Education Savings Options -- Tax Treatment of Withdrawals


R

Ron Sheldon

In 1998 I established what was then called "Education IRAs"
for each of my grandchildren. As I recall from then,
withdrawals from these accounts for qualified higher
education expenses was tax free with no provision for the
termination of that tax free status.

Subsequent legislation renamed these accounts as Coverdell
Education Savings accounts, increased maximum annual
contributions for a beneficiary and made certain other
changes, e.g., permit use of withdrawals for qualified K-12
expenses.

Q: Am I correct that the original 1997 legislation
establishing these accounts permits tax free withdrawal of
earnings and did not contain a termination date for that
status?

Q: Did any of this change with subsequent legislation?

I'm now reviewing various state 529 college savings plans
and note that the provision for federal tax free withdrawal
of earnings for qualified higher education expenses expires
Dec. 31, 2010, unless the provision is renewed/extended/made
permanent by Congress. There are no in-state tax benefits
or matches for the 529 plans offered by my, my
grandchildren's and their parent's states of residences.
For planning purposes, I'm presuming that the federal
provision won't be renewed/extended. Assuming that this
comes to pass:

Q: I'm presuming withdrawals of earnings after 2011 will be
treated as ordinary income for tax purposes -- correct? If
not, please clarify.

Q: Would withdrawal of earnings after 2011 for qualified
higher education expenses be consider income to the account
owner [me or the child's parent] or the beneficiary [my
grandchild/ren]?

Q: Would there be tax advantages or adverse tax
consequences if the initial account owner [again, me or the
child's parent] established a new 529 plan the year of or a
few years before withdrawals begin with the grandchild as
the account owner and beneficiary of the new plan, with
partial annual partial rollover transfers from the initial
plan to the new plan to fund anticipated expenses as they
are soon to come due? Assume the grandchild will be at
least 18 years old and will have minimal other income.

The state 529 college savings plans I reviewed so far seem
to me to have fairly high management expenses, when combined
with the underlying expense ratios of the mutual funds
involved, restrictive structured portfolio options, overly
conservative or somewhat inefficient asset allocation models
and/or restrictive individual mutual fund options.
Presuming that the tax free status earning withdrawals
terminates Dec. 31, 2010, tax deferral appears to be their
main tax related benefit. I'm thinking that I may be able
to constructed more efficient portfolios using various tax
efficient index mutual funds, ETFs, tax managed funds, etc.,
than those offered in the 529 plans I reviewed. The
difference, of course, is that I would lose some tax
deferred growth by paying annual taxes on whatever
distributions such a portfolio generated, but these taxes
might be less than the management expenses of the 529 plan.
I could also use a separate portfolio for equities and a 529
plan for the more highly taxed bond/fixed income of an
overall higher education savings plan. And, I'd avoid the
10% penalty if the growth in a separate portfolio is used
for other than qualified higher education expenses and
probably, whether or not withdrawn for higher education
expenses, that growth would be taxed lower longer term
capital gains rates than as ordinary income if the 529 tax
free status terminates Dec. 31, 2010. Of course, if the tax
free status is renewed/extended, then taxes on sales from a
separate portfolio for qualified higher education expenses
is an offsetting tax exposure.

Q: Am I looking at this correctly regarding tax
considerations and are there other tax related factors you
think I should include in making a decision about a separate
portfolio versus a 529 plan, or some combination of the two?

Q: If I decide to pursue a separate portfolio and gift
portions of that portfolio the a grandchild and/or parent
for sale to pay college expenses as they occur, does the
grandchild and/or parent retain my original cost basis of
the assets gifted? Do they also obtain my long term capital
gains status for the assets gifted?

I will appreciate any other thoughts you might have
regarding 529 plan decisions -- I've reviewed
Morningstar.com and SavingForCollege.com Web sites for
various 529 plan options, and studied the plan documents for
W. VA [DFA funds], Delaware/Mass./N. Hampshire [Fidelity
funds], Alaska [T Rowe Price funds], Nevada and Utah plans
[different Vanguard funds and plan management expenses], but
didn't have enough monthly return data to analyze the three
very similar state plans that use TIAA-CREF funds.

Thanks in advance to all,

Ron Sheldon
 
Last edited by a moderator:
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J

joetaxpayer

Ron said:
In 1998 I established what was then called "Education IRAs"
for each of my grandchildren. As I recall from then,
withdrawals from these accounts for qualified higher
education expenses was tax free with no provision for the
termination of that tax free status.

Subsequent legislation renamed these accounts as Coverdell
Education Savings accounts, increased maximum annual
contributions for a beneficiary and made certain other
changes, e.g., permit use of withdrawals for qualified K-12
expenses.

Q: Am I correct that the original 1997 legislation
establishing these accounts permits tax free withdrawal of
earnings and did not contain a termination date for that
status?
This is my recollection as well

Q: Did any of this change with subsequent legislation?

I'm now reviewing various state 529 college savings plans
and note that the provision for federal tax free withdrawal
of earnings for qualified higher education expenses expires
Dec. 31, 2010, unless the provision is renewed/extended/made
permanent by Congress. There are no in-state tax benefits
or matches for the 529 plans offered by my, my
grandchildren's and their parent's states of residences.
For planning purposes, I'm presuming that the federal
provision won't be renewed/extended. Assuming that this
comes to pass:

Q: I'm presuming withdrawals of earnings after 2011 will be
treated as ordinary income for tax purposes -- correct? If
not, please clarify.
I think there would be a backlash to remove the tax-free
provision, but I believe you are right. Ordinary income.
Q: Would withdrawal of earnings after 2011 for qualified
higher education expenses be consider income to the account
owner [me or the child's parent] or the beneficiary [my
grandchild/ren]?
I'd think it would be the beneficiary as this is a completed
gift. You have no legal right to withdraw the money.
(Although there's a provision to change beneficiaries, so I'm
not 100% here.
Q: Would there be tax advantages or adverse tax
consequences if the initial account owner [again, me or the
child's parent] established a new 529 plan the year of or a
few years before withdrawals begin with the grandchild as
the account owner and beneficiary of the new plan, with
partial annual partial rollover transfers from the initial
plan to the new plan to fund anticipated expenses as they
are soon to come due? Assume the grandchild will be at
least 18 years old and will have minimal other income.

The state 529 college savings plans I reviewed so far seem
to me to have fairly high management expenses, when combined
with the underlying expense ratios of the mutual funds
involved, restrictive structured portfolio options, overly
conservative or somewhat inefficient asset allocation models
and/or restrictive individual mutual fund options.
Presuming that the tax free status earning withdrawals
terminates Dec. 31, 2010, tax deferral appears to be their
main tax related benefit. I'm thinking that I may be able
to constructed more efficient portfolios using various tax
efficient index mutual funds, ETFs, tax managed funds, etc.,
than those offered in the 529 plans I reviewed. The
difference, of course, is that I would lose some tax
deferred growth by paying annual taxes on whatever
distributions such a portfolio generated, but these taxes
might be less than the management expenses of the 529 plan.
I could also use a separate portfolio for equities and a 529
plan for the more highly taxed bond/fixed income of an
overall higher education savings plan. And, I'd avoid the
10% penalty if the growth in a separate portfolio is used
for other than qualified higher education expenses and
probably, whether or not withdrawn for higher education
expenses, that growth would be taxed lower longer term
capital gains rates than as ordinary income if the 529 tax
free status terminates Dec. 31, 2010. Of course, if the tax
free status is renewed/extended, then taxes on sales from a
separate portfolio for qualified higher education expenses
is an offsetting tax exposure.
You've given this alot of thought and I tend to agree. The
100% tax free option is the one thing that makes the 529
desirable. If not tax free, the fees and ordinary income tax
are quite the disadvantage. Add to that the limited investment
options, and a low cost index fund wins out. If you wait till
the child is 14, and avoid the kidde tax, you can capture
gains and pay little in taxes right up to the point you need
to sell in full.
Q: Am I looking at this correctly regarding tax
considerations and are there other tax related factors you
think I should include in making a decision about a separate
portfolio versus a 529 plan, or some combination of the two?
The 529 has a provision where you can gift 5 years out. i.e.
this year, you can gift 12K to whomever you wish. But in a
529 you can gift 60K and take the five year's worth of gift
exclusion at once. That's the only thing you didn't mention.
Otherwise I think you covered it well.
Q: If I decide to pursue a separate portfolio and gift
portions of that portfolio the a grandchild and/or parent
for sale to pay college expenses as they occur, does the
grandchild and/or parent retain my original cost basis of
the assets gifted? Do they also obtain my long term capital
gains status for the assets gifted?
A gift while you are alive takes the date of purchase and cost
basis with it. A gift that's inherited gets stepped up to
market value. I'm a big fan of leaving a ROTH Ira to a
grandchild. They can have a tax free income stream for life.
I will appreciate any other thoughts you might have
regarding 529 plan decisions -- I've reviewed
Morningstar.com and SavingForCollege.com Web sites for
various 529 plan options, and studied the plan documents for
W. VA [DFA funds], Delaware/Mass./N. Hampshire [Fidelity
funds], Alaska [T Rowe Price funds], Nevada and Utah plans
[different Vanguard funds and plan management expenses], but
didn't have enough monthly return data to analyze the three
very similar state plans that use TIAA-CREF funds.
I'm in Mass. where Fidelity is the approved State Fund. It
seems ok, but the fees are still on the high side.

JOE
 
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