A WELL-ROUNDED APPROACH TO COLLEGE SAVINGS

In recent years, college expenses have become one of the biggest expenses many families face, rivaling retirement and buying a home for top billing. Fortunately, sound planning can help you prepare for these expenses, and there are a variety of savings tools available. This article outlines some of the options. Choosing the right investment plan requires an examination of your overall financial plan and considerations such as the availability of financial aid.

Section 529 Plans

ASection 529 plans - named after the tax code provision that created them - offer one of the most powerful and flexible options for college saving.

There are two types of plans: prepaid tuition plans and college savings plans. Most families prefer the latter, which allow you to make nondeductible contributions to a state-sponsored investment program on behalf of a beneficiary. Earnings grow on a tax-deferred basis and withdrawals are tax-free if they're used to pay for qualified higher education expenses.

College savings plans can be used to pay most higher-education expenses - including tuition, fees, room and board, books, computer equipment, and supplies - and they can be used at most accredited colleges or universities in the United States (plus vocational schools and some schools overseas).

One of the most attractive features of these plans is their generous contribution limits. Limits are determined on a state-by-state basis, but they usually exceed $100,000 and some plans allow you to contribute more than $250,000. What's more, the tax benefits of Section 529 plans aren't phased out for higher-income taxpayers. Most plans are open to both residents and nonresidents (although some states offer state income tax breaks or other tax incentives to residents).

Section 529 plans also provide significant estate and gift tax benefits even though the donor retains control over the funds. Contributions are removed from the donor's estate for estate tax purposes and qualify for the $11,000 annual gift tax exclusion. In addition, donors can elect to treat a contribution as if it were made over five years, sometimes allowing contributions up to $55,000 ($110,000 for a married couple) in a single year free of gift tax. This benefit applies only if the donor lives for five years after making the gift. Otherwise the contribution is treated as a taxable gift. Donors retain the power to change beneficiaries to another member of the original beneficiary's family. They can also roll over funds from one Section 529 plan to another for the same beneficiary, as frequently as once every 12 months.

Despite their appeal, Section 529 plans aren't without their disadvantages, which include the following:

• Money not used for qualified education expenses is subject to tax plus a 10-percent penalty.
• In most states, donors have little control over investment decisions (although the rollover option lets you change plans if you're dissatisfied).
• Withdrawals from Section 529 plans may have an impact on financial aid eligibility.
• There's some uncertainty over the future tax treatment of Section 529 plans. Several significant enhancements to these programs, including tax-free treatment of qualified distributions, were added by the 2001 tax act and are subject to that law's "sunset" provision. Unless the law is amended, withdrawals from Section 529 plans after 2010 will once again be taxable at the beneficiary's tax rate.
  

Coverdell Education Savings Accounts

Formerly known as Education IRAs, these accounts allow annual nondeductible contributions of up to $2,000. Like Section 529 plans, earnings grow on a tax-deferred basis and withdrawals are tax-free. Coverdell ESAs can be used for elementary and secondary school expenses as well as college costs.

Disadvantages, in addition to relatively low contribution limits, include an income requirement: benefits are phased out for joint filers beginning at adjusted gross income of $190,000 and eliminated at $220,000. The phase-out range for single filers is $150,000 to $160,000. One way around the income cap is to give money to your child and have him or her contribute it to an ESA.

Also, student eligibility for financial aid will be diminished since Coverdell accounts are considered student assets and disbursements are included in student income..

UGMA and UTMA Accounts

With a Uniform Gift to Minors Act or Uniform Transfer to Minors Act account, money is invested in your child's name. For 2002, the first $750 in annual earning is tax-free; the next $750 is taxed at the child's rate; and earnings in excess of $1,500 are taxed at the parent's rate. An advantage of UGMA or UTMA accounts is that there's no penalty if the money isn't used for education expenses. On the other hand, at 18 (or in the case of UTMA, 21), the recipient takes control of the funds and can use them for any purpose. Also, since the child owns the funds, the account may have a negative impact on financial aid eligibility..

Taxable Investments

Tax-favored savings vehicles can be extremely effective, but don't overlook ordinary taxable investments, such as mutual funds, stocks, or bonds. Despite being handicapped by taxability, these investments offer a number of advantages. There are no contribution limits, you have complete control over investment decisions, and the funds are in your name so the impact on financial aid eligibility is minimal. Plus, if the money isn't needed for college expenses, it can be used for other purposes without penalty.

Do Your Homework

Each of the savings option outlined above has unique advantages and disadvantages. To design an appropriate strategy, work with your financial advisor to determine how saving for college fits in with your overall financial plan.

Most experts agree that you should fund your retirement first, then save for college, since alternatives are available for college expenses, such as financial aid and scholarships. Plus, your 401(k) and IRA savings aren't counted as assets in determining financial aid eligibility.

If, after setting aside what you need for a comfortable retirement, you have resources left for college savings, your financial advisor can help you select one of the investment options described above or, more likely, a combination of several of them. The best approach will depend on your income, your children's ages, and your projected eligibility for financial aid.

IRS FINALIZES IRA MINIMUM DISTRIBUTION RULES

Last year, the IRS proposed new regulations that dramatically altered the rules on required minimum distributions (RMDs) from IRAs and other retirement accounts. Most people are required to start taking distributions by April 1 of the calendar year after they turn 70½. The proposed rules simplified the computation of RMDs and, in most cases, resulted in substantially lower required distributions.

In April, the IRS issued final regulations that, for most taxpayers, are even more favorable.

Under the old rules, RMDs were computed so that the account balance was distributed over the account owner's remaining life expectancy or over the combined life expectancies of the owner and a designed beneficiary. A number of important decisions had to be made, and fixed, by the required beginning date. These included determining whether to make an irrevocable election as to whether life expectancy should be recalculated annually and designating a beneficiary. If the account owner died without a designated beneficiary, the account balance had to be distributed within five years.

Final Rules

The final rules, like the proposed rules, simplify the computation of RMDs by incorporating a uniform lifetime distribution period. All taxpayers consult a single table to determine RMDs based on their ages and prior year-end account balances. For most taxpayers, the new table specified by the proposed rules resulted in smaller RMDs. The final rules incorporate updated life expectancy tables under which distributions may be made over an even longer period.

It's no longer necessary to elect whether to recalculate life expectancy and the age of the beneficiary is not a factor. (A taxpayer whose only beneficiary is a spouse who is more than 10 years younger, however, is eligible for a longer payout period.)

Distributions after the account owner's death are based on the beneficiary's life expectancy, and a beneficiary need not be designated until the end of September of the year following the account owner's year of death. Any time prior to this date, multiple living persons can be designated as beneficiaries, each entitled to use his or her own life expectancy for computing RMDs.

The final regulations go into effect in 2003. This year, taxpayers have the option of using the new rules, the 2001 proposed rules, or the original 1987 proposed regulation. Although most taxpayers will be better off applying the final rules, consult your tax advisor for guidance on choosing the best option.

Take Advantage of Tax Breaks in Stimulus Bill

The Job Creation and Worker Assistance Act of 2002 provides businesses with several important tax breaks, some of which are retroactive to 2001. Eligible businesses that didn't claim these benefits for 2001 should consider filing an amended return.

For many businesses, the most significant benefit is "bonus depreciation" - an additional first-year depreciation deduction equal to 30 percent of an eligible asset's adjusted basis. Qualifying assets include property with a depreciable life of 20 years or less, water utility property, depreciable computer software, and certain leasehold improvements - provided they're otherwise covered by the modified accelerated cost recovery system (MACRS).

The benefits, which are available for both regular and alternative minimum tax purposes, can be considerable. Suppose that in 2002 a business acquires $100,000 in computers and office equipment ordinarily depreciable over five years under MACRS. The business also qualifies for a Section 179 expensing election. Under the new law, the business can claim total first-year depreciation deductions of $57,440.

To qualify for bonus depreciation, assets must be acquired (or construction of leasehold improvements must begin) between September 11, 2001, and September 10, 2004, and placed in service before January 1, 2005. Additional benefits are available to businesses in New York City's "Liberty Zone."

The stimulus act also:

• Increases the first-year depreciation limit for luxury cars from $3,060 to $7,660 (for vehicles purchased between September 11, 2001 and September 10, 2004 and used more than 50 percent for business).
• Extends the net operating loss carryback period to five years for tax years ending in 2001 and 2002 - normally, the NOL carryback period is two years (three years for certain casualty losses). The act also allows NOLs arising in those years or carried forward to those years to be fully deducted against alternative minimum taxable income.
• Reinstates the welfare-to-work and work opportunity tax credits.
• Extends unemployment benefits 13 weeks.
  

Tax Breaks Won't Benefit Everyone

The bonus depreciation and NOL provisions will produce big tax savings for many businesses, but some taxpayers will be better off under the regular rules. For example, a business that was in a lower tax bracket five years ago than it was two years ago may enjoy greater tax savings by using NOLs to offset more recent income. The new law allows taxpayers to opt out of the bonus depreciation and extended NOL carryback provisions, provided they file a special election. Be sure to consult a tax advisor to help you determine the best option and to file the appropriate paperwork.

To receive a copy of the IRS's Frequently Asked Questions Regarding Required Minimum Distributions, please contact us by phone or e-mail.