Education Funding

Education funding should be part of everyone’s financial planning process. This page will discuss three avenues that provide education funding in a tax-wise manner and hopefully will provide some ideas to discuss with one’s financial advisors.

Prepaid Tuition Programs

The State of Alabama has for several years offered a program called Prepaid Affordable College Tuition ("PACT") that allows a parent or other person to prepay college or vocational school tuition and mandatory fees for an individual ("beneficiary"). If the beneficiary earns a scholarship, PACT withdrawals may be used to pay for other higher education expenses, including room and board. PACT is known as a "Section 529" plan, a reference to the Internal Revenue Code section that governs this type of plan.

The main income tax advantage to PACT under the tax law through December 31, 2001 has been that income is earned tax-free until the beneficiary uses funds in the account to pay for tuition and fees. When money is withdrawn from the account, income earned over the years is included in the beneficiary's federal taxable income based on annuity tables, but the original contributions are withdrawn tax-free. So, not only is tax on the income deferred, but the tax is calculated at the student's tax rate, which is usually lower than the rate of the parent or other person who purchased the PACT. Income earned by the PACT is never taxed for Alabama income tax purposes as long as it is used to pay for qualified education expenses.

The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") changed the law for PACT withdrawals made after December 31, 2001. As long as withdrawals are used to pay for qualified higher education expenses, no part of the withdrawals will be subject to federal income taxes. This could be a substantial savings. For example, using information from the Alabama State Treasury's web site, if a PACT contract was purchased with a single sum for a child in the eighth grade in 2001, the cost would be $14,364. The average total benefit received if the child enrolls in an Alabama public university is expected to be approximately $23,002. The difference, $8,638, would be income that is not taxed on the student's federal or state income tax returns. If this change in the law were kept after the 10-year life of EGTRRA is over, then the savings would extend to children who are now in the third grade or below.

Educational Savings Plans

Alabama College Education Savings ("ACES") is the name of an educational savings plan being developed by the State of Alabama. Like PACT, it will be a Section 529 plan. The State hopes to have ACES in place and ready to accept contributions beginning in the first quarter of 2002.

At this time, ACES will have the same federal, but not Alabama, income tax benefits as PACT (the income is never taxed if used to pay for qualified education expenses). For the time being, income will be taxed for Alabama income tax purposes when withdrawals are made, regardless of whether the money is used to pay for qualified education expenses. Also note that ACES will not have the inflation protection of PACT. The account will accumulate funds based on the investment returns of the investment option chosen by the contributor. But it does have an advantage over PACT in that, regardless of whether the student earns a scholarship, the ACES account may be used to pay for books, supplies, and room and board (subject to certain limitations). One might consider, then, using both a PACT account and an ACES account for the same student. The PACT account would pay for tuition and fees, and the ACES account would pay for books, supplies, and room and board.

For additional information on PACT and ACES, visit the Alabama State Treasury web site at www.treasury.state.al.us and click the "Tuition Assistance" button.

Education IRAs

Education IRAs have been around since 1998, but their use has been hampered by the $500 annual contribution limit. Even though they carry the label "IRA," contributions to education IRAs are non-deductible for income tax purposes. Contributors to education IRAs have much more discretion as to the investment of funds than do contributors to PACT or ACES, and this may be an important consideration for some. Like PACT and ACES, withdrawals after December 31, 2001 from education IRAs will not be subject to federal or state income taxes if used to pay for qualified education expenses. EGTRRA also increases the annual contribution limit to $2,000 for years beginning after December 31, 2001, making education IRAs much more attractive. After that date, a married couple having no more than $190,000 in adjusted gross income ("AGI") may make annual $2,000 non-deductible contributions to an education IRA for each of their children. The allowable contribution is completely phased out when AGI exceeds $220,000.

EGTRRA clarifies the rule that contributions by corporations and other entities to education IRAs are not subject to the phase-out. Individuals who are in the phase-out range might consider taking advantage of this rule, if they are an owner of a corporation or other entity, by having the corporation or other entity make part or all of the contribution in lieu of, or in addition to, the individual's salary. The contribution would be income to the owner, but at least it could be made.

EGTRRA made some other changes to education IRAs beginning in 2002:

May be used to pay for qualified elementary and secondary education expenses
Individuals may wait until April 15 to make a contribution for the preceding year
Contributions may be made to PACT, ACES and an education IRA for the same student without incurring the 6% excise tax on excess contributions

Other good things to know about PACT, ACES, and education IRAS:

Contributions qualify for the $10,000 annual exclusion from gift taxes
Contributions exceeding $10,000 in a year may be "electively" carried over and offset up to four future annual exclusions
This feature makes them good for grandparents looking for a way to provide for their
grandchildren and reduce their taxable estate at the same time
Distributions are not subject to gift taxes, except when a distribution is rolled over to the account of a lower-level generation beneficiary
The account balance is excluded from the contributor's estate, except when there is an
unamortized balance of contributions in excess of $10,000 per year
PACT is good for four years of undergraduate tuition and fees, so ACES (assuming the State of Alabama drafts ACES to allow graduate level benefits) and education IRAs may be used for graduate school

Things to watch out for when using PACT, ACES, and education IRAs:

Taxable distributions get hit with 10% additional tax unless the distribution is made:
On account of beneficiary's death or disability
On account of a scholarship or other nontaxable educational assistance awarded to beneficiary, to the extent of the assistance
To return excess contributions
Excess contributions to an education IRA are charged a 6% excise tax
This most likely will occur when more than one person opens up education IRAs for a single beneficiary
The 6% excise tax does not apply to PACT or ACES
The changes made by EGTRRA expire at the end of 2010 and, without further Congressional action, the law will revert to what is in place currently (2001)

One should also consider any effect on financial aid these plans may have. Educational savings plans (ACES, for example) and education IRAs are treated as assets on the Free Application for Federal Student Aid ("FAFSA"), and withdrawals from the accounts are not treated as educational resources for future years. On the other hand, prepaid tuition programs, like PACT, are not assets on the FAFSA, but the annual benefit is treated as an educational resource. Contact a financial aid professional for complete information.

These three vehicles allow one to provide for the education of a child or grandchild in a way that minimizes the tax bite. As always, prior to selecting one or more of these options, anyone considering doing so should contact their tax or financial planning professional to determine which, if any, of these financing vehicles is appropriate for them.

This material is provided solely for educational purposes and is not meant to be an exhaustive explanation of the items covered. This is not intended as professional advice, accounting, legal, or otherwise, by the University of South Alabama or its employees. Further, there may be items or issues relative to the subject matter that are not covered here but should be studied depending on individual situations. Also, because laws are subject to change at any time, current authoritative resources should be consulted before steps are taken to implement any ideas presented in this material. Readers are encouraged to seek the services of a professional familiar with their financial needs.