The 9 Steps to Financial Freedom (42 page)

Assuming the child has no other income and is under age nineteen (or if a full-time student through age 23), the first $950
in investment income from a UGMA is tax-free. The next $950 is taxed at your child’s lower tax rate. This is what is known as the kiddie tax. But any investment income beyond $1,900 is then taxed at the parent’s tax rate. Once a child is older than nineteen (or twenty-three if a full-time student) all investment income in the account is taxed at the child’s tax rate. These numbers are for tax year 2011 and are indexed for inflation. Also note that the IRS regulations require all minors fourteen or older to sign their tax returns. Finally, please note that these tax rules are for income earned by a minor; there is no special treatment for UGMA accounts.

Financial Aid

Another element to keep in mind with UGMA accounts is that it may make it harder for your child to qualify for college financial aid. To determine how much financial aid your child can qualify for, your assets will be taken into consideration. Assets in your child’s name will be assessed at the rate of 20 percent. If you have accumulated $50,000 in the UGMA account, your child will have to contribute 20 percent of that, or $10,000, before financial aid could kick in. But only a maximum of 5.6 percent of certain assets in the parents’ name are taken into consideration, so if instead you kept that $50,000 in your name, just $3,000 or so of that money will be used to determine your child’s financial aid package. This is a big difference.

For years, the government has been offering an Education IRA (officially now known as the Coverdell Education Savings Account) as another way to save for a child’s education. You can save up to $2,000 per year per child (or, as the IRS terms it,
per “beneficiary”). This contribution level is in effect through 2012; future limits will be set by Congress. As with the Roth IRA, your contributions are not tax-deductible, but your earnings are tax-free when used for “qualified educational expenses.” Qualified expenses may include not only college and graduate school expenses but also tuition or other costs for grade school and high school and incidental education expenses, such as computers and educational software.

You don’t have to be related to a child to contribute to an Education Savings Account, so godparents, friends of the family—anyone—can open an Education Savings Account to help fund a particular child’s education. The only restriction here is that the beneficiary, or child, must be under the age of eighteen when contributions are made.

There
are
income limitations in effect for the person making the contribution to a Coverdell. For single individuals, eligibility starts to phase out at $95,000 of income and is completely phased out at $110,000 of income. For married couples filing joint returns, the limits are twice those for single individuals. That is, eligibility to contribute starts to phase out at $190,000 of income and is completely phased out at $220,000 of income for married partners filing jointly.

There’s more good news. You can take tax-free distributions from a Coverdell and still be eligible to take the American Opportunity credit or the Lifetime Learning credit, as long as the funds from the Coverdell and the credit are not used to cover the same educational expenses. For example, if a child’s tuition is $25,000, and a withdrawal of $15,000 is made from a Coverdell, the excess of $10,000 can be used to claim the American Opportunity credit or Lifetime Learning credit (see
this page
–
this page
). But money in a Coverdell account may make it more difficult for your child to qualify for financial aid.

Please note: Your contributions to a Coverdell do not have any impact on your eligibility to save any amount up to the maximum allowable in a traditional IRA, a Roth IRA, or a combination of the two. In other words, you can save for your child’s education in a Coverdell and still put money away in an IRA for your own retirement.

Taxation and Regulations

Distributions from a Coverdell will not be subject to tax if used for “qualified education expenses.” If distributions are not used for qualified education expenses, they will be subject to tax and included in the gross income of the person receiving the distribution. Additionally, if they are not used for qualified education expenses, a 10 percent penalty will usually apply. All funds in an Education Savings Account must be distributed before the time the beneficiary reaches the age of thirty, but the account can be transferred to another beneficiary, without tax or penalty, if the new beneficiary is a member of the family of the old beneficiary.

More Help with College

American Opportunity Credit

This tax credit replaces the former Hope Scholarship credit. In 2011, the allowable credit is $2,500. The credit can be claimed for the first four years of college. The way the credit works is that you can claim a 100 percent credit on the first $2,000 in qualified tuition and fees. Then you can also claim a 25 percent credit on the next $2,000 in tuition and fees; that works out to another $500 credit. The combined value is $2,500. There is an income limit to be eligible to claim this tax credit. In 2011, individuals with income below $80,000 can claim the full credit; between $80,000 and $90,000 a partial credit is available. Married couples
that file a joint tax return can claim the full credit with income up to $160,000. A partial credit is available for joint filers with income between $160,000 and $180,000. No credit is allowed if your income is above those upper limits. The credit is in place through 2012. Beyond 2012, it must be reauthorized by Congress.

The Lifetime Learning Credit

This is an additional credit to help pay for college, but you can’t claim this credit in the same year you claim an American Opportunity credit for school for the same student. There is no limit to the years this credit is available, so it can be especially useful for graduate students or if you want to take classes to improve your job skills. You can claim a 20 percent credit on up to $10,000 in qualified tuition and fee expenses. That works out to a maximum annual credit of $2,000. Individuals with income above $60,000 and married couples filing a joint tax return with income above $120,000 are not eligible for this tax break. The Lifetime Learning credit limits discussed here are in place through 2012. Beyond 2012, the program requires Congressional reauthorization to stay in effect.

Another way to save for your child’s education is by using what is called a 529 plan. Many states have adopted these plans that are open to anyone to use at any accredited college of their choosing.

In a particular 529 plan, regardless of what state you live in or what state your child actually ends up going to school in, you or anyone who wants to can put tens of thousands of dollars, up to $300,000 per account in some states, into one of these savings plans and use this money to pay for the costs at any accredited
school of higher education. The costs include not only tuition, but also books, computers, and room and board. What you need to know is that anyone can put money into a 529 plan regardless of the relationship that person has to the beneficiary of the plan. There is no income limit on who can fund a 529 plan.

Taxation of 529 Plans

When the earnings of this money are withdrawn from these accounts and used for educational purposes, there is no federal tax due. If the funds are put in a 529 plan within your own state, then when you go to take the money out to pay those school bills, state income taxes will also be avoided on the earnings on the fund. Not only that, but if you contributed to a 529 plan in the state where you live, you may get a tax deduction or credit for your contribution. If you invest in a 529 plan outside of the state in which you reside, you will not get a state tax deduction.

Other benefits include the fact that if you have a 529 plan and your child gets a scholarship, in most cases you can get the 529 plan refunded to you without a penalty. Also, if your child decides not to go to college at all, you can ask to get a refund or else transfer the money to another family member. If you do get a refund under this circumstance, please know that there will be a 10 percent penalty, plus taxes due, on the earnings in the account. But the bottom line is that unlike a UGMA account, in a 529 plan, you can take this money back and do whatever you want with it whenever you want. With a UGMA account, the money belongs to the child, who can access it at a state-mandatory age. You can’t touch it. Money held in a 529 by the parent also qualifies for the preferential treatment when computing a family’s financial aid eligibility.

Here are a few more things you should know about 529
plans. When you invest in a 529 plan you are simply putting money in an investment account that someone else is managing. If you do not like the investment performance of your particular 529 plan you can transfer your money to another 529 plan. You can make this transfer only once in any twelve-month period. Find out what the 529 plan that you are interested in invests money in, what their investment return has been, and who manages the money. On the other hand, be cognizant of tax benefits. Many people think that it is better to invest in a 529 plan out of state that’s been getting better returns than their state’s 529 plan. This could be true, but it will depend on your state plan and your own state income tax bracket, as well as the returns for the different plans. Run the numbers. This is what you need to take into consideration: any state tax deduction for your contributions as well as your child not having to pay state income taxes on the funds they withdraw to pay for educational expenses. And pay very close attention to the annual expenses charged by the mutual funds offered inside the 529. A low-fee plan that is out-of-state can be smarter than an expensive in-state plan. Compare those bottom line numbers to the return the out-of-state 529 plans have been getting. The numbers will tell you which way is the best to go.

For the best up-to-date information on 529 plans, visit the website
www.savingforcollege.com
.

College notwithstanding, your children’s real education about money will take place all through their childhood, in the way you talk about money, in the way you present what working is all about, in the way they learn what they have a right to hope for in this world.

Children can absorb so much, if you will just trust yourself
and open up to them. Play money games with them, using mail-order catalogs and price tags in stores—teach them value. When they’re old enough, tell them about your 401(k), your strategies for investing, and what this all means in the context of their young lives. Rather than a traditional passbook savings account, give your children a little money in a mutual fund and let them keep careful watch over it. Talk to your children about how the world presented in advertisements, with a stunning array of things to consume, is different from the real world. Turn the dinner table conversation to the subject of money, and talk to your children about what it means to save for college, for example. Explain what credit cards are, and what you’re doing when you go to the bank, and what the cash machine is all about. Talk about what it means to be poor. Talk about what it means to be rich. Talk about charity, and let your children see it in action often. Talk about prices, and values, at the supermarket. Talk about mortgages, and debt, and insurance, and how you make choices about money.

By talking to your children about money, you will be talking to them about the way the world really works. And teaching them well.

With this sixth step toward financial freedom, you have now learned to trust yourself more than you trust others. Now, along with that trust, you must watch over all that you have begun to create.

Whether you are managing your money yourself or have handed it over to an adviser, or a combination, you must know
exactly how it is doing at all times. Remember, not only must you trust yourself; you must also be respectful of yourself and your money.

You can keep track any way you want, but you must keep track, studying all statements carefully and keeping watch in between. The easiest way to do this is by signing up for an online service like America Online, which will automatically value your portfolio and tell you exactly how much you are up or down every time you punch into it. Make checking your mutual funds and any other investments you own a part of reading the paper every day. It can be a pleasurable part of your day: you are creating wealth.

Your wealth.

With these last three steps we have covered the vital forces behind the doors to financial freedom.

You must be responsible to those you love.

You must be respectful of yourself and your money.