How is the best way to save money
- An IRA, 529 plan and life insurance have different advantages and disadvantages Consider the tax implications, including gift tax Consider what the college savings can be used for
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Money Watch, a personal finance column that runs every Saturday, features a financial planner from the National Association of Personal Financial Advisors answering reader questions about saving, protecting and growing your money.
Q: I would like to start putting some money away for my young grandson's college education. Should I invest in a 529 plan, IRA or buy a life insurance policy for him? It would not be a large amount at first but the value would grow in time.
A: These three options for college savings have advantages and disadvantages that may or may not be relevant to you, your grandson, and your family.
An IRA, a life insurance policy and a 529 all provide the advantage of tax-deferred or tax-free growth. Growth in the IRA occurs tax-deferred — that is, all dividends, interest and capital gains are not taxed until withdrawal. If the IRA is a traditional IRA, you may also receive a tax deduction for the contribution. If this is the case for you, you will not pay tax on the contribution until it is withdrawn. (You should check with your accountant on the deductibility of IRA contributions.)
Growth in the life insurance policy is tax-deferred. If withdrawals are taken in the form of loans against the cash value, then those are also not taxed. Growth in 529 plans is tax-free, if used for qualified education expenses.
The tax advantages of each account type come with conditions, however. With an IRA, any distributions before age 59 1/2 incur a 10% penalty, which may be waived for education expenses by filing Form 5329 in the same year you take the distribution. With a life insurance policy, if distributions are not taken as loans, then any growth will be taxed at ordinary income rates. With a 529 plan, withdrawals for non-education expenses can be subject to both income tax and penalties.
Gift taxes are a second tax factor for some grandparents. The annual gift tax exclusion amount is currently $14,000.If your contributions to a 529 plan for a grandchild, when combined with all other gifts to that child during the year, exceed the $14,000 annual exclusion, you must file a gift tax return.
Contributions to IRAs and life insurance premiums are not considered gifts, however, any distributions from them to your grandson would be. Direct payments to the school are currently exempt from gift taxes.
Distributions from 529 plans are not considered gifts if used for qualified education expenses, however, contributions are. Grandma and Grandpa can each contribute up to the annual exclusion for a total possible contribution of $28,000 in 2013. 529 plans also allowing bunching of five years of
gifts into one year. For example, if Grandma and Grandpa gave no other gifts to Grandson in 2013, they could each contribute $14,000 to his 529 plan ($28,000) and then bunch their annual gifts for 2014-2018 for a total contribution of ($28,000 x 5 =) $140,000. Ask your accountant how to report the bunching of gifts to 529s.
Besides taxes, another consideration is financial aid. If you think your grandson might qualify for need-based financial aid, life insurance policies and IRAs owned by you are not counted in the formula. But a portion of 529 accounts is counted.
Costs and fees are yet another factor to consider. Even small percentage costs can add up over 18 years. Life insurance policies tend to have sales charges, annual administrative fees, mortality fees and investment management fees totaling from 2% to 12%, depending upon the company and the policy. Ask your agent to show you a sample contract, pointing out all of the fees and charges.
It is possible to structure an IRA or a 529 account with funds that have no sales charges, no annual administrative fees, and very low investment management expenses (between 0.1% and 1%), but you should ask a representative to disclose all costs to you, as well.
Flexibility is important, too. For information about qualified education expenses for 529 and IRA accounts, see IRS Publication 970. or ask your accountant or a fee-only financial adviser. The list includes not only tuition, room and board, but also school-required computers, software, Internet service, supplies and activity fees.
If your grandson receives a scholarship, 529 funds can be returned to you without penalty, or, the 529 can be used for a sibling, parent or even your grandson's children. 529 plans are administered by each state, so there are at least 50 different programs to consider. It is not necessary for your grandson to attend a school in that state in order to participate in its 529 program. A Florida grandmother could open a Nevada 529 plan for her Ohio grandson.
Loans from a life insurance policy's cash value may be used for any kind of expenses. It is important not to begin taking loans before the policy has an opportunity to build up cash value, or the cash value may diminish too quickly. It is also more difficult to grow the value in a policy where the premiums start out lower and grow over time. Find out how the insurance company decides what interest rate to charge against your cash value for any loans before entering into a life insurance contract.
Your grandson is fortunate you are thinking of him at a young age. With a long time frame, you have many options. Consulting an accountant or fee-only financial adviser would be one way to sort through any other factors unique to your situation.
Holly P. Thomas, Tampa
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Category: Personal Finance