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COLLEGE SAVINGS 101

Education incentives survive fiscal cliff

Posted: 2013-01-03

by Joseph Hurley

Financial Professional Content

President Obama has just signed the 2012 American Taxpayer Relief Act (ATRA), saving many of the education tax incentives scheduled to expire on December 31, 2012, and even resuscitating incentives that had expired at the end of 2011. Here are some frequently asked questions concerning the new law (feel free to email Joe Hurley if you have other questions):

Has the Coverdell education savings account been saved?

Yes. While not exactly going down the fiscal cliff in flames, the ESA would have been severely gutted if returned to its pre-2002 tax status. All of the beneficial changes made with the 2001 Tax Act are now permanent. These include the tax-free use of an ESA for K through 12 expenses; the $2,000 annual contribution limit (it was $500 before 2002); the coordinated use of tax-free ESA distributions in the same year an education tax credit (see below) is claimed; and allowing contributions to both an ESA and to a 529 plan for the same beneficiary in the same year.

So if you are partial to the self-directed nature of Coverdell ESA investments, or have clients planning to spend money for private grade school, you should be pleased.

Has the 529 plan been saved?

No. It did not need saving. The provisions of Section 529 were already permanent, thanks to the 2006 Pension Protection Act. However, it would be nice if legislation comes along in the future to include computers as qualified expenses for every college student, and to expand the number of investment changes in a 529 account.

The tax-deferral and tax-exclusion benefits of 529 plans actually increase for taxpayers with incomes above $400,000 (married couples above $450,000) thanks to new higher income-tax and capital-gains brackets, not to mention the new 3.8% Medicare tax on investment income for high earners.

Won’t the high estate tax exemptions reduce the appeal of 529 plans?

I suppose it might, figuring that fewer American families are exposed to the federal estate tax as a result of the now-permanent $5 million (adjusted for inflation) estate and gift tax lifetime exemption. You will have fewer clients with a burning desire to reduce their estates, and who are interested in 529 plans as the only vehicle accommodating a transfer of wealth without transferring control.

On the other hand, we should see much larger contributions going into 529 plans as a direct result of the $5 million ($10 million for a couple) estate exemption. There will be less reluctance in making contributions that exceed the $14,000 gift tax annual exclusion when the consequence of doing so is to simply eat into a lifetime exemption that will never be fully utilized.

And don’t forget about state-level inheritance and estate tax. Many states have exemptions well below the $5 million level, and shifting wealth via a 529 plan can still make a big different in tax exposure without giving up control.

What is happening with the education tax credits?

The very generous American Opportunity tax credit has been extended for five years, through 2017. After that, we return to the somewhat less-generous Hope credit. Your clients should be doing everything they can to take maximum advantage of the American Opportunity tax credit because you really cannot beat it. This includes in some cases shifting the credit to the student—along with some income—when the parents exceed the income threshold. Notably, ATRA brings back the phase-out of personal exemptions for high earners, which makes shifting the credit to the student a no-brainer for many high-income families.

The Lifetime Learning credit was not at risk of expiring. We are still awaiting 2013 inflation-adjusted income threshold numbers from the IRS.

How about the above-the-line deduction for tuition and fees?

The tuition and fees deduction has been extended retroactively from the end of 2011 to the end of this year 2013. For the life of me, I cannot understand why. With a maximum deduction of $4,000, the American Opportunity tax credit is almost always a better deal.

What else has been extended or made permanent by ATRA?

Section 127 employer-provided educational assistance is now permanent. So is the expanded deduction for student loan interest.

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