College Planning in the Wake of New Tax Laws

Planning for college has never been easy. But such planning became a bit easier when President Bush signed the TIPRA and DRA into law earlier this year.  Among other things, DRA and TIPRA changed the treatment of pre-paid tuition plans and 529 plans, two popular vehicles Americans use to save for and pay for college.

Chief among the changes are those that pertain to the so-called “kiddie tax.”  Effective in 2006, the new law calls for the "kiddie tax" to remain in effect until a child turns 18.  Previously, unearned income attributable to children age 14 and older was usually taxed at the child's tax rate.  The new tax law, however, raises the age to 18 effective January 1, 2006.  Exceptions apply for minor children who are married and file a joint tax return, and distributions from certain qualified disability trusts.

This change affects parents and grandparents who were or continue to use custodial accounts such as UTMAs (Uniform Transfer to Minors Act) or UGMAs (Uniform Gift to Minors Act) for college savings instead of 529 college savings plans.  At present, UTMA and UGMA dollars are considering the child’s asset in the financial aid formula.  But selling funds, or at least selling funds that have appreciated in value, in an UTMA or UGMA prior to a child turning 18, could create a significant tax bill.  What’s more, assets in UGMA and UTMA accounts become the child’s at the age of maturity, which varies by state.

For many parents and grandparents, the new law makes 529 plans a more viable savings vehicle.  With a 529 plan, contributions will grow tax-free and withdrawals are tax-free through 2010 as long as they are used for qualified education expenses.  In addition, financial planners note that with 529 plans, the parent or grandparent controls the money.

Of course, parents and grandparents who established UTMA and UGMA accounts to pay for college education do have options.  Under the act, UTMA or UGMA assets can be invested in a 529 plan, although assets have to be liquidated and cash invested in the plan.  Doing so may create a tax burden, but financial planners note that it may be more than offset by preferential treatment of 529 plans in the financial aid formula.  A tax analysis should be performed to determine the impact.

According to SavingforCollege.com, 529 plans do indeed receive preferential treatment.  Sometimes referred to as the “529 loophole,” the new law removes student-owned 529 plans and Coverdell education savings accounts from the expected family contribution (“EFC”) in the federal financial aid formula.  A 529 account or Coverdell ESA is considered an asset of the account owner; however, 529 accounts or Coverdell ESAs owned by a dependent student are excluded from the Free Application for Federal Student Aid or FAFSA.  Most undergraduates are dependents for FAFSA purposes.

This is exceptional treatment, reports SavingforCollege.com.  Under the federal financial aid rules, college savings plans are counted as an asset of the parent (if the parent is the account owner) and assessed at a rate of 5.6 percent.  This means that 5.6 percent of the funds are deemed available for college expenses in the year a student applies for aid.  By contrast, 35 percent of assets owned by the student are used to calculate the EFC.

In addition, parents and grandparents who have been using prepaid tuition plans to save for their children's college education received some good news on July 1, 2006 when the federal government began treating 529 prepaid tuition plans the same as 529 college savings plans for financial aid purposes.

Distributions (withdrawals) from a college savings plan that are used to pay the beneficiary's education expenses are not counted as either parent or student income.  Prepaid tuition plans will now be treated the same way.

By way of background, prepaid tuition plans prior to July 1, 2006 were treated differently than college savings plans under the government's financial aid formula.  A prepaid tuition plan wasn't counted as an asset of either parent or student, but any distributions from the plan were considered a "resource" that reduced the cost of attendance at any given college.  And that resulted in a corresponding dollar-for-dollar reduction in financial aid.  That is, every dollar that flowed out of a prepaid tuition plan reduced the beneficiary's aid award by one dollar.  The new financial aid rules ensure that both types of 529 plans will be treated equally.

August 2006— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Hillebrand Financial Planning, LLC, a local member of FPA

 

Navigating Interest Rates, Inflation and the Economy

These are tricky times for American investors and consumers in general.  The economy seems to be cooling down!  The second quarter GDP rose just 2.5 percent, down from 5.6 percent in the first quarter of 2006 and below its average of 3 percent during the recent expansion.  And the housing market, perhaps in reaction to 30-year fixed rate mortgages above 6 percent in late July, also seems to be slowing down: Sales of new homes fell 3 percent to 1.13 million homes in June and revisions to data released by the Commerce Department also showed the U.S. housing market was weaker in the first quarter than previously reported.

 

Meanwhile, recent inflation and spending data show inflation to be at an 11-year high.  For instance, The Federal Reserve’s favored inflation gauge -- the core personal consumption expenditure price index -- increased 0.2 percent for the third straight month in June.  Core inflation, excluding food and energy, has risen 2.4 percent in the past 12 months, matching the largest year-over-year gain since the spring of 1995.  Consumer prices including food and energy also rose 0.2 percent in June, and were up 3.5 percent in the past year.  As a reference, the 20-year average annual rate of inflation was 3 percent.

 

The cross currents of a cooling economy and housing market with rising prices and the threat of wage pressures has left the Federal Reserve in a bit of bind.  For the past two years, the Federal Reserve has been increasing short-term interest rates as part of an effort to slow down the economy and inflation.  But while the Federal Reserve has indeed slowed the economy, it has yet to bring inflation under control.  The main culprits are surging raw material and energy prices – the average gallon of unleaded gasoline hovering around $3 – over which the Fed has little control.

 

This coincidence of an inflationary threat with a slowing economy has led some to raise the prospect of the return of something not experienced in decades – stagflation.

 

Stagflation occurs when economic growth stalls and inflation continues to rise.  According to Wikipedia, the online encyclopedia, stagflation is considered to be a problem because most tools for influencing the economy using fiscal and monetary policy are thought by some analysts to be based upon the trade off between growth and inflation.  “Either they slow growth to reduce inflationary pressures, or they allow general increases in price to occur in order to generate more economic growth.”  Stagflation creates a policy bind wherein attempting to correct one problem exacerbates another.  However, although some similarities exist in the form of rising oil prices and inflationary risks, there is little in the current situation to indicate the return of the stagflation of the ‘70s.  Economic growth, while showing some signs of slowing, remains generally strong.  And the forces of globalization and the global competition that results, in the context of world wide central bank restraint, make serious inflation less of a threat than in the earlier period.  The more serious threat today is that the Federal Reserve will go too far, resulting in a recession.

 

For investors, the upshot of the unholy combination of rising inflation in a cooling economy might be devastating.  What can an investor do?  Investors might consider repositioning your investment portfolio by shifting a portion from stocks to bonds.  Putting a larger portion of funds into high-quality, long-term bonds, such as the 10-year Treasury bond, is one strategy since these had a yield of 4.98 percent at the end of July.

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According to financial planners, if the Fed keeps pushing the button marked “increase short-term interest rates” too long, a mild recession could result.  Should this happen, market interest rates would come down in response and a bull market for long-term bonds would result, with the price of bonds increasing.  Likewise, experts also recommend using five-year certificates of deposit to produce income.  High quality CDs that mature in five years had a recent yield of 5.04 percent.

 

On the equity side of a portfolio allocation, investors might also want to consider investing more in high-quality, dividend-paying stocks.  Stocks of companies that pay out a good percentage of their earnings as dividends generally have less price fluctuation than stocks of non-dividend payers.  The dividend represents a big part of the return, which often smooths out price volatility of those stocks.  More often than not, large companies, such as those that are part of the Standard & Poor’s 500 stock index, pay high dividends.  The current yield of the S&P 500 is, for instance, 1.86 percent.

 

August 2006— This column is produced by the Financial Planning Association, the membership organization for the financial planning community, and is provided by Hillebrand Financial Planning, LLC, a local member of FPA