With tax reform it is more important than ever to have a plan that also includes your children.
As a financial planner, the most common goal that I hear parents have is “to protect and provide for my children”. There has been a lot of discussion around the individual and corporate tax changes and we cannot forget about the changes affecting our children’s education savings plans and investment accounts.
Throughout this article, I will touch on the most significant changes that may affect your education savings plan and the impacts to your child’s investment account.
- Kiddie Tax Rates have changed and your child’s unearned income that exceeds $2,100 will now be taxed at the trust tax rates. Any unearned income that exceeds $12,100 will be taxed at the highest tax bracket, 37%.
- 529 education savings plans have expanded their Qualified Education Expenses to include K-12 education costs. Do not be so quick to write checks to your child’s private high school. Your state sponsored plan may still adhere to the old rules.
- 529 education savings plan can now be rolled into 529 ABLE Accounts. This is a long-awaited amendment that can greatly benefit families with disabled children.
- Coverdell Education Savings Accounts (ESA) are now explicitly, eligible to be rolled into 529 education savings plan accounts. If you have an ESA account, it may be wise to consolidate these accounts by rolling them into 529 plan.
Unearned Income and Your Children’s Tax Bracket
Unearned income to children may have received the largest tax impact through the recent tax reform. In the past, Kiddie Tax Rates, (tax on unearned income for children or full-time students under age 24), on income which exceeds $2,100 would be taxed according to the parent’s tax rate. Starting in 2018, Kiddie Tax rates are now based on trust tax rates. Children’s unearned income that exceeds $12,100 will be taxed at the highest tax bracket, 37%.
If you are not in the top tax bracket, your children’s unearned income (i.e. dividends and interest) could easily be taxed at higher rates than you. Conversely there may be opportunities to transfer income to your children and also allow your children to take advantage of Roth IRA contributions. Over the years, there have been many strategies used to take advantage of your children’s tax brackets and these strategies still exist. If your children have investment accounts or earned income, it is important to talk with a professional or your financial planner about strategies like Roth IRA contributions to help reduce the significant tax impacts down the road.
The recent tax reform also extended into education funding. As a background, since being introduced in 1996, 529 plans have been a valuable resource to help families save for college. 529 college savings plans are a tax-advantaged, education savings accounts and until recently they have only been applicable for higher education expenses (post-secondary). Currently, 529 plan withdrawals are completely tax-free as long as the withdrawals are used for qualified higher education expense which include tuition, room and board, and computer software and equipment.
With the recent tax reform, the federal tax code extends qualified education expenses to cover K-12 public, private, and religious school costs. The K-12 qualified education expense is capped at $10,000 per student, per year. With any changes to tax code, we are bound to have some kinks that need to be ironed out. The recent tax change is a federal tax code change and 529 plans are sponsored by individual states, meaning each state has its own set of law’s regarding taxation on 529 plans. In the past, every state had passed legislation to make qualified withdrawals for higher education tax-free (mirroring federal tax guidelines). Additionally, some states offer tax incentives to their residents for participating in their state sponsored plans. This means that each state needs to amend their current legislation which currently precludes distributions for K-12 education expenses. At this point, over 20 state sponsored plans have amended their legislation to mirror the Federal Tax Code and it is important to talk with your financial planner, or 529 plan sponsor, before making any withdrawals for K-12 education expenses. While we expect New Jersey to make the appropriate amendments, they have not yet done so and early withdrawals, (non-qualified), will be subject to state income tax on any gains from the withdrawal. Furthermore, if you participate in a state which offers a tax deduction for contributions, the withdrawal would be recaptured as income for non-qualified withdrawals. Nevada and Utah’s state sponsored 529 plans, which are among our favorites, are part of the 20 states that have already made the appropriate amendments.
Children with Special Needs and 529 ABLE
529 ABLE accounts received a long-awaited amendment to allow rollovers from standard 529 education savings plans. 529 ABLE accounts provide a valuable resource for families with children who have disabilities. They have similar characteristics to traditional 529 education savings plans and have an expanded list of qualified expenses which includes expenses like job training, healthcare management, and financial management. 529 ABLE accounts provide similar protections that special needs trust may provide in determining eligibility for government programs. If you have a family member with special needs, 529 ABLE accounts can be a tremendous resource and it is important to talk to a professional about your alternatives.
Coverdell Education Savings Accounts (ESA)
As a result of the expansion of qualified education costs for 529 education plans, Coverdell ESA accounts have become less valuable. In the past, ESA accounts were the only tax-advantaged account to help families pay for K-12 education expense. Unfortunately, ESA accounts had many restrictions that hindered their popularity. With the recent expansions to 529 plans, you can consolidate your Coverdell ESA account into a state sponsored 529 education savings plan and receive the same tax-advantaged characteristics without the added restrictions that ESA accounts pose.
Throughout this article we talked about many tax reform changes that are affecting children and we have seen significant improvements to education savings plans. The changes are significant and require a discussion with your Financial Life Planner to see how the changes impact your family.
If you have questions about education planning or would like to learn more about the information reviewed, contact Bret Kaye, MBA, CFP® or your AEPG Financial Life Planner to arrange a meeting.
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