CHAPTER 12 Long-Term Savings and Retirement Tax Issues for the Very Young

MY FRIEND RITA BECAME an Enrolled Agent later in life. She was in her fifties when she started her tax practice, working out of her home. Many of her first clients were young people—college students and newlyweds who worked for fairly low wages. She gained a large following quickly. Why? Not because she got them high, unreasonable refunds. Her popularity soared because she taught these young people how to start saving money even when they didn’t have much spare cash. How did she do it? First of all, Rita Veen, EA, is one of the most loving, focused women I know. She really cares and pays attention to her clients and their long-term needs. Second, Rita started setting her young clients up with three-month trial subscriptions to The MoneyPaper so they could learn some basic investment skills. (More about this in a moment.) A funny thing happened. The young folks started telling their parents and grandparents about Rita. Some of those adults were quite wealthy with complex tax issues. Because Rita honestly cared for her clients (and their children and grandchildren), it took no time at all to build up a healthy and wealthy client base. I care about you, too. So let’s start with Rita’s secret weapon—saving in tiny increments.

Tip #198:

It’s never too early to start saving for retirement. A good time to start is when your baby is born. There are all kinds of ways to start build savings. All of them have advantages and disadvantages. But so does everything in life. The DRIP Investment site (it used to be the MoneyPaper magazine) shows how much security you can build up for your children with as little as $25 per month for 62 years (https://www.directinvesting.com/index.cfm). You start it and teach them to keep adding to it as soon as they are old enough to understand numbers. Naturally, you can put the money into savings accounts, brokerage accounts, “dividend reinvestment programs” (DRIPs), or save up for US Savings Bonds. But if you want your children to learn secure investing, the DRIP site helps you find no-fee or low-fee DRIPs where you can buy the shares directly from the company, sometimes for as little as $10 or $25 (https://www.directinvesting.com/25_dollar_drips.cfm). Take a look their “kid’s portfolio” (https://www.directinvesting.com/drip_learning_center/starter_portfolio.cfm?from=kids). In the past, they would include stocks that came with benefits. Now fewer companies offer them (http://www.wsj.com/articles/SB10001424052702303330204579250763759331636). Disney used to offer shareholder discounts, Wrigley sent out packs of gum, Starbucks gave out gift cards—all gone! Kimberly Clark stockholders still get an annual gift box of goodies for about half the retail price (http://www.kcgiftbox.com/store/c/18-Gift-Box.aspx). Ford shareholders who can prove ownership get discounts on vehicle purchases. Some cruise lines offer onboard discounts. Berkshire-Hathaway shareholders who attend the stockholders’ meetings can get a whole array of discounts and goodies in their meeting packet.

Tip #199:

Speaking of saving in small increments, there is a relatively new IRA you can set up, called myRA (https://myra.gov/how-it-works). It works a lot like a Roth IRA, which means you don’t get a deduction for your contributions and will not pay tax when you draw the money at retirement (age 59½ or more).

• The main advantage is that once you open it, you may make deposits in teensy tiny increments, like $2. Of course, you may deposit more . . . but you don’t have to.
• It costs nothing to open.
• You can fund it from your paycheck, if your boss participates in the program. Just set it up and forget it and you build up savings painlessly.

• Or you can fund it via direct deposit from your savings or checking account.

• You can even use your IRS tax refund to put money into your myRA. Just check the “savings account” box on your tax return or on Form 8888 and enter the account number.

• The annual contribution limit is the same as the limit for IRAs and Roth IRAs—$5,500 ($6,500 if you are age fifty or older) through December 31, 2016. Visit the IRS website for annual updates (https://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics-IRA-Contribution-Limits).
• The myRA is backed by the US Treasury and earns a higher rate of return than most small savings accounts—they claim it averaged 3.19 percent over the ten years ending in December 2014. As I write this, Bankrate.com is showing a return of .85 percent on the five-year certificate of deposit. Five years at less than 1 percent? Wow! In the weekly CD rates analysis on November 12, 2015, the one-year CD yields 0.27 percent while the five-year CD yields 0.85 percent. For a $100,000 deposit, the average one-year jumbo CD yield was 0.31 percent for the ninth straight week. The five-year jumbo yield was 0.89 percent for the second consecutive week. The average money market account yield was 0.09 percent for the fifty-seventh consecutive week (http://www.bankrate.com/cd.aspx). OK, the Federal Reserve raised the interest rate in December, for the first time in years. The returns increased by a small fraction. http://www.federalreserve.gov/newsevents/press/monetary/20151216a.htm.
• There are no fees!
• When your account reaches $15,000, you need to roll it over to a Roth IRA. Hopefully, by then, you can get a decent rate of return in the Roth IRA. In fact, if you see that you can get a better rate of return sooner, roll it over to your Roth IRA anytime you like.

• Note: To learn how much your investment would be worth in the future, Google this phrase to find a calculator to help you—“future value of monthly deposit.”

Tip #200:

Coverdell Education Savings Accounts (ESA). This is another IRA-type account with no tax break when you fund it. This is often called the Education IRA (https://www.irs.gov/publications/p970/ch07.html). Folks may contribute up to $2,000 per year into the ESA for each designated beneficiary as long as the contributor’s modified adjusted gross income (MAGI) is less than certain annual limits, which change each year (https://www.irs.gov/publications/p970/ch07.html#en_US_2014_publink1000178431). You may contribute to your offspring, your grandchildren, even the children of your employees or just for a friend. The purpose of this account is to set aside money to help fund a person’s education someday. While there is no deduction for the contribution, the earnings in the account grow tax-free. So if you can find a stable investment that can generate a decent rate of return, these accounts can be a valuable way to grow college funds tax-free. If you don’t have the skills or contacts to find secure investments paying more than a quarter of a percentage, skip it. Just put the money into a savings account for your child. It won’t have any strings attached to the withdrawals. And the earnings will be low enough each year that the annual taxes will be insignificant, or there won’t be any at all.

Tip #201:

Strings on the Coverdell ESA withdrawals. There are restrictions on how the money can be used. For this account, the restrictions are not too burdensome. Let’s explore them:

• The educational institution must be “qualified.” The IRS says, “This is any college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the US Department of Education.” It includes virtually all accredited public, nonprofit, and proprietary (privately owned profit-making) postsecondary institutions.

◦ This includes certain overseas educational institutions.
◦ Did you notice that this also includes “vocational” schools? You don’t need to be a scholar to use these funds. You can train to become an auto mechanic, plumber, long-haul trucker, master chef, esthetician, hairdresser, dress designer, deep sea diver—or whatever your heart desires.
◦ However, if the educational institution simply provides continuing professional education, or isn’t accredited with the US Department of Education, you cannot use the ESA account funds for those schools.

• Eligible higher education expenses include:
- ◦ For special needs students, only those additional costs related to making it possible to enroll in and attend the school.

• Surprise! You can also use these funds for an eligible elementary or secondary school. This includes any public, private, or religious school that provides elementary or secondary education (kindergarten through grade twelve) as determined under state law.

◦ Most people don’t realize that the ESA is the only account that lets you use the savings for K-12 costs.
◦ When you have friends, employers, and relatives funding these accounts, this is a great way to tap into the money to cover the high costs of private schools.

• Eligible K-12 education expenses include all the above, plus these additional costs:

◦ academic tutoring
◦ transportation
◦ uniforms
◦ extended daycare programs or other supplementary costs

Tip #202:

Coverdell ESA myth. The main drawback is that we may only deposit up to $2,000 per child, per year, no matter who provides the funds. Even if you start the account the year the child is born, by the time they turn 18 there will only be $36,000 in the account, plus the earnings. At 3 percent per year, that would be about $50,000 (http://www.hcuonline.com/HCU_Calc_PeriodicSavings.html). That might be enough to cover higher education costs for a year or two. But if you use the funds for private school (K-12), the money would be depleted before it even earned any interest.

Tip #203:

No harm, no foul. Direct gifts of educational costs. Did you know that when you pay someone’s education costs directly to the school there is no gift tax consideration and no limit on how much you may contribute? Talk to all those nice people who would have been willing to chip in toward the Coverdell ESA. Instead of limiting their combined contributions to $2,000, they could pay any amount at all directly to the school. True, there’s no tax deduction for this. But they also won’t have to file any gift tax returns, regardless of how much they contribute.

What is the value of this to the recipient? More than you can imagine. When families, religions, or communities require that their children attend private schools, the costs can be overwhelming. Even with scholarships to help out, there are still funds the parents must pay. In absolute dollar terms the additional costs might not seem high. But when you look at the supplement cost in terms of a percentage of the budget—especially if you must pay for more than one child—this can cause severe hardship.

Tip #204:

The consequence of not getting financial help when needed. When I came to California, my brother and I went to a small private religious school. Even with a financial hardship scholarship, our parents still had to pay $15 per month for each of us, or $30 per month. That doesn’t seem like much, does it? After all, you spend more than that at Starbucks in a week, right? Uh huh.

Back then, that was 15 percent of our $200 mortgage. Today, that same house would rent for about $6,850 per month, or the mortgage would be about $5,900 per month. Without even taking cost-of-living inflation rates into account and just looking at the equivalent mortgage rates, that additional stipend would mean a copay of at least $885 per month, or $10,620 per year. It might explain why my father couldn’t maintain those costs. Yes, he lost the house to foreclosure rather than asking for help from family members who might have been willing to pay our tuition shortfall. (If he had been able to keep the house, the mortgage would be long gone by now. The house would be worth more than $1.5 million! My brother is still fuming.) Let’s not let that happen to you.

Tip #205:

Another way to save is the Qualified Tuition Program (QTP), also known as the Sec 529 plan (https://www.irs.gov/publications/p970/ch08.html). Why is it called the Sec 529 plan (https://www.law.cornell.edu/uscode/text/26/529A)? Simple. That’s the Internal Revenue Code section where you will find all the details. As with the other plans we have been discussing, there is no tax deduction for your contribution to the 529 plans. These plans were designed to allow family members to put a lot of money into a college savings plan. Essentially, the first year’s contribution to the plan is designed to be quite large. Family and friends may contribute up to five times the annual gift tax limit, which is currently $14,000. Five times that amount is $70,000. When these plans became popular, I made up a detailed Benefit and Drawbacks list on the TaxMama.com site (http://taxmama.com/Articles/529.html).

Julie Garber, About.com’s gift and estate planning guide, provides the updated annual gifting limits from 1997 to the current year (http://wills.about.com/od/understandingestatetaxes/a/historygifttax.htm). This large initial contribution was valuable in several ways:

• Having a lot of money in the plan made it possible to invest in securities with higher returns than you could buy with lower balances.
• The big benefit of plans that were tied to specific educational institutions was that if you paid in a specified amount, your college tuition was guaranteed to be covered, regardless of the increase in fees over the years. (Of course, that guarantee was only valid at that institution or in that state. What if the student didn’t want to attend that college, or wanted to study in a different state, when they grew up?)
• You could fund the account quickly for a student who would be starting college in just a few years.
• Some states may offer incentives that the IRS doesn’t offer. They are well worth looking into.
• Funds could be used for tuition, books, and supplies as well as housing.

The drawbacks?

• Once that large initial deposit was made, the generous relative could make no more gifts to that person for five years.

• When you fill out the FAFSA (Free Application for Federal Student Aid) form for financial aid, the balance of the Sec 529 plan owned by your or your parents is taken into account (https://fafsa.ed.gov). Note: If the trustee, who controls the plan, is a grandparent, you might not need to show the whole balance on your application.
• Funds not used for educational purposes would face penalties when withdrawn from the account.

The details of these accounts have evolved a decade or two. Read the IRS overview in Publication 970 (https://www.irs.gov/publications/p970/ch08.html). Better yet, explore the excellent information on the Saving for College website (http://www.savingforcollege.com/college_savings_201). They can answer all your questions.

Tip #206:

Moving on from Sec 529 to Sec 529A. Young or old, sometimes you face disability issues. Have you ever heard of the ABLE Tax-Advantaged Accounts for Disabled Individuals (IRC Section 529A; https://www.law.cornell.edu/uscode/text/26/529A)? Most people have not because this is a new plan. You will find an excellent explanation by the good folks at www.smbiz.com. Let me give you a summary. Essentially this allows for contributions of up to $14,000 per year to go into a special bank account to help the person with a qualified disability. The “advantage” part of this account is that Medicaid and other aid programs won’t take this bank account into consideration when they determine if the person is qualified for state aid. However, as with all tax benefits, there are drawbacks:

• The balance in the account can never exceed $100,000.

• Anything over that amount will be taken into account to reduce government aid and benefits.

• Excess annual contributions are subject to a 6 percent excise tax for each year until the excess amounts are removed.

• The funds may only be used for medical and support costs for the beneficiary.

• Any funds left in the account at death must be paid back to the various state aid programs up to the amount they contributed to the care of the individual.

Some benefits of the account include:

• There are no complicated legal processes to set up an ABLE account as there are in “special needs trusts” and the like.
• The funds may be used for funeral costs.
• You may pay legal and financial administration costs.
• The account balance may be transferred to another close relative who is disabled.

Bonus Tip #207:

News flash! The IRS just issued new rules to simplify how people can qualify for these accounts: https://www.irs.gov/pub/irs-drop/n-15-81.pdf. The guidelines were open to comment, and commenters noted that three of the requirements for qualified Achieving Better Life Experience (ABLE) programs in the proposed regulations would create significant barriers to the establishment of such programs. So the IRS simplified them. Please read the notice. These ABLE plans are brand new. States still need to establish guidelines, so check with the experts before trying to set these up on your own. Meanwhile, here are the changes:

• Categorization of distributions not required. ABLE programs need not include safeguards to determine which distributions are for qualified disability expenses, nor are they required to specifically identify those used for housing expenses. Commenters noted that such a requirement would be unduly burdensome and that, in any case, the eventual use of a distribution may not be known at the time it is made. Designated beneficiaries will still need to categorize distributions when determining their federal income tax obligations.

• Contributors’ TINs not required. ABLE programs will not be required to request the taxpayer identification numbers (TINs) of contributors to the ABLE account at the time when the contributions are made if the program has a system in place to reject contributions that exceed the annual limits. However, if an excess contribution is deposited into a designated beneficiary’s ABLE account, the program will need to request the contributor’s TIN. For most people, the TIN is their Social Security number (SSN).

• Disability diagnosis certification permitted. Designated beneficiaries can open an ABLE account by certifying, under penalties of perjury, that they meet the qualification standards, including their receipt of a signed physician’s diagnosis if necessary, and that they will retain that diagnosis and provide it to the program or the IRS upon request. This means that eligible individuals with disabilities will not need to provide the written diagnosis when opening the ABLE account, and ABLE programs will not need to receive, retain, or evaluate detailed medical records.

Watch for updates here: https://www.irs.gov/irb/2015-27_IRB/ar09.html. Note: Section 303 of the PATH Act of 2015 changed the residency requirement for ABLE beneficiaries. Please see Bonus Tip #270 for more details.

Tip #208:

Using whole life insurance to save up for college (or anything at all). This is something we haven’t touched on at all. In early 2015, I was invited to do a TwitterChat for the @CollegePrepped team (http://collegeapptraining.com/chatcollege-on-tax-tips-and-preparation-for-parents-of-college-bound-students-recap). Via a link on their website I found a very thought-provoking article by Miguel Palma, CPA (http://www.mpalma.com/blog/life-insurance-better-bet-529-plan). I was wondering how he would make good on his statement “Why Life Insurance is a Better Bet than a 529 Plan.” It’s simple and brilliant, actually. You start funding the whole life policy for the child when the child is born or is very young. At that time, there are no health issues. The insurance companies are happy to take your money, knowing they will hold it for decades. The policy will build up value. When the child is ready to go to college, they simply borrow the funds. They can use the money for anything they choose without having to track the costs of books, fees, and so on. They won’t have to care if the institution is accredited or not. There are no taxes on the borrowed funds. Either they can pay themselves back over the years or they can get a lower payout when they die or cash out the policy.

All right, since we started talking about education benefits anyway, let’s move on to that topic!