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As one of life’s many transitions, the admission to partnership in a law firm is rewarding not only in terms of status but also in terms of finance. The relationship between newly admitted partners and their firms has changed. Financial concerns may no longer be as pressing as before. But the one constant worry that does not disappear is the means of providing for their children’s education. Even those who are wealthy need to plan for the cash flow requirements of paying for their children’s education. Virtually every family is concerned with the cost of college education. The average cost of a four-year college education, including room and board, is more than $100,000 and is projected to rise to about $250,000 by the time today’s newborn attends college. This expense is increased by the number of children in the family, making financial planning for college education a primary issue for many families. Parents who send their children to private or religious elementary and secondary schools may face even greater financial burdens. Fortunately, there are several tax incentives, as well as strategies, that may be utilized to help alleviate the financial burden. More than in previous generations, today’s grandparents and great-grandparents have accumulated wealth that will pass on eventually to their children and grandchildren. The tax law provides several avenues to transfer this wealth gift and estate tax-free. ‘TIS THE SEASON One of the primary steps toward reducing one’s wealth is by establishing a gift-giving program. The annual exclusion permits tax-free gifts up to $11,000 per year, per person ($22,000 if the donor is married and uses a gift-splitting election). The exclusion can be applied to an unlimited number of people. The recipient, of course, may use the gift for any purpose. Although the gift and estate tax exemptions are currently $1 million, only the estate tax exemption is scheduled to increase to $1.5 million in 2004, $2 million in 2006 and $3.5 million in 2009 before full estate tax repeal in 2010. The question then arises whether it’s worth making taxable gifts over $1 million or let the property be subject to estate tax, betting that the estate tax will be repealed. Despite the potential of estate tax repeal in 2010, reasons still exist for reducing one’s wealth. One is that there is no certainty as to one’s death occurring in 2010, the only year that there is no estate tax. The provisions of the Economic Growth and Tax Relief Reconciliation Act of 2001 (new law) are scheduled to “sunset” after 2010, bringing back the law as it existed prior to 2002. Secondly, there is almost a certainty that the repeal of the estate tax itself will be repealed even before 2010. Notwithstanding these issues, there are educational tax benefits that also can be utilized as part of a wealth transfer program. The tax law provides a major incentive for educational gift-giving by permitting an unlimited amount of tuition to be paid for anyone free of gift taxes. This exclusion is above and beyond the $11,000 annual exclusion. Tuition payments for nursery school through graduate school qualify for this exclusion. The payments, however, must be made directly to the qualifying educational institution. Grandparents and great-grandparents can maximize their use of this exclusion by prepaying the tuition for their grandchildren and great-grandchildren. In fact, grandparents or other older donors with short life expectancies often wish to get more out of their estate by paying more than one year’s tuition without incurring any gift tax. In a private ruling, the Internal Revenue Service allowed an unlimited tuition exclusion for prepaid tuition for the benefit of a designated individual. Although the ruling may not be cited as precedent, it does indicate the IRS’ thinking in this particular fact pattern. The ruling concerned a grandparent who wanted to prepay nine years’ worth of tuition (more than $163,000) for her grandchildren at a private school. Class levels ranged from preschool through 12th grade. Although the payments were for tuition for specific years, they were not refundable even if a grandchild ceased to attend the school. In addition, the grandparent and the father agreed that the school would be paid additional amounts in the event of any future tuition increases. The IRS ruled that all the grandparent’s tuition prepayments qualified for the exclusion because they were made on behalf of designated individuals as tuition and paid directly to an educational institution. The payments do not have to be for the current year’s tuition to qualify for the unlimited exclusion. The exclusion, however, applies only to tuition. Other educational expenses — such as books, supplies, dormitory fees or board — do not qualify for the tuition exclusion. In addition, the donor does not have to be related to the donee, and the tuition can be for elementary or high school education. The ruling, however, did not make clear whether such prepayments must be nonrefundable for the exclusion to apply. SECTION 529 PLAN Another major tax incentive for college savings that has no income or age restrictions is the so-called “Section 529 Plan.” These plans are special savings accounts for higher education that are offered in every state. Investment options and contribution limitations vary from state to state (e.g., some states allow more than $250,000 per beneficiary). Residency is not required, permitting one to choose the most appropriate plan for a particular situation. Distributions can be used to pay for qualified expenses at any accredited college or graduate school, including most community colleges and certified technical training schools in the United States. Since these plans are considered assets of the owners (e.g., parents), not the beneficiary (e.g., child), more financial aid resources may be available. Contributions to Section 529 savings accounts qualify for various income tax benefits. Although the contributions are not deductible for federal income tax purposes, they may be deductible for state income tax purposes. New York state, for example, allows a maximum $5,000 deduction for such contributions or a $10,000 deduction on a joint income tax return even if only one spouse contributed $10,000 or only one spouse had income. Plan contributions are not taxable to the beneficiary for income tax purposes. Earnings accumulate tax free in the account and continue to be tax-free when withdrawn for qualified higher education expenses. Prior to 2002, the withdrawn earnings were taxable to the beneficiary for federal income tax purposes. Some states never taxed the earnings included in qualified withdrawals. The contribution portion of qualified withdrawals is not taxable, either to the account owner or to the beneficiary. Qualified expenses include tuition, books and equipment. Room and board also are included to the extent that such expenses are used to calculate a student’s costs of attendance for federal financial aid purposes. Expenses of a special needs beneficiary that are necessary in connection with the enrollment or attendance of such beneficiary also are included. Qualified expenses, however, are reduced by the following: nontaxable scholarships and fellowships, any other nontaxable education benefits, and amounts taken into account in determining the HOPE Scholarship Credit or a Lifetime Learning Credit for federal income tax purposes by the beneficiary (or the taxpayer who can claim the beneficiary as a dependent). Although plan contributions are taxable gifts by the owner of the account to the beneficiary, they qualify for the $11,000 per person annual exclusion. In addition, up to five years’ worth of annual exclusions can be used up front. This would permit a contribution of $55,000 ($110,000 if the donor is married) per beneficiary without incurring any gift tax (assuming no other gifts are made by the owner or the owner’s spouse to the beneficiary during those five years). If the owner dies before the end of the five-year period, however, the portion of the contributions allocable to the remaining years, not including the year of death, is includable in the owner’s estate for estate tax purposes. Except for this provision, the value of an account is not taxable in the account owner’s estate. The account owner may change the beneficiary to any other family member, including the owner, at any time and for any reason. Generally, no additional taxes are imposed on such changes. If, however, the new beneficiary is a member of a younger generation than the previous beneficiary, federal gift and/or generation-skipping transfer taxes may apply. This provides flexibility in case the original beneficiary does not attend college or excess funds remain in one beneficiary’s account and there is a shortfall in another’s. Amounts distributed due to the beneficiary’s death are included in that beneficiary’s taxable estate. Plan funds may be rolled over to other plans every 12 months, even to a plan in a different state. Multiple plans are permitted for a single beneficiary, whether in one or more states. The new law allows an increased amount of room and board expenses that will qualify as education expenses. The new law also expanded Section 529 plans to include prepaid tuition plans established and maintained by entities other than a state, such as a university. Private educational institutions, however, can establish only prepaid tuition plans, not savings accounts. Distributions made after Dec. 31, 2003, from these plans also will be tax-free to the extent they are used for higher education expenses. Tuition credits accumulate in the same manner as funds under a state program and generally are transferable to other tuition plans. Tuition and rollover rules are the same. Unlike savings accounts, however, prepaid tuition plans may count for financial aid purposes as a resource that would reduce a student’s need for financial aid dollar-for-dollar. Section 529 plans have several disadvantages. The owner does not have direct control of all future investment decisions. Investment options are limited to those permitted by the plan. In addition, although funds can be withdrawn for other than qualified higher education expenses, they will be subject to a 10 percent penalty on the earnings. As mentioned above, plan contributions are subject to the $11,000 per person per year gift tax exclusion limit. They do not qualify for the unlimited tuition exclusion because the payments are not made directly to an educational institution. Despite the fact that tuition and expenses of many private or religious elementary or high schools may match those charged by many colleges, Section 529 plan distributions are to be used only for qualified higher education expenses. There are various other tax benefits, some of which were enhanced by the new law. However, they generally may not be applicable to high-income taxpayers due to income limitations. Another tax-favored education plan is the Coverdell Education Savings Account (ESAs, formerly called “education IRAs”). Contributions to ESAs are not deductible and are limited to $2,000 per year, per beneficiary. The maximum allowable contribution begins to phase out when adjusted gross income is $190,000 for married individuals filing jointly ($95,000 for singles). No contribution is allowed if adjusted gross income is more than $220,000 ($110,000 for singles). Distributions are tax-free and may be used to pay qualified educational expenses from kindergarten through grade 12, whether at a public, private or religious school. A new deduction is available for some higher education expenses paid in 2002 through 2005. The maximum deduction is $3,000 for 2002 and 2003 and may be taken by taxpayers with adjusted gross incomes of no more than $65,000 ($130,000 for married filing jointly). The HOPE or Lifetime Learning Credit may be claimed only for tuition paid by the taxpayer, the taxpayer’s spouse or the taxpayer’s dependent. The HOPE credit is limited to $1,500 per student and applies only to education expenses paid during the first two years of higher education. The Lifetime credit, limited to $1,000 per student, is based on 20 percent of qualifying expenses up to $5,000. Both credits begin to be phased out at modified adjusted gross income of $41,000 for single or head of household, $82,000 for married filing jointly. As can be seen from the above, there are educational tax benefits for everyone from the low-income to the high-income taxpayer, including incentives provided by the new law. Due to the complexity of these provisions, however, planning is necessary to determine how to best utilize these tax benefits. Marc A. Aaronson is a tax partner in Richard A. Eisner and Co., a New York-based accounting and consulting firm.

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