Knowledge is Power

The Certainties of Life

Benjamin Franklin once wrote, “Nothing in this world can be said to be certain, except death and taxes.” As a parent of young children, I would add a third item to Ben Franklin’s famous list – paying for college education expenses. Unfortunately, even the best financial planning will not allow any of us to avoid death, but recent developments have provided two strategies to help reduce the impact of taxes and assist in saving for college education expenses. So, we are going to interrupt our regularly scheduled “back to investment basics” topic this month to review two planning opportunities which will help navigate two of life’s certainties – taxes and paying for college.

Charitable Intentions

Individual retirement accounts (IRAs) are a tremendous tool for accumulating wealth for retirement. Money contributed to an IRA benefits from tax-deferred investment growth, which can offer substantial benefits versus non-IRAs over time. For example, if your investment account is earning 6% per year but your investment earnings are taxed at a 15% rate, a non-IRA will return only 5.1% per year after taxes. Within the tax deferred IRA, however, the full 6% annual investment return will be retained, resulting in much greater growth over time.

What’s the catch? Unfortunately, the IRA only defers the taxes due on the growth of the account – any withdrawals taken from the IRA are subject to ordinary income tax. So, whether you take IRA withdrawals at retirement for your needs, to give to charity, or to finally buy that Mustang convertible, amounts distributed from the IRA will be fully taxed in the year of withdrawal.

Of course, many strategies exist to assist in reducing the tax impact of IRA distributions. However, for individuals with charitable intentions, the recently enacted Pension Protection Act of 2006 provides a method for taxpayers to take a withdrawal from an IRA account and donate the withdrawal to a charity without ever paying tax. In 2006 and 2007, taxpayers age 70 ½ or older can make a tax free IRA withdrawal of up to $100,000 each year if the withdrawal is donated directly to a public charity. As public charities are tax exempt organizations, the gift of IRA assets is never taxed, maximizing the charitable contribution. Thus, the donor can accomplish a charitable contribution while minimizing the negative tax impact of the gift. Clearly this strategy may not be appropriate for every taxpayer, and thus a qualified tax professional should be consulted before utilizing the charitable IRA contribution.

Obviously the charitable IRA contribution is only available for older taxpayers, but another recent tax law change will be of benefit to an entirely younger generation.

Educate U

The cost of a college education continues to rise. The national average cost of a public university education is now approximately $13,000 per year. Private university costs now average approximately $30,000 per year. As noted in last month’s article, general inflation has averaged approximately 3% annually over time, while college education costs are increasing at a far greater rate - approximately 7% per year. Anyone with children to educate is most likely feeling a little depressed after reviewing these cost figures. Don’t be disheartened, an excellent tool to assist in saving for college is the section 529 savings plan.

Many of you may already know of, and may be using, 529 plans for education funding, but let’s review the basics. A 529 plan allows anyone – parents, grandparents, aunts, uncles, friends, etc. - to contribute money into the plan for college education savings. Similar to an IRA or other tax advantaged account, assets accumulate in the 529 plan without taxation of the investment earnings. However, unlike the IRA, if money is withdrawn from the plan to pay for the “qualified college education expenses” of the account beneficiary, the withdrawals are also not subject to taxation, providing greater resources to pay for college expenses. “Qualified education expenses” encompass a wide range of costs including tuition, room and board, required books, and supplies.

Until recently, the tax benefits of 529 plans were primarily limited to Federal income taxes. However, a recent change in Pennsylvania tax law now gives residents of this state even greater incentive to save. As of July 6, 2006, Pennsylvania residents will now receive an annual state income tax deduction of up to $12,000 per account for contributions to section 529 plans. In addition, Pennsylvania also offers a state tax exemption for distributions from 529 savings plans. Thus, utilizing a section 529 plan now provides both Federal and state income tax advantages for taxpayers, creating an even more effective tool for college savings.

Let’s face it – neither of the strategies outlined in this article will completely solve your tax planning and education funding challenges. However, for older taxpayers who are charitably inclined, or for anyone accumulating assets for college education expenses, these strategies will make accomplishing some of the basics in life a little easier.

Source: American Funds