Gift Tax Treatment of Tuition Plans

Article Highlights:

  • Purpose of Qualified Tuition Plans
  • Gift Tax Implications
  • Special Five-Year Election
  • Change of Beneficiary
  • Eligible Expenses
  • Direct Payment of Tuition

Qualified tuition plans (QTPs) provide a means for family members and others to save for the future educational needs of children. Investment earnings within a QTP account are tax deferred and not taxable when withdrawn if used to pay qualified tuition and certain other expenses.

Each individual’s contribution to a QTP (also sometimes referred to as a “Section 529 plan”) on behalf of a designated beneficiary is treated as a gift subject to the normal gift tax rules. Thus, no gift tax return is required for any contributor if the contribution is equal to or less than the amount of the gift tax annual exclusion for the year of the gift, which for 2019 is $15,000.

Special Election – When a donor’s total contribution to a QTP for the year exceeds the annual exclusion amount, the donor may make a special election treating the contributed funds as if they had been contributed ratably over a five-year period starting with the year of the contribution.

Example: Grandpa Lee contributes $75,000 to granddaughter Whitney’s QTP in 2019. By using the election, grandpa’s contribution is treated as if the contribution was made equally over a five-year period – that is, as if he’d contributed $15,000 in each of 2019, 2020, 2021, 2022 and 2023. If grandpa makes any more QTP contributions during those years, those contributions would then exceed the annul gift limit and require a gift tax return to be filed. The same would be true if grandpa makes other gifts to Whitney.

To make the five-year election grandpa must file a Form 709, Federal Gift Tax Return, for the calendar year in which the contribution is made.

The election is available only with respect to contributions not in excess of five times the annual exclusion amount for the calendar year of the contribution. Any excess is treated as a taxable gift in the calendar year of the contribution. However, that does not necessarily mean any gift tax will be owed since there is also a unified gift and estate tax lifetime exclusion (currently in excess of $11 million) that will shield most taxpayers like grandpa from any gift tax.

If grandpa were married, he and grandma could make an election under the gift-splitting rules for the QTP contribution to be made one-half by each of them, thus allowing them to double up on the annual and the special 5-year amounts.

If in any year after the first year of the five-year period, the amount of the gift tax annual exclusion is increased for inflation, the donor may make an additional contribution in any one or more of the four remaining years up to the difference between the exclusion amount as increased and the original exclusion amount for the year or years in which the original contribution was made.

Example: In 2017 when the annual gift tax exemption was $14,000, grandpa made a $70,000 contribution to his granddaughter’s QTP and made the 5-year election. For 2018 the annual gift tax exemption was increased to $15,000. Thus, grandpa can make an additional $1,000 contribution for each of the remaining 4 years of the 5-year election period.

Change of Beneficiary – A change in the designated beneficiary, or a rollover to the account of a new beneficiary, is treated as a taxable gift if the new beneficiary is assigned to a generation below the generation of the old beneficiary. Such a transfer isn’t a taxable gift if the new beneficiary is a member of the family of the old beneficiary, and is assigned to the same generation, as the old beneficiary.

If the new beneficiary is assigned to a lower generation than the old beneficiary, the transfer is a taxable gift from the old beneficiary to the new beneficiary, regardless of whether the new beneficiary is a member of the family of the old beneficiary.

In addition, the transfer would be subject to the generation skipping transfer tax (GST) if the new beneficiary is assigned to a generation which is two or more levels lower than the generation assignment of the old beneficiary. The five-year averaging election may be applied to a transfer.

Example: Suppose Whitney had not used the funds from the QTP or has finished her higher education and had some funds left over in the plan, and grandpa (or the trustee of the account if grandpa is not the trustee) decides to change the account beneficiary to his great-granddaughter Annabelle. Since Annabelle is in a generation lower than Whitney, the change of beneficiary represents a gift from Whitney to Annabelle. However, the five-year averaging election may be applied to the gift.

Eligible Expenses – Distributions from QTPs, including earnings on the amounts contributed to a QTP, aren’t taxed for income tax purposes if they are used to pay qualified higher-education expenses of the account beneficiary. In addition to tuition, eligible expenses include the following:

  • Fees;
  • Books;
  • Supplies;
  • Equipment;
  • The purchase of computers or peripheral equipment, computer software, or internet access and related services that will be used primarily by the beneficiary while the beneficiary is enrolled at an eligible educational institution;
  • Room and board if the beneficiary is attending a qualified school at least half time; and
  • A special needs student’s expenses that are necessary to enable the student to enroll or attend an eligible educational institution.

When distributions exceed eligible expenses, the beneficiary of the QTP is the one who would include the nonqualified distributions in his or her income. The calculation of the taxable amount of the distribution can be complicated if the beneficiary received a tax-free scholarship. In some cases a 10% penalty also applies on the taxable distribution that is included in income.

While QTPs are generally intended to be used for higher education expenses, for years after 2017, up to $10,000 distributed from a QTP for tuition expense (but not for related other expenses) paid so the beneficiary can attend an elementary or secondary school (kindergarten through grade 12) is considered a qualified education expense that would be tax-free. However, some states have not recognized this provision, and so such distributions would be at least partially taxable for state purposes.

Direct Payment of Tuition – Some potential contributors to a QTP for family members may wish to pay for the tuition when it is actually incurred rather than saving for it in advance. If that individual makes the tuition payment directly to a qualified school, college or university the gift tax does not apply.

If you have questions related to QTPs in general or changing beneficiaries, please give this office a call.

Don’t Be a Victim of Cybercrooks

Article Highlights:

  • What They Are After
  • Email Attachments or Links
  • Emails from the IRS
  • Detecting Phony Email Addresses
  • Embedded Hyperlinks
  • Security Software
  • Strong Passwords
  • IRS Phone Calls
  • Educate the Elderly
  • Too Good to Be True

Well, here it is: 2019. The holiday season is over, and the season for preparing tax returns is about to begin. But unfortunately, it is also the season for scammers who are out to steal your identity, swindle you out of your money and even file tax returns in your name. All of this can make you poorer, ruin your credit rating, cause financial havoc, and cost you hours upon hours of time trying to straighten out the messes caused by cybercrooks.

The best way to prevent your ID from being stolen, your computer from being hacked, or yourself from being tricked by some clever schemer is not to take their bait. These schemers will target you in a number of ways, including through email, regular mail and phone. Each one will try to scare you, appeal to your greedy side or trick you into allowing access to your electronic devices.

The most common way for cybercriminals to steal money, bank account information, passwords, credit cards and Social Security numbers is to simply ask for them in an unsuspecting way.

Here are a few steps you can take to protect against phishing and other email scams:

  • Be vigilant and skeptical. Never open a link or attachment from an unknown or suspicious source. Even if the email is from a known source, the recipient should approach it with caution. Cybercrooks are good at acting like trusted businesses, friends, family and even the IRS.
  • Emails and other electronic contact from the IRS. If you should receive an email claiming to be from the IRS or directing you to an IRS web site, you should know that the IRS never initiates contact via email. This includes asking for information via text messages and social media channels. The first thing you should do is contact this office. But above all, DO NOT reply to the message, open any attachments (which may contain malicious code that will infect your computer), or click on any links in a suspicious email or phishing website and enter your confidential information. The IRS never asks for detailed personal and financial information like PINs, passwords, or similar secret access information for credit cards, banks, or other financial accounts.The address of the official IRS website is www.irs.gov. Do not be misled by sites claiming to be the IRS but ending in .com, .net, .org, or anything other than .gov. If you discover a website that claims to be the IRS but you suspect it is bogus, do not provide any personal information on the site.
  • Double check the email address. Thieves may have compromised a friend’s email address. They might also be spoofing the address with a slight change in text, such as by using narne@example.com instead of name@example.com. Merely changing the “m” to an “r” and “n” can trick people.
  • Remember that the IRS doesn’t initiate spontaneous contact with taxpayers by phone or email to ask for personal or financial information. The IRS does not call taxpayers with aggressive threats of lawsuits or arrests. It is a common tactic for criminals to call, acting as an IRS agent to try collecting a tax bill and threatening to arrest you or have your home seized for payment. These same individuals will sometimes ask you to make payments using a gift card, which the IRS would never do.
  • Don’t click on hyperlinks in suspicious emails. It is common practice for cyber crooks to send out emails asking you to click on an embedded link to update your password or other sensitive information. Legitimate firms would not do that, so be safe and ignore and then delete the email. If the email is from a business or person you deal with and you are concerned, contact the business directly, either through its main webpage or by phone. Also remember that no legitimate business or organization will ask for sensitive financial information by email. Another trick cybercrooks employ is to hack into a friend’s emails and then send you messages asking you to click on an embedded link in the email, which can end up installing malware on your computer.
  • Use security software to protect against malware and viruses found in phishing emails. Some security software can help identify suspicious websites that are used by cybercriminals as well as detect malware on your computer.
  • Use strong passwords to protect online accounts. Experts recommend the use of a passphrase, instead of a password, with a minimum of 10 digits, including letters, numbers, and special characters. But don’t use a family name or birth date, as cybercriminals may already have that information and will try it.
  • Use multi-factor authentication when offered. Two-factor authentication means that in addition to entering a username and password, the user must enter a security code. This code is usually sent as a text to the user’s mobile phone. Even if a thief manages to steal usernames and passwords, it’s unlikely the crook would also have a victim’s phone.
  • Communication from the IRS. If you receive a phone call, fax, or letter from an individual claiming to be from the IRS, you should immediately contact this office before providing any information. You should do this whether you suspect the contact is legitimate or not. You can also contact the IRS at 1-800-829-1040 to determine if the IRS has a legitimate need to contact you.
  • Educate the elderly. The elderly are frequent victims of scammers. If you have elderly family members or friends, take the time to sit down with them and educate them about scammers, email phishing and the like.
  • Too good to be true. One of the tactics used by scammers is fooling you into thinking that you won a foreign lottery or have received a foreign inheritance and that you need to send money before the funds can be transferred. Remember the old adage: “If it is too good to be true, it probably isn’t true.”
  • Report phishing scams. Should you receive a suspicious email, you can help the government fight the cybercrooks by forwarding it to phishing@irs.gov.

Our modern means of communication have provided opportunities for cybercrooks to scam you, which is a growing problem. You have to be vigilant and always keep your guard up. Don’t take their bait.

Always contact this office if you receive any communications from the IRS or state tax authorities. Be extra cautious with emails, phone calls, or mail. If you have questions related to phishing or ID theft, please call.

Taxation of Egg Donors

Egg donors typically receive between $5,000 and $10,000 for a donation. While you may think that it is a good deal, keep in mind that the IRS treats that pay as self-employment income.

In the 2015 Tax Court case of Perez v. Commissioner of Internal Revenue,  the court ruled that the money paid to Perez was indeed taxable income. If you’re thinking about becoming an egg donor, you need to look at the tax consequences before you commit to the process.

Depending on your tax bracket, that is how much you will get taxed on your income from this donation. For example, if you got paid $10,000 and were taxed at the self-employment rate of 30.3%, you will really only make $6,970.00.

Big Changes to College Savings Plans

Article Highlights:

  • Sec. 529 Plans
  • Saving for College
  • Elementary and Secondary School Tuition
  • ABLE Account Transfers

Tax reform added some new taxpayer-advantageous changes to college savings plans. These plans are also known as qualified tuition programs (QTPs) or Sec. 529 plans, named after the part of the Internal Revenue Code that established them.

Background: Sec. 529 plans allow taxpayers to put away larger amounts of money than other tax-advantaged education savings plans do, limited only by the contributor’s gift tax concerns and the contribution limits of the intended plan. There are no limits on the number of contributors, and there are no income or age limitations. The maximum amount that can be contributed per beneficiary (the intended student) is based on the projected cost of college education and will vary between the states’ plans. Some states base their maximum on the projected costs of an in-state four-year education, but others use the cost of the most expensive schools in the U.S., including graduate studies. Most have limits in excess of $200,000, with some topping $370,000. Generally, additional contributions cannot be made once an account reaches the state’s maximum level, but that doesn’t prevent the account from continuing to grow.

Although the plans are authorized by the various states, it is not necessary for the plan to be set up in the future student’s home state, and the student isn’t restricted to using the funds to attend college in their home state or the state where the plan was set up. Some states provide state income tax incentives to the plan’s contributors, such as a state income tax deduction or a tax credit for contributions to the state’s 529 plan.

When the time comes for college, the distributions will be part earnings/growth in value and part contributions. The contribution part is never taxable, and the earnings part is tax-free if used to pay for qualified college expenses. In addition to a tax-free distribution from the 529 plan, a taxpayer may claim an education credit – such as the American Opportunity Tax credit, which can be as much as $2,500 – in the same year, provided the same expenses aren’t used for both benefits and the taxpayer’s income level does not phase out the credit.

The big advantage of a Sec. 529 plan is tax-free accumulation, so the sooner the account is established and funded, the better. A special provision of Sec. 529 allows those who are concerned with the annual gift tax limitations, currently $15,000, to contribute five years’ worth of contributions ($75,000) up front. These limitations apply to each contributor, but if there are multiple contributors, such as parents, grandparents, aunts and uncles, huge amounts can be contributed up front and provide the greatest long-term growth.

Tax Reform Changes: Under the recent tax reform, the use of Sec. 529 plan funds was expanded to include:

Elementary and Secondary School Tuition – As of 2018, tax-free distributions of up to $10,000 per year per designated beneficiary are allowed for tuition (no other expenses are allowed) in connection with enrollment or attendance at elementary or secondary schools, including public, private and religious schools. However, this option should be considered cautiously, since Sec. 529 plans work best when the money put into the plan is allowed to grow for a long period of time. For less well-to-do families who can’t afford to frontload their 529 plan contributions, making pre-college withdrawals will defeat the long-term tax-free accumulation benefit and could deplete the account before the student even starts college. It should be noted that while this tax reform change applies for federal purposes, some states are still limiting qualified distributions from their plans to only those used for college expenses.

Sec 529 to ABLE Account Transfers – Tax reform also provides that a distribution from a Sec. 529 qualified tuition plan account is tax-free and penalty-free if it is rolled over within 60 days to an ABLE account of the same designated beneficiary or a member of the designated beneficiary’s family. This rollover provision is only available through 2025. The amount of the rollover is limited, when combined with other contributions, to the annual maximum.

Qualified ABLE programs provide the means for individuals and families to contribute and save for the purpose of supporting individuals who became blind or severely disabled before turning age 26, in maintaining their health, independence, and quality of life.

Example: Bill, who finished school and graduated, still has $8,000 in his Sec. 529 qualified tuition plan that his parents had set up to pay his college tuition. Bill will no longer have any education expenses, so he rolls the balance of his Sec. 529 plan into his 14-year-old blind niece’s ABLE account within the 60 days allowed. There are no taxes or penalties on the rollover. However, since contributions to the ABLE account are limited to $15,000 (2018), others may only contribute an additional $7,000 ($15,000 − $8,000) to the niece’s ABLE account. 

If you have any questions about how Sec. 529 plans and the changes made to them by tax reform might affect your specific circumstances, please call.

Tax Reform Adds Education Benefit

Article Highlights:

  • Tax Benefits
  • Types of Tax-advantaged Education Savings Plans
  • Differences in Permitted Contributions
  • Differences in Qualified Education
  • New $10,000 Allowance

Note: This one of a series of articles explaining how the various tax changes in the GOP’s Tax Cuts & Jobs Act (referred to as “the Act” in this article), which passed in late December of 2017, could affect you and your family, both in 2018 and in future years. This series offers strategies that you can employ to reduce your tax liability under the new law.

Tax law provides two tax-advantaged savings plans for the Qualified State Tuition Plan (commonly referred to as a 529 Plan). They are similar in that contributions to the plans are not tax deductible (although some states do allow a deduction for contributions to their plans) and the earnings are tax deferred and tax free if used for qualified education expenses.

They are different in that only $2,000 per year can be deposited into a Coverdell account, whereas contributions to a 529 plan are only limited by gift tax considerations and the cost of attending the state’s highest-cost university. This generally means the annual contribution to a 529 plan is limited to the annual gift tax exclusion amount ($15,000 for 2018) in order to avoid gift tax complications. However, the annual gift limit is per contributor and multiple individuals, typically grandparents, can also contribute to a 529 plan. On the other hand, a maximum of only $2,000 can be contributed to a Coverdell account regardless of the number of contributors. Thus, 529 plans typically accept the largest amount of college savings funds.

Another difference has been that Coverdell accounts can be used for education in kindergarten and above, while 529 plans can only be used for post-secondary education. As a practical matter, the $2,000 annual Coverdell contribution limits don’t provide for a substantial amount of savings that can be used for early childhood education.

To alleviate that disparity, the Act amended the 529 plan rules to allow, beginning in 2018, up to $10,000 of 529 plan funds to be used federally tax-free annually, per student, for elementary school and high school education expenses. In addition the funds can be used to cover the expenses of attending public, private and religious schools. However, some states have not yet adopted the Act’s law change or may need to change the language in their tax codes that define the accounts as “college” savings plans before distributions for elementary and secondary school expenses will qualify as totally state tax free. States that have allowed a deduction for contributions to their plans may decide to scale back some of the tax benefit if distributions are used for expenses in grade K-12.

Both a Coverdell and a 529 plan can be established for the same student, and the combination allows more funds to be accumulated.

For additional details or assistance in planning for a child’s higher education, please give this office a call.