Working families will likely face an even tougher road to pay for their children’s college educations in 2013. With 2012 tuition rates already rising hastily for both public and private colleges, at 4.8%1 and 3.9%2 respectively, many parents and students are scrambling for financial aid and scholarship packages to cover increasing college costs. Only about two-thirds of full-time students receive aid in the form of grants or federal tax breaks, and now a change to Coverdell Education Savings Accounts (ESA) and cuts to tax credits associated with the impending “Fiscal Cliff” may increase the college contributions families will have to make next year.
Fiscal Cliff and Higher Education
Let’s back up. You’ve certainly heard of the Fiscal Cliff by now, most likely in a highly politicized, partisan fashion. We’ve discussed some of the realities and implications in previous posts. We won’t get into that now. Neither will we discuss here the implications for Medicare, unemployment benefits, Social Security, the defense budget, and so forth.3
In the coming weeks, Congress will likely target social programs and, in particular, those that aid Americans most in need of them–the elderly, veterans, working poor–as they attempt to reduce the deficit long-term.4 However, these cuts are not likely to have a direct, substantial effect on paying for higher education.
Here’s what you should know about the Cliff, assuming you are a member of a working family planning to pay for higher education in 2013 and beyond:
- Bush-era tax cuts expire (on income, investments, married couples and families with children and inheritances):
- Alternative Minimum Tax has not been adjusted for inflation in 2012, leaving some American families to pay average of $3,900 because of income levels, and up to $8,000-plus extra5
- Child tax credit to drop from $1,000 to $500.
- Obama’s 2% cut in payroll taxes expires, which would push Social Security withholding back up to 6.2%.6
How would this affect you? With state budget cuts for higher education looming (40% cut in higher education budgets in 2011), and college tuition continuing to climb faster than the rate of inflation, you could be in serious trouble come Fall 2013, parents.7
Let’s put it into perspective:
If you are in a middle-class household, with three children (one in college), and your combined income and investments surpass the unpatched Alternative Minimum Tax threshold, you could owe—using the figures above—over $5,000 in taxes and SSI deductions. Ouch.
A Coverdell ESA is “an account created as an incentive to help parents and students save for education expenses.”8 You can set up a Coverdell with banks, mutual funds or brokerage firms and generally have control over your investment options. You could put your Coverdell funds in a savings account, certificate of deposit, mutual fund, stock or bond. You can also change investment options as often as you like.
Here are the existing terms for the ESA:
- Beneficiary of account must be under age 18 or a special needs beneficiary
- No more than $2,000 in contributions for beneficiary in any year
- Contributions not deductible, but earnings grow tax-free until distributed. If the distributions total less than the beneficiary’s qualified education expenses, the beneficiary will not owe tax.
- There are income limits for contributions ($190-220k for joint, $95k single).9
New investors quickly learn the advantages of long-term planning and starting early. Many get the terms “compound interest” and “tax-advantaged,” drilled into their craniums for all of eternity—the Coverdell ESA incorporates both. It’s no surprise, then, that ESAs were originally named Educational IRAs.10 Like a retirement account, ESAs provide an opportunity to get the best ‘bang for your buck’ while you plan for the future.
Now with the Fiscal Cliff and Congress’s focus elsewhere, major changes may be looming for this popular option for middle-class families looking for help to cover rising college costs.
Changing Limits for Coverdell
Some of the key provisions (listed above) for the Coverdell ESA were last extended by The Tax Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010. So as you can see, educations costs were lumped in with the other social programs; programs that are bound to be focal points of the Fiscal Cliff discussion before the Dec. 31, 2012 expiration date. Coverdell ESAs likely won’t.
Here’s what’s in store for 2013 if the Coverdell extension goes unaddressed:
- Only postsecondary education expenses will qualify for the tax law; K-12 expenses will no longer be eligible.
- Income cutoff for married couples filing jointly now $160,000 (previously $220k).
- The annual contribution limit will be reduced from $2,000 per beneficiary to $500 per beneficiary.
- Distributions will be tax-free only for taxpayers who do not claim an American Opportunity or Lifetime Learning Credit in the same year.
The latter two provisions are the most relevant here: a substantial plunge in the eligible contribution amount, and an exclusion of middle-class families that depend on the two higher education tax credits (previously allowed).
Rolling Coverdell ESAs into a 529
If you’re worried about the contribution limits for the Coverdell ESA for 2013, you have the option to consolidate your educational assets by rolling-over the ESA into a 529 Plan. A 529 Plan, legally known as a qualified tuition plan, is a “tax-advantaged savings plan designed to encourage saving for future college costs.” States, state agencies or educational institutions can sponsor the college savings plan.11
If the 529 plan is set-up for the same beneficiary as the Coverdell ESA, the rollover would be a tax-free transaction, without any adverse tax consequences. You would have to inform the 529 plan that the money is coming from a Coverdell ESA, and then deposit an equal or greater amount of money than the ESA into the 529 plan. This must occur in the same calendar year and within 60 days of closing the ESA.
There is a downside. 529 plans do not offer the same flexibility as a Coverdell:
- You have to choose among the investment options offered by the state plan, instead of a choice of the asset allocation in the Coverdell.
- You can only change investment options once a year (unlimited for ESA).
However, the 529 plan does not have the minimized annual contribution limit that is looming for the Coverdell ESA come January 1, 2013.
If you’re okay with the contribution limits, and any of the other applicable provisions, you can max out your 2012 contribution and put the money to use this year on other qualified expenses such as computers and books. You can also choose to prepay next year’s tuition early, as most colleges will accept a deposit and apply a credit to your account to be used down the line.
In either case, the Fiscal Cliff discussion’s focus on restructuring social programs and on tax code reforms means middle-class families will have to be proactive in the next month and a half about planning for, and paying for, higher education costs in the year to come and beyond.
Stay tuned, and here’s hoping the Cliff doesn’t make a Sisyphus out of all of our politicians!