What’s the best method to provide money to children? Since school began this week at Fort Collins and the back-to-school season kicking off for a lot of people in the lead-up to Labor Day weekend, it’s hot!
It’s about giving to children grandchildren, grandkids or nieces, nephews, or any other special children that you love, we’re asked many of these questions. With this year’s Secure 2.0 Act permitting rollovers of 529 Plans to Roth IRAs in the coming year, we’ve decided to transform our three-part series on “Giving Money to Kids” into an all-inclusive article.
from college saving strategies and gifts not always intended to be used for education, you’ll find everything here.
Most of the inquiries we’ve received are focused on where the most appropriate “place” to put money for babies is. What’s intriguing about this issue is there’s so many possibilities for solutions that it can be a bit overwhelming. From basic “mental accounting” — i.e. that $X in this account will go to Jr.’s college tuition -to complex trusts and everything else in between, the possibilities are almost limitless.
But, I think there are some strategies that don’t have to numb the mind, but are definitely worth a look. The first question to think about when you are faced with this issue is “Do I want this money to be used specifically and only for college?”
If the answer to both these questions can be yes, you need to be focusing on the tax advantages you can avail when you save for college.
EDUCATION GIVING
The most renowned investment option currently available in college savings is Section 529 College Savings Plan. Due to its popularity, I’m going to begin here. While it’s not a guarantee that I believe that this is the most ideal place to save to save for college but the upcoming Roth IRA rollover option certainly can make it a little more sweet. Let’s look at the 529 Plan and how it operates.
THE 529
How do 529 Plans Work?
There’s a good chance you’ve heard of the 529 Plan and are asking, “How do 529 plans work?” 529 plans are government-sponsored college savings plans that permit the investment of funds in a tax-deferred manner. This means that there aren’t taxes on dividends, interests or capital gains they are earned within the account.
When funds are distributed through the account provided it is used to pay for eligible education expenses, it can be withdrawn tax-free. Recent changes in tax law increased the kinds of expenses 529 funds can be used to pay for and now includes private K-12 education for instance.
There are restrictions on the kinds of investments that are included in a 529 plan generally the mutual fund and other bank-related productsas well as the frequency with which investments can be modified.
There isn’t a tax advantage for making a contribution to 529 plans. In Colorado, the State of Colorado — as well as a few other states, you are generally able to be able to deduct your contribution for tax purposes of the state in the event that you contribute to a plan that is sponsored through the state. In the context of applying for the Free Application for Federal Student Aid (FAFSA) the assets of a 529 plan are typically considered as assets belonging to the parent. This is significant due to the fact that, under the formula for federal aid the parent’s assets are assessed to be “available” for college expenses at about 1/4 of the cost of the assets belonging to the student– 5.64 percent and. 20 per cent, for instance — which means that making the assets less “available” means potentially more available aid.
There are both good and bad aspects about a 529 program. The most frequent complaint I hear about is the range of investments options. If you’re faced with this decision-making reality, if, due to some reason, a college 529 savings plan isn’t the right choice, three other avenues are usually left open to research. Each of them has an element of tax benefits which I believe is the most important thing to consider after you’ve made the decision that the money is going to be used to fund education.
SECURE 2.0 Act: 529 Plan-to-Roth-IRA Rollover
For the 529 Plan-to-Roth IRA rollover option there are a few important details to keep in mind to be aware of how it operates. First, it’s only available to $35,000 for total rollovers. This is a good chunk of change that can help start the savings of a child’s retirement!
However, transfer limits are set at the child’s earnings or IRA contribution limit per year, whichever is lower. Therefore, they must be working and earning income in order to transfer money from their 529 plan to your Roth IRA. It’s quite in line with the minimum wage age but it’s important keep in mind that the 529 Plan account has to be in existence for a minimum of 15 years prior to the first rollover occurs. In addition, there are the limited amount that can be rolled over annually in order to have another five or so years until the rollover is completed to the limit amount in 2023, based on the Roth IRA contribution maximum. In total, it will take 20 years to get to the maximum of $35,000!
However, this doesn’t leave enough time to put the funds in the Roth IRA before age 18 or so, based on the timing. The impact is “giving money to kids” is small and may be more suitable to have a backup plan in place for those who don’t spend the entirety of the funds from their 529 Plans for education as college students. If you are an adult or a child who satisfy the requirements the rollover of the 529 Plan to Roth IRAs can be made from January 1st 2024..
COVERDELL
There’s also another option, the Coverdell Educational Savings Account. The Coverdell is an a bit of an unusual type of account; think of it as an amalgamation of an Roth IRA and a 529 plan, each with its own rules.
The maximum amount is $2,000 that can be deposited into the Coverdell to benefit children under 18 years old every year. The funds can be reinvested into virtually anything a normal brokerage account would be able to invest in, making it more flexible as compared to a 529 program. While the contributions aren’t tax-deductible, the funds that is in the account grows tax-free. If it’s taken out to fund secondary, primary, or postsecondary schooling expenses, it’s tax-free.
Similar to a 529 plan Coverdell funds is able to be used for private high and elementary school tuition, and more direct expenses related to education such as a computer to school. But unlike a 529 plan the income thresholds can limit the contributions you can make to the Coverdell. If your modified adjusted gross income (MAGI) exceeds the amount of $110,000 and $220,000 (single or joint or joint) it is not possible to contribute to the Coverdell in any way. In addition, if the beneficiary who is designated has reached age 30 years old, the beneficiary has to be changed to a person who is younger than 30 years old to avoid penalties and taxes.
OTHER GIVING OPTIONS
IRAS
Let’s say you’re trying to find an innovative solution and, despite the fact that you think that this money will go towards educational expenses, you’re still not certain. In addition, let’s suppose that you’re not certain you’d like give “give” this money to the child for any particular reason, or at least not right now.
Incredibly, your Traditional or Roth IRA can serve as an excellent education fund that can accommodate these kinds of thoughts.
TRADITIONAL
If you have an Traditional IRA, you can consider distributions that you make to fund “qualified higher education expenses” for your children, yourself or grandchildren as an “normal” distribution, regardless of age. This is because this can be considered an exemption to 10% early penalty tax for distributions.
If the contributions you made towards the IRA were tax-deductible or transferred from a plan that is deductible for employers like the 401(k) and a 401(k), the distribution is tax deductible as income. If your contributions were not tax deductible — which is the best use of a tax-deductible IRA — only the part of the distribution that was attributed to growth will be taxed, while the rest will be considered an income tax-free repayment of principal.
Be aware that in both cases you may also have experienced tax-deferred growth.
ROTH
Roth IRAs follow the same route like Traditional IRAs with no tax deductions with one major differentiator. When the regulations for getting distributions out of an Roth IRA are written, it’s always your principal that gets out first. This means that you can use the payments to pay for higher education costs — or anything else that you want to — and the distributions are tax-free.
If you exceed the amount that you have put to the Roth IRA, and assuming that the Roth IRA for you has been open for a period of five calendar years, then the distributions will be tax deductible. However, there is no 10percent penalty tax for premature distribution due to the exemption to the penalty mentioned in the previous paragraph.
DOWNSIDES TO USING AN IRA FOR EDUCATION FUNDING
Be aware that while this could be beneficial based on your personal circumstances however, there are some important disadvantages of making use of your IRA to fund your college. In the first place, although an IRA account is shielded from federal aid calculations because it is an asset, distributions are regarded as income and are incorporated to the formula which affects aid for the next school year.
In addition This is the case of a 529 plan as well as the Coverdell the distribution should be made in the year in which the expenses are incurred. They cannot be used to pay back the student loan or any other previous expenses.
Remember that the main purpose behind an IRA is to serve as a retirement savings instrument. After the money has been withdrawn to cover college costs the IRA is not earning any returns The only way to get it back is to make regular, limited contributions.
In the next section, we’ll consider providing money for education when it isn’t the main focus. Perhaps you’d like to offer the financial foundation for your children when they turn adults, perhaps so that they can all start a business or purchase a house. You might even want to use the funds to fund college or other education costs … however, you’re not sure if this is the direction your kids are going to take.
To be honest It’s a bit difficult to pinpoint exactly what’s going to happen five, 10 or fifteen years in the future. The only option is to think about all options and then make a sound plan based on that information.
NON-EDUCATION-SPECIFIC GIVING
Here is where non-education-specific gifting comes into play. In fact, only a handful of options are available when it comes to plainly gifting money to minors:
1. A lawful operation is referred to as an uniform transfer to Minors Act (UTMA) account or an Unified Gifts to Minors Act (UGMA) account.
2. Making the gift into a trust account for the child with the most popular being a Section 2503(c) trust also known as an ” Minors trust.”
The main difference between them is that the first one that is an UGMA (or UTMA account is extremely simple and almost no cost to establish. The latter — a minors trust — is likely to require the assistance by an attorney.
MINORS TRUST
Beginning with the second trust, it is a trust that is a Section 2503(c) trust takes its name from a Section of Internal Revenue Code that makes its creation an option. The goal of the Section 2503(c) trust is to make a gift to minors that he will not be able to make use of immediately, yet the gift qualify for the annual exclusion of gift tax amount of $15,000 in 2021. In general, only gifts that are made in what is known as “the present interest” would be eligible for the annual tax exemption for gifts.
Typically, trusts provide a time frame when the minor turns 21 in order for the beneficiary to take the trust’s principal. After this time, if the property remains within the trust the terms in the trust documents define how the property will be removed at any time. After this time of time, donations to the trust will not be eligible to be tax-deductible in the annual tax exemption amount. In addition to the expense of hiring an attorney to write the trust document, the biggest drawback of the Section 2503(c) trust would be that in default, it will be taxed in the same manner as an independent entity with higher tax rates for trusts.
UGMA AND UTMA
For UTMA or UGMA accounts every state, except for South Carolina recognize an UTMA account as a type of ownership in property. This is significant since an UTMA account is able to hold nearly every kind of asset, including real property. A UGMA account is, however is restricted to depositing money into banks, securitieslike bonds, stocks mutual funds, stocks and bondsand insurance policies.
Donations for UTMA as well as UGMA accounts are also eligible for the annual tax exclusion amount. Both types of accounts are exempt from tax. the law of the state dictates when a minor is an adult. In most instances, it’s the age is 18 or 21 (in Colorado, it’s 21). The laws of the state in which you live or where your UTMA as well as the UGMA was created or in which state the minor resides.
The taxation process for UTMA or UGMA accounts is governed by rules known as the “kiddie tax” rules. For 2020, the first $1100 of income earned is tax-free for a child and the following $1,100 will be taxed at the rate of the child that is higher than $2,200. Anything above can be taxed by the parents’ maximum tax rate. Although this may provide some tax relief, addressing tax-related issues is essential in the event that the account contains resources to potentially earn more than $2,200 in capital gains or income.
For all of the non-education-specific funding arrangements: a caveat.
Contrary to the savings vehicles for education and strategies that we discussed earlier where a designated beneficiary may change, gift made to minors under the circumstances that we’ve been discussing are irrevocable. In the case of an UGMA or Section 2503(c) trust the asset is owned by the trust and, in the end it is transferred to the minor. If you have a UTMA as well as an UGMA account the asset is immediately transferred to the minor, with an adult as the custodian until the child attains the age of reaching the age of majority. In these instances it is possible to use the funds before reaching the age of the majority if it’s for the benefit to the child. It could be used for education or even to pay for braces or an excursion to summer camp.
This is the tradeoff: tax breaks and rigidity and tax breaks, or flexibility with limited tax advantages.
Should you wish to go about any of the options mentioned above — or another alternative, such as making a children the primary beneficiary in the account -contact us to set up a time to meet. We’ll be able to guide you in setting up some of the accounts mentioned above and even help you prepare the paperwork required to help you set up an classic IRA, Roth IRA, or UTMA. If you’re thinking of the option of a section 529 plan, or Coverdell ESA Let us know and we’ll include it in the tab for education funds in your financial planning software. If you’re planning to consult with an attorney in order to establish the Minor’s Trust, we’re glad to be a part of the meeting along with you.
Remember that gifting the money is just one aspect in the process. What your child does with the gift is a different. If you’re trying to impart some knowledge about finances to the young receiver, our posts on changing from a piggy account to a real banks and making money education an interactive game can be a great help.
Happy giving!
