NRPTC National Retirement Plans Training Conference, Inc. PO Box 2614, New Brunswick, NJ 08903 Phone:  1-800-438-1737 or (732) 636-2400 | Fax: 732-636-3323 We've Got Plans for You

NRPTC Roundtable

K-12 Savings

We hate calling the types of accounts and plans that we discuss "retirement plans".  While retirement is probably the single most common reason for contributing to IRAs and employer-sponsored plans, the law doesn't require it to be the sole purpose.  Each of us has short, medium, and long-term savings needs.  These include such things as:

• primary, secondary and post-secondary education;

• purchase of primary and/or vacation residence;

• children's weddings, bar mitzvahs or bas mitzvahs;

• health and/or long-term care cost for ourselves and close family members;

• purchase of large luxury items such as boats, jewelry, etc.;

• and, of course, the proverbial "rainy day".
  
  We believe that to the extent possible, individuals should utilize tax-favored savings vehicles for all of their savings and investment purposes.
  
  By "tax-favored" we mean vehicles that provide employers with a tax deduction, and/or employees with tax deferral, and/or reduced or eliminated income taxes on earnings or gains.  The problem is that this fairly large group of savings and investment alternatives includes some options that are better than others, depending upon the savings purpose.  In the near future, we plan to do an issue or supplement where we compare various tax-favored savings vehicles.  But for now, let's look at ways that we can accumulate funds to pay for the educational expenses of our "little ones".  Much has been written about vehicles designed to pay for higher education expenses.  For now let’s look at tax-favored saving for K -12 expenses.

  ---

The Fictional Roundtable Discusses
Saving for K-12 Expenses

[Kim De Garden]: I'm struggling with a dilemma.  I have two little children.  Should I be saving for their K-12 expenses; their college costs; or my own retirement?

[NPIN]: An excellent question.  One that we hear a lot.  I guess the best answer is that you should try to do all three if possible.  But many people can't afford to do that.  Here are some thoughts that might be helpful.

- Separate all of your savings objectives into short-term, medium term and long term.

- Make sure you allocate a reasonable part of your short term savings objectives to "rainy day" or emergency needs.

- Identify those savings purposes that by definition will depend more heavily on your own accumulations.  For example, when you retire you will look to your retirement plan accumulations, personal savings accumulations, social security, and possibly the gain from downsizing your residence and/or relocating to a less costly area.  But, since you will probably have less chance to add to your post-retirement accumulations (other than through earnings and gains) you must realize that while these funds might seem fairly extensive they often represent a somewhat fixed resource.

Saving for your children's' college education is quite different.  First of all one or more of your children might opt to by-pass college all together.  And those who do attend might have many other resources to pay for part or all of their costs, including:

• financial aid
• student loans
• employment by the student in general
• employment by the student with a firm that will absorb part or all of the cost of the student's education.

Remember even if you set aside 100% of your savings in accounts oriented toward your own retirement, if structured properly (pre-tax vs. after-tax) you can probably take sufficient withdrawals for your non-retirement needs, such as your child's education, wedding, etc.

• If you're an employee, steer your long-term savings into pre-tax vehicles such as elective contributions to 401(k), 403(b), 457, SIMPLE IRAs or deductible traditional IRAs. 
• Consider limiting your pre-tax salary reduction contributions (i.e., to a 401(k)) to amounts that would trigger an employer match.
• If you're self-employed your savings vehicles should be expanded to include small business retirement plans.

Steer your short-term savings into after-tax vehicles such as Roth IRAs, nondeductible contributions to traditional IRAs, Education Savings Accounts, and after-tax contributions to employer plans.


[Jim Nasium]: What about annuities?

[NPIN]: Annuities are probably the worst choice for short-term or medium-term savings purposes, especially if you're under age 59 1/2.  I would even consider them to be a last choice for long-term savings after fully utilizing my other resources, such as 401(k)s, Traditional IRAs, etc.


[Jim Nasium]:  But, I thought that investing in annuities is much like making after-tax contributions to IRAs, without the limit on amount.

[NPIN]: That's a common misconception.  While both vehicles allow for tax-deferred growth, random (non-annuitized) distributions of after-tax contributions from each are handled quite differently for federal income tax purposes.

- Traditional IRA distributions have a prorated tax treatment.  That means that part of each distribution is taxable and part is tax-free.

- Roth IRA distributions (other than qualified distributions, which are tax-free) are taxed on a FIFO (First In, First Out) basis.  That means that there is no tax on earnings until all of the person's after-tax principal has been recovered tax-free.

- Random qualified retirement plan and 403(b) distributions are taxed on a prorated basis.  You either use the entire plan balance or only the after-tax portion as the denominator of the faction, depending on the plan’s provisions.

- Random distributions from annuities have the worst tax treatment of all.  They are taxed on a LIFO (Last In, First Out) basis.  That means that all distributions are fully taxable to the extent of any accumulated earnings in the account before any of the after-tax contributions can be recovered tax-free.

[G. Omitree]: I keep hearing about 529 plans.  May I use them to pay for my kids' K-12 expenses?

[NPIN]: Technically, you may use 529 plan funds to pay for anything.  But if you use them for anything other than "qualified higher education expenses", the part of the distribution representing income is subject to federal income tax, plus a 10% penalty.  That would be the case, for example, if you used it for K -12 expenses.


[G. Omitree]: What about these new Education IRAs?

[NPIN]: Now those are a different story.  Technically they're now called Coverdell Education Savings Accounts, but we'll refer to them simply as Education Savings Accounts or ESAs.  Distributions from ESAs may be used for either K - 12 or qualified higher education expenses.


[Art Rithmitic]: But you can only contribute $500/year to those accounts, right?  That doesn't permit much of an accumulation.

[NPIN]: That was the dollar limit on contributions before 2002.  Under the present law up to $2,000/year can be contributed to ESAs of each child.


[Art Rithmitic]: Who can contribute to a child's ESA?

[NPIN]: Although it's often the child's parents or grandparents that actually contribute to these plans, it could be anyone. There's no restriction under the law as to who may contribute, except that the contributor's adjusted gross income for federal income tax purposes must not exceed certain limits.  In certain cases where the parents' AGI is too high, the family might look to grandparents or other family members to be the "nominal" donor, if their AGI is low enough.


[Art Rithmitic]: So the person making the contribution doesn't have to be related to the child?

[NPIN]: Not at all.  The donor could be a godparent or even an unrelated neighbor or friend.


[Guy Dance]: Those accounts are kind of like IRAs, right?

[NPIN]: They are similar to IRAs in some ways, but actually they're quite different.  For example, neither the donor to the ESA nor the beneficiary (the child) needs to have any earned income like they would with an IRA.  Also, unlike traditional IRAs, contributions to an ESA are NEVER tax deductible.  And unlike IRA distributions, distributions from an ESA may be rolled only to an ESA, never to an IRA or employer-sponsored plan.


[Guy Dance]: Is there a 10% penalty for an early distribution from an ESA like there is with an IRA?

[NPIN]: While there is the possibility of a 10% penalty on ESA distributions, it's not for an early distribution.  It's for any payment that isn't for "qualified education expenses".  That's either qualified higher education expenses or qualified K - 12 expenses.  As with IRAs, the penalty is only on the taxable portion of any ESA distribution.

[G. Omitree]: What kinds of expenditures are included as qualified K - 12 expenses?

[NPIN]: Just about any expense incurred in connection with enrollment or attendance in a K - 12 institution.


[Jim Nasium]: Does that include expenses that are incurred in connection with "home schooling" my child?

[NPIN]: That's not clear to us.  It includes expenses incurred with respect to public, private or religious schools.  So unless the IRS views home schooling as a type of private school, the answer is apparently not.  Parents in this situation might want to consider obtaining advice form their own legal or technical resource, or filing for an IRS private letter ruling.


[Kim De Garden]: Can you give us a list of the types of costs that represent qualified K - 12 education expenses.


[NPIN]: Sure:

• Tuition
• Fees
• Academic Tutoring
• Special Needs Services
• Books
• Supplies
• Computer Equipment (including related software and services)
• Other equipment expenses incurred in connection with enrollment, or attendance at a public, private or religious school for K - 12 education
• Room
• Board
• Uniform
• Transportation

Supplementary Items or Services (including extended day programs) required or provided by such school in connection with such enrollment or attendance.


[Jim Nasium]: Wow.  That's rather all-encompassing.  So, I can contribute up to $2,000/year to the ESA accounts of each of my children and withdraw amounts on demand, tax-free to pay for any of these items, right?

[NPIN]: That's correct, but no contributions may be made to the account of a person who has reached age 18.


[G. Omitree]: Once the money is contributed may I simply leave it there to grow tax-deferred until a withdrawal is needed?

[NPIN]: Yes, except that the "child's" account must be liquidated by the time the person reaches age 30.


[Guy Dance]: What happens if the funds haven't been completely used up by the time the person reaches 30?

[NPIN]: You have a couple of choices.  You can:

- try to find appropriate expenditures to utilize the balance on a tax-free and penalty-free basis.

- withdraw the funds for non-qualified purposes.  This means adding the amount representing earnings and gains to the child's taxable income and having it subjected to a 10% additional federal tax penalty.

- transfer the balance to the account(s) of one or more other eligible person or persons.

[Art Rithmitic]: Who are the "persons" you refer to in the last item and how does that work?

[NPIN]: The recipient of the transfer can be anyone related to the child in any of the following ways (so long as such person is below age 30):

- spouse
- son, daughter or other descendent
- brother, sister, step brother, step sister
- father or mother
- stepfather or stepmother
- niece or nephew
- uncle or aunt
- the following in-laws:  son, daughter, father, mother, brother or sister
- first cousin

You can either advise the financial institution serving as trustee or custodian of the ESA of the change of beneficiary, or make a rollover or transfer of the funds to an account established for the benefit of such a person.


[Art Rithmitic]:  Can that person be over age 18?

[NPIN]:  Yes, but parents, parents in-law, etc., or any others would not qualify if they have already reached age 30.


[Jim Nasium]: How can I set one of these accounts up?

[NPIN]: You'd have to go to a bank, securities firm or other financial organization that offers such a plan.  Our staff called some of the largest financial organizations to get an idea of what's available.

[Kim De Garden]: Where can I get additional information about these plans?

[NPIN]: The following is a link to ESA material on the IRS website http://www.irs.gov/newsroom/article/0,,id=128874,00.html.   If the link doesn't work, you can go the IRS website (www.IRS.gov) and search for "Educational Savings Accounts", or obtain a copy of IRS Publication 970.

[Hugh B. Hayve]: I put money into a 401(k) each year.  Can't I take a withdrawal from that plan for K - 12 expenses?

[NPIN]: The elective contributions that you make to a 401(k) are generally not available until you reach age 59 1/2 or leave the company.  But some plans provide an exception in the case of "hardship" distributions.  The law permits 401(k) plans to include as hardship distributions payments for certain post secondary education expenses.  So, K - 12 expenses wouldn't qualify.  That means that other than taking a plan loan, you probably wouldn't be able to access your 401(k) funds to pay for K - 12 expenses, even if you were willing to pay a penalty.

But, if your 401(k) plan permits you to make after-tax contributions, that part of the plan may be an excellent vehicle for saving for your child's education expenses, whether K - 12 or post-secondary.  This is especially true if the plan permits on-demand withdrawals of after-tax contributions.


[G. Omitree]: What about contributing to a traditional or Roth IRA?

[NPIN]: That depends on which of the following you use.

1. Fully taxable traditional IRA - If all of the money in all of your traditional IRA(s) represents taxable funds, a distribution from any of your traditional IRAs, SEPs or SIMPLE IRA plans will be fully taxable.  Also, if you're under age 59 1/2 you can't look to distributions for K - 12 expenses to provide an exception to the 10% penalty on early distributions.

2. Partially taxable traditional IRA -  If some of the money in your traditional IRA(s) represents after-tax contributions, part of any distribution would be taxable and part tax-free.

3. Partially taxable Roth IRA - With Roth IRAs there's good news and bad news.  First the good news.  As we mentioned earlier, any Roth distribution is tax-free to the extent that you have not yet recovered all of the principal amount of your non-deductible contributions or your conversions.  But, unless you have reached age 59 1/2, any additional amount is includable in your federal taxable income, and subject to the same 10% penalty rules that apply to traditional IRAs.

4. Tax-free Roth IRA - If you have reached age 59 1/2 and have had your Roth IRA for at least 5 years even the portion of your distribution that represents earnings is tax-free and penalty-free whether you use the distribution to pay for ESA expenses or a gambling junket to Las Vegas.


[G. Omitree]: So that sounds like a traditional IRA might be a so-so to bad choice for accumulating for K - 12 expenses, but a Roth IRA might be an excellent alternative.

[NPIN]: That's true, if your AGI qualifies you to contribute to your own Roth IRA.


[G. Omitree]: But couldn't I simply contribute to a Roth IRA for the child?

[NPIN]: Yes, if the child has his or her own earned income (salary, tips, etc.).  But, since the child wouldn't be age 59 1/2 when taking K - 12 expenses (at least we hope not), any distribution of earnings would be taxable (albeit at the child's rate) and also subject to a 10% penalty.  Of course unlike ESAs, there would be no requirement to withdraw from an IRA by the time the "child" reached age 30.  And, to the extent that the taxable proceeds from the IRA were used for qualified higher education expenses, rather than K - 12, they would be includable in the child's  income, but not subject to a 10% penalty.

Also, if instead of eventually using the funds for either K - 12 or higher education expenses the child used a Roth IRA distribution for a "first-time home purchase" the distribution of earnings (up to $10,000) would be neither taxable nor subject to penalty.


[Hugh B. Hayve]: If anything remains in the child's ESA when he or she applies for college would there be any impact on eligibility for financial aid?

[NPIN]: Parents whose children might be eligible for financial aid should seriously consider using up the ESA balance for qualified expenses, or transferring the balances to the ESA of an eligible relative before the year in which the initial financial aid evaluation is made for the original participant.  ESA balances are considered to be funds available to pay for the child's higher education costs and would therefore reduce the amount of possible financial aid.


[Hugh B. Hayve]: But isn't that also true of the child's IRA balances?

[NPIN]: It's not quite the same.  While some colleges and universities include a child's IRA balances in the school's own evaluation for financial aid assistance, IRA balances are not automatically included under the federal formula.

return to www.nrptc.com