February 2002 Bulletin

High net worth tax savings opportunities

Tax incentives for education and retirement savings

By Michael J. McCaslin, CPA, and Kevin O’Connell, CPA, JD

Congress sprinkled the Tax Act passed in May of 2001 with tax incentives for educational savings and retirement savings. A few of these tax incentives apply to taxpayers regardless of their income. This article will focus on those breaks and how to qualify for the breaks even if your income is over the income limits.

Education savings plans

In the 1970s and 1980s, after Congress tweaked section 401 of the Internal Revenue Code, Section 401(k) became a household phrase and recruiting tool. In fact Webster’s Unabridged Dictionary accepts "401(k)" as part of the English vocabulary. There are 529 Plans that have been simply named after the Internal Revenue Code Section that pardons the earnings from the plan from federal income taxes. Soon "529 Plan" may also make its way into Webster’s Dictionary.

Beginning January 1, 2002, a 529 Plan will offer several generous tax incentives for both income tax and estate and gift tax planning. Considering the purpose behind the plans–to support college education–it may be awhile before the 529 laws are changed or revoked.

The first generous tax break is that the earnings on the principal in a 529 Plan can build up tax-free. That’s right, tax-free not tax deferred–tax free just like interest on a municipal bond. No tax on the earnings (dividends, interest or capital gains)–ever. And because most states use federal adjusted gross income as a tax base, there should be state tax breaks on the earnings as well. In fact some states allow for deductions just to invest in the plan.

Briefly, here is how they work. You are saving for a four-year college education. Place $10,000 into a 529 Plan for your child, grandchild or other beneficiary. This beneficiary does not need to be informed of your investment. Therefore, it can be a confidential gift. Professional money managers will invest your funds. Your rate of return should be higher than municipal bonds because these plans are investing in higher yielding mutual funds. If the child is 15 years old in 2001, you may accumulate an additional $1,500 of earnings before he or she enrolls in college. When the child is ready for college, you can purchase the state-of-the-art laptop in the year 2004 for $2,000 and use the balance of $9,500 for room and board, books, supplies and tuition. No tax on $1,500 of earnings and of course you receive your original investment of $10,000 back tax-free as well.

In our example we used $10,000 to begin your account. As you may know, all taxpayers are entitled to exclude $10,000 per year per done from gift tax ($11,000 starting in 2002). Now here is the second generous tax break, Congress is allowing you to claim an additional four years of exclusion today without incurring a gift tax or utilizing your lifetime gift tax credit. You can now transfer to these plans $50,000 in one year.

That is five years of exclusion in one year. Your spouse can also contribute $50,000, which means you will have a total of $100,000. That is a good start for a four-year education at a private college and would most likely pay for all tuition, room and board, books, and supplies for a four-year public university for in-state residents.

Who owns the plan? You have made a completed gift for federal estate and gift tax purposes. If you die and the plan still has unused funds on the date of your death, the balance is not included in your estate. Legally you control the plan. At least you control who is the beneficiary, how much the beneficiary will receive and when the funds are withdrawn. In fact, financial aid forms will treat the plan as the donor’s asset. This is the third generous tax break. You have made a gift for federal estate and gift tax purposes, but can still control the beneficiary of the funds.

There are few downsides to these plans. One downside occurs if your child does not use all of the funds. If the funds are not used, the funds are not forfeited. Rather, you have a choice of changing the beneficiary to a qualified relative of the beneficiary, or simply withdrawing the funds for your own use. However, if the funds are not used for education, any earnings withdrawn by you are subject to normal income tax rates, plus a 10 percent penalty. Of course, the original investment can still be withdrawn tax-free. Another less attractive feature is the lack of flexibility in investments and the investment fees charged; however, this downside will vary from plan to plan. Your original investment must be made in cash; therefore you cannot fund the plan with appreciated securities.

Certain states will either limit the investments to residents or waive fees for residents. The states have all hired investment firms for these funds, some of the investment companies charge fees (load funds) up front and others amortize the fees over the life of the investment. Your decision as to whether the money should be set-aside in a load fund or no load fund may very well depend on the age of the child. The older the child the more likely you are to consider a no load fund. The size of the funds is limited per donor per state to about $150,000. Rhode Island will allow almost $250,000. That will cover four years at Brown University.

For more information on a state plan, visit www.collegesavings.org or www.savingforcollege.com.


Scholarships are excluded from the recipient’s income. Further, if your beneficiary receives a scholarship you can withdraw the amount of the scholarship from the 529 Plan penalty-free, even if the funds are not used for education.

Other education savings ideas

Education IRAs (a.k.a., Coverdell Education Savings Accounts) that provide a tax deferral on savings can be set up by other relatives on behalf of your children, even if you are over the income limits.

Congress has increased the amounts that you can contribute to an Education IRA from $500 to $2,000 per year per beneficiary starting in 2002.

If you invest in a 529 Plan for college, you might consider supplementing the savings with an Education IRA. One other distinguishing feature is that education IRAs can be used for private high schools and elementary schools, whereas a 529 Plan can only be used for post high school education.

Income taxed at the child’s rate

You can still transfer money to your children under either the Uniform Gifts to Minors Act or Uniform Trust to Minors Act. The child is taxed on the earnings. If the child turns 14, the income is taxed as if the child were a single adult who cannot claim a personal exemption. Once the child turns 18, unless the funds were placed in trust, the funds you had transferred to your child will become his or hers outright.

Education tax credits

It may be more beneficial for a student to claim either the Hope or Lifetime Learning Scholarship credit. The student must decide to claim one or the other of these credits and cannot claim both. This credit might be useful to a student who has taxable income from employment or investment income. Claiming the credit assumes the student has not been claimed by another taxpayer as a dependent.

The maximum Hope Credit is $1,500 per year for the first two years of college and the Lifetime Learning Credit is $1,000 ($2,000 in 2003) per person for an unlimited number of years. Amounts expended for the Credits cannot be financed with 529 Plan distributions.

Retirement savings

Congress has been generous to taxpayers on retirement savings. In 2002 a taxpayer can contribute to and deduct up to $40,000 a year from a retirement plan. This figure is up from $35,000 in 2001, and $30,000 in 2000. Your retirement plan documents must be in place by December 31, unlike individual retirement accounts that can be set up after year-end.


While income from an IRA or 401(k) or profit sharing plan are subject to income tax when distributed to the beneficiary, life insurance proceeds are not subject to income tax when received. Further, the cash value of whole life policies can build up tax-free and withdrawals are still subject to favorable taxation if structured properly. Voluntary Employee Benefits Associations (VEBAs) can be used by taxpayers to make tax-deductible contributions to finance life insurance contracts. Also health, disability, and possibly education benefits can be paid from VEBAs. While Congress has not changed any legislation regarding VEBAs, the courts are interpreting VEBA legislation favorably. However, the IRS does not like these VEBA transactions. Absent legislative changes, we feel the VEBA is still a viable tax planning opportunity.

Unlike savings for education, amounts set-aside in retirement plans or VEBAS cannot favor the owner employees/partners of a business. In tax parlance these plans must be non-discriminatory.

In summary, despite the limitations created over the years through tax legislation to prevent high income and high net worth individuals from taking advantage of certain tax breaks, there are still some education and retirement provisions that are quite appealing to the high income and high net worth individuals. With proper planning and implementation, tax breaks for the wealthy still exist.

Michael J. McCaslin, CPA, is Director, Health Care Group Services (mmccaslin@somr.com) and Kevin O’Connell, CPA, JD, is Director, Tax Services (koconnell@somr.com), both at Somerset Financial Services Health Care Group in Indianapolis, Ind. They can be reached at (800) 469-7206.

Home Previous Page