Chapter 19
Ten Ways to Dodge the Tax Code Minefield
In This Chapter
Keeping tabs on contributions and qualified expenses
Making sure you don’t overfund your account
Understanding how the tax laws apply to you
Turning to experts for answers to your questions
Almost everything in life carries with it some tax consequences. Some are unavoidable, such as paying a sales tax every time you purchase a roll of toilet tissue. Others you may voluntarily choose, such as contributing more tax to the total pot when you begin earning a higher salary. The government tries to discourage certain behaviors by highly taxing products related to those behaviors (such as tobacco and alcohol). Not every consequence makes sense, though: Married couples pay a higher tax for the privilege of being married. Frankly, if you try to make sense of the social policies that are entwined with taxes, you may go nuts. Suffice it to say that tax policies touch your life in a myriad of ways.
And, for the most part, because taxes are such a part of your life, you live your life without paying much attention to the number of ways in which you’re taxed. If you’re like most people, you tend to focus only on newsworthy items, which are generally the ones that affect you the least: things like the drop in the capital gains and dividends tax, the estate tax, and so on. Although you may realize a small amount of tax relief from these reductions, you’d really be far better off if the government magically halved the gasoline tax, which is a tax that really hits you in your pocket.
So it will come as no surprise to you that tax implications figure hugely in any discussion about savings and that you may positively impact your savings program by focusing on the various rules and regulations surrounding college savings accounts. This chapter points out several areas where you may want to pay careful attention so that you can maximize your savings and minimize the amount that you hand over to the government.
Knowing Who’s Giving and How Much
Anonymous benefactors belong in fiction, not in your life. If someone other than you is making gifts to your children in Coverdell Education Savings Accounts (ESAs) or in any other type of account, you need to know about it. The regulations are especially strict in Coverdell (no more than a total of $2,000 may be given per child per year without triggering excess contribution rules and penalties), but anything that is gifted to your child needs to be on your financial radar. You need to know about any assets your child is accumulating that may impact financial need down the road. In addition, should some well-meaning but potentially misguided person be making contributions into an Uniform Gifts to Minors Act or Uniform Transfers to Minors Act (UGMA/UTMA) account, you need to crank up the level of money management skills your child will have by the time he reaches majority (age 18 or 21, depending on what state your child lives in). On that date, she’s going to be in charge of a reasonably large sum of money, and she needs to know how to use it wisely.
Being Aware of Your Income and Phaseout Amounts
Coverdell accounts limit and/or prohibit the amount higher-income taxpayers are allowed to contribute, but the phaseout amounts are always subject to change, as is your income. If you are trying to fund a Coverdell account and feel that your income may begin touching the limitation amounts, you may want to wait until after the end of the year before making your contribution; you have until your tax filing deadline to make a contribution for a prior year. Remember, contributions from taxpayers who fail to meet the income requirements are considered excess contributions and are subject to an excise tax until the excess amount (including all income earned on it) is removed from the account and paid to the beneficiary.
If, on the other hand, you’re buying Series EE or Series I savings bonds now with the intention of using them later, tax-free, to pay for your child’s educational expenses, you don’t need to be concerned with your income at the time you purchase the bonds. If your income increases up to and beyond the phaseout range in the years that you need to redeem the bonds, however, you may end up paying income tax on the interest you’ve earned in the interim period.
Keeping Track of Your Contributions
The current rules regarding the tax-exempt status of qualified distributions from Coverdell ESAs and Section 529 plans are only temporary. Your guess is as good as mine as to whether they’ll become permanent. Only qualified distributions currently receive tax-exempt treatment, and many accounts will have at least one nonqualified distribution to close out the account at the end of your child’s education. For those reasons, you need to know how much money you contributed to the account and how much income was earned on that money in order to accurately calculate any tax and penalties due.
Avoiding the Penalties from Overfunding an Account
True, you don’t know how much sending your child to college will cost, and that makes it really difficult to calculate just how much you should save in a Section 529 plan or a Coverdell account. Still, given the penalties that you’ll pay if you save more than you need in either type of account, you’re probably better off saving slightly less than you think you’ll need rather than more.
.jpg)
Knowing Your Effective Tax Rate
If you read articles about college savings plans, you’re probably convinced that there are only two tax brackets: the highest one (which is yours, of course) and the lowest one (your child’s). When you’re using these extremes, the examples in these articles always show how beneficial it is to push income to your child, who pays taxes at a lower rate.
The reality is that the gap between your tax bracket and your child’s is usually not as great as the illustrations show. The vast majority of taxpayers pay tax at one of the two lowest levels, so the benefit of paying tax at the student’s level rather than at the parents’ level is generally not all that great.
Staying Aware of Tax Laws in Your State
Although federal tax regulations for college savings plans are the same for everyone, state laws vary, and no two states are exactly alike. Be sure that you understand how your college savings plans are taxed in your state before you begin funding any plan. Before you open any account, check carefully into available income tax deductions for current contributions, the tax-exempt status of qualified distributions, and how other states’ plans are treated in your state if you’re considering a 529 plan.
Of course, knowing what the laws are when you create a plan is one thing; keeping track of any changes is something else altogether. If you move, don’t assume that you must change your plan — you may not need to. Likewise, don’t think that current state laws are set in stone — college savings plans represent a huge amount of currently untapped tax revenues for many states, and currently advantageous laws are always subject to change, particularly in tough economic times.
Keeping Track of Your Qualified Education Expenses
The tax-exempt nature of qualified distributions from Coverdell accounts and Section 529 plans and tax-exempt redemptions from Series EE and Series I savings bonds are powerful incentives for you to save in these vehicles. Keep in mind, though, that anything that is so attractive is also something that is ripe for abuse, and the IRS may be very vigilant in policing these tax-exempt distributions and redemptions.
Keep copies of paid tuition bills and other qualified educational expenses together with your tax returns, and destroy them only after you’re certain that you’re well past the date for audit from the IRS or your state tax department. If one of these agencies calls you for proof of your expenses, your honest face and forthright manner won’t hold much water, but receipted bills will.
Staying Informed about Changes in Current Laws
As a tax professional, I love to see Congress change tax law on a frequent basis — that’s what keeps me in demand. As a taxpayer, however, I find that trying to keep track of the current law seems to be an exercise in futility — as soon as I think I’ve got it, Congress changes it.
And this is especially true of Congress’s tinkering with any sort of tax-deferred or tax-exempt savings plan, including Section 529 plans and Coverdell accounts. Almost yearly since their inception, Congress has made changes in the rules and regulations governing these accounts, from who may participate to how much may be contributed to what expenses you may pay for using distributions from these accounts. Both Coverdell accounts and Section 529 plans will continue to evolve, especially because many of the current provisions are set to expire after 2010, unless Congress renews them.
Being Honest about Your Child’s College Plans
When you look at your newborn for the first time, you’ve no doubt that this child is headed for an Ivy League school. With that vision in mind, you open a college savings account. As the years go by, however, that same child, who isn’t exactly thriving in school, begins to live inside the engine of your car and comes up for air only long enough to raid your refrigerator.
The lesson here is to be honest with yourself about what your dreams and aspirations are — and what his are. Funding a college savings account only for the sake of keeping your dreams alive is expensive in the long run. If you’re not sure how much money, if any, your child will use for postsecondary qualified expenses, save money in ways that allow you more latitude, such as in personal investment accounts or in a trust for that child’s benefit. The tax savings may not be as great while you’re actually putting money away in these types of accounts because there are no tax deferrals and you annually pay the income tax that’s due on that year’s earnings. Still, if your child ends up not needing your savings for college expenses, your overall results may be as good as, or even better than, saving the same amount of money entirely in a Section 529 plan or a Coverdell account. Unlike nonqualified distributions from Section 529 or Coverdell accounts, any distribution that your child takes from a personal investment or trust account is only taxed to the extent that he receives current, untaxed income as part of that distribution. Any amounts previously taxed won’t be taxed again to him, and a nonqualified distribution penalty is never imposed.
Getting Answers by Asking Questions
Some tax considerations are complicated, new and different tax provisions crop up frequently, and old provisions are reinterpreted. Consequently, you may find yourself in the position of not being exactly sure what you should do in a given situation. If so, join the crowd. Although college savings accounts are actively marketed as do-it-yourself vehicles, they’re do-it-yourself in the same way that bicycle construction instructions are so simple that a 4-year-old could build it.