jointly with AGI between $100,000 and $130,000 (between $50,000 and $65,000 for single filers).

Bank loans. The interest on loans used to pay educational expenses is personal interest which is generally not deductible (unless you qualify for the deduction for education loan interest, described above). However, if the loan is "home equity indebtedness," and interest on the loan is "qualified residence interest," the interest is deductible for regular income tax purposes, although not for alternative minimum tax purposes. If interest is deductible as qualified residence interest, it can't be deducted as education loan interest.

Borrowing against retirement plan accounts is permitted by some company retirement plans. This is an alternative to a bank loan. However, the loan must carry an interest rate equal to the prevailing commercial rate for similar loans, and, unless you qualify for the deduction for education loan interest (described above), there's no deduction for the personal interest paid. Moreover, unless strict requirements are satisfied, a loan against a retirement account is treated as a premature distribution (withdrawal) that's subject to regular income tax and an additional penalty tax.

Prepaid tuition plans, also know as 529 plans are becoming the college savings vehicle of choice. Named after the section of the tax code that created them, 529 plans are currently offered or being developed in all 50 states. The program currently offered by the State of Connecticut is called CHET (Connecticut Higher Education Trust), however in most cases you may use any states plan regardless of your residency, or which state your child decides to attend school in.

What is a 529 Plan? A 529 plan is a tax favored way to put money aside for your children’s future college education. Under this program, funds that you place in the program are held in a special account to be used to cover the future education costs of the child you designate as beneficiary. While the funds are in the plan, they grow tax deferred. Not only do the earnings grow tax deferred on these plans, but beginning in 2002 all earnings on qualified withdrawals from a 529 plan are exempt from federal and state income tax.

What about withdrawals? Qualified withdrawals are those used to pay for qualified higher education expenses. In general, these are expenses for tuition, fees, books, supplies, and equipment, plus reasonable room and board costs for students enrolled on at least a half-time basis at an eligible educational institution. The room and board allowances are available for students even if they live at home while going to school. Accredited colleges, junior colleges and area vocational schools are qualified to participate in the tuition program. In addition, accredited post-secondary schools offering credit towards a bachelor’s degree, an associate’s degree, a graduate or professional degree, or another recognized post-secondary credential, are eligible to participate. Any withdrawals from a 529 plan that are not used for education expenses would be considered non-qualified withdrawals, the earnings of which would be subject to income tax plus a federal 10% penalty.

HOPE & Lifetime Learning Credits. The 529 plan can also be used in conjunction with the HOPE and Lifetime Learning credits. Taxpayers may claim the HOPE or Lifetime Learning credit and receive a qualified distribution from a 529 plan in the same year as long as they are not used for the same expenses.

Estate Planning/Gift tax features. Section 529 plans also have some very unique gift and estate tax features. The contributions you make to a 529 plan are not subject to gift tax, except to the extent the contributions exceed $ 11,000 annually. There is also a special gift tax provision that allows an individual to treat up to $ 55,000 of contributions as having been made ratably over a 5 year period.

For many individuals, the most difficult aspect of estate planning is the actual transfer of assets to someone else’s control. With a 529 plan, you can remove the money from your estate, but still retain control over withdrawals from the plan. As owner of the account, you authorize all expenditures and can even veto footing the bill for a college you don’t approve of. Furthermore, if the original beneficiary decides not to attend college at all, or does not use all the funds in the 529 plan, you are allowed to change the beneficiary to another member of the family at any time. Member’s of the family can include, sisters, brothers, sons, daughters, and spouses of these individuals. These aspects of 529 plans, make them a very attractive option for both parents and grandparents, in reducing their taxable estate.

Some 529 plans also have relationships with affinity programs, where members can earn contributions when they buy gas, make a long distance call, use a credit card, dine out, or shop online. These contributions can then be directed to an individual’s 529 account.

Want More Information? If you would like to discuss how a Section 529 plan might help to meet your child’s or grandchild’s future college costs, or have any additional questions, please give us a call. We can help you coordinate this with your estate, financial, and tax plan.

Section 529 plans can be opened through a broker, bank, insurance company, and other financial service institutions. For the plan offered by the state of Connecticut you can get additional information at www.aboutchet.com.