Don't overlook the impact of federal income taxes on your savings. Taxes can erode the savings you have, and it pays to be familiar with methods that reduce taxes. In addition, there are special tax-advantaged investment programs that can assist you.

Tax-Advantaged Investments
Investors today can choose among many investments with tax advantages. For example, the Economic Growth and Tax Relief Reconciliation Act of 2001 eliminated federal income taxes on any earnings for certain investments intended to pay for higher education expenses.

While offering less growth potential, many income investments also offer tax advantages. The income from municipal bonds is usually exempt from federal income taxes, and interest on redeemed U.S. government Series EE savings bonds and Series I bonds may be exempt from federal taxation provided the proceeds are used for college tuition.


Qualified Tuition Programs (529s)
State-sponsored college savings plans can be an attractive option since they offer relatively high contribution limits and federal income tax-free withdrawals when the assets are used to pay qualified education expenses. These are also called qualified tuition programs or 529 plans (after the IRS code section which established them).

States may offer two broad types of 529 plans:

Prepaid tuition plans let you pay for future education at discounted rates set today. These plans generally assure that some education, usually tuition at a public school in that state, will be paid in full at the time of registration. Your plan assets can typically also be used at other public or private colleges in or out of state. In addition, prepaid plans may be offered by private institutions.

Savings plans let you set aside money (typically $250,000 or more) in a professionally managed account that can be used at nearly every U.S. college and university.

Both types of plans offer numerous tax advantages:

• Any withdrawals used to pay qualified higher education costs are free of federal income tax and may be either state tax-deferred or tax-free. Earnings on a distribution not used for qualified expenses may be subject to income taxes and a 10% federal penalty.
• There are no income restrictions.
• Some states offer additional tax benefits to their residents—for example, there may be a state income tax deduction for your contribution.
• 529 plans can largely be used in conjunction with other federal education incentives, such as Education Savings Accounts and the Hope Scholarship and Lifetime Learning Credits.

529 plans vary from state to state, and each has somewhat different costs, penalties, investment options, and tax incentives, so be sure you review a plan's details carefully before enrolling.Currently, most states offering 529 plans make them available to residents of any state. Please note that state tax benefits are generally only available to residents of that state.

Education Savings Accounts (ESAs)
Education Savings Accounts are another tax-advantaged way to save for a child's education. Individuals making less than $110,000 annually, or couples filing jointly earning less than $220,000, can contribute on behalf of any child. These accounts can be used to pay for elementary, secondary, or higher education. The annual contributions to all ESA accounts for any one child cannot exceed $2,000. A contributor's $2,000 maximum contribution for a beneficiary is gradually reduced if the individual's modified adjusted gross income ("MAGI") is between $95,000 and $110,000 (between $190,000 and $220,000 for a joint return). If MAGI falls within these ranges, the permissible contribution amount is determined proportionately. Withdrawals are federal income tax-free if the proceeds are used for qualified education expenses.

Education Savings Accounts are simple and offer you great flexibility in choosing investments and targeting rates of return. They also may be used in conjunction with the Hope Scholarship and Lifetime Learning Credits (as long as they aren't applied to the same expenses).


UGMAs/UTMAs
Should college savings be held in your name or the child's name? You may save tax dollars by maintaining assets in a child's name through an UGMA or UTMA (Uniform Gifts to Minors Act or Uniform Transfers to Minors Act) account. If the child is under 18, the first $850 of his or her unearned income is tax-free. If the child's unearned income is $851 to $1,700, it is taxed at 10%. Unearned income over $1,700 received by a child under 18 is generally taxed at the parents' top marginal rate.

In addition, assuming the child is 18 or over and in the lowest income tax bracket, any gain on the sale of appreciated assets that have been held for at least 12 months will be taxed at a 5% rate—rather than the parents' likely 15% rate. This approach can provide substantial tax savings on growth investments made in a child's account or on appreciated assets transferred to a child.

There are potential drawbacks to this approach. Gifts and transfers to minors are irrevocable and give complete control over the use of the money to the child once he or she reaches the age of majority. Also, college financial aid formulas typically require a student to contribute more of his or her total assets to college costs each year, whereas parents are expected to contribute less, sometimes only 5% of their total assets per year. Therefore, unlike 529 plans and ESAs which are generally not considered a student asset for purposes of financial aid, holding assets in your child's name in an UGMA/UTMA may decrease the chance of receiving need based financial aid.

Other Tax-Saving Information
The Hope Scholarship Credit allows for a tax credit of up to $1,500 for the first two years of college. Beyond the first two years, individuals can use a $2,000 Lifetime Learning Credit for additional post-secondary learning. For 2006, full program benefits are available to individuals making less than $45,000 (partial benefits are available for those with incomes between $45,000-$50,000) or families filing a joint return with incomes below $90,000 (partial benefits are available for those with incomes between $90,000-$110,000). Despite the name, however, these credits are not true scholarships. They represent end-of-tax-year refunds for expenses paid, rather than up-front defrayal of costs.

IRA withdrawals can be used to pay for qualifying family educational costs without incurring the 10% penalty for premature withdrawals before age 59˝ (although income taxes may still be assessed).

Interest paid on college loans. Up to $2,500 of interest paid on college loans each year may be tax-deductible. For 2006, full benefits under this provision are available to individuals with incomes of $50,000 or less (partial benefits are available to those with incomes between $50,000-$60,000) or married couples filing jointly earning $105,000 or less (partial benefits are available to those with incomes between $105,000-$135,000).

The legal requirements for these tax benefits can be complex. More information can be gained by calling the IRS at 1-800-829-1040, or by accessing the IRS Web site. You may also wish to consult a financial or tax adviser.

 

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