May 2000


In This Issue

Saving for College Is Easier Than You Think

The Lighter Side: More Resumania

The Dependency Exemption: A Tricky Problem in Divorce Situations

Reporting and Valuing Property Donated to Charity Tax Calendar

Do You Know. . .

Who said, The greater part of our happiness or misery depends on our dispositions, and not on our circumstances.

Answer:  Martha Washington

Saving for College Is Easier Than You Think

For many, the cost of a college education looms as one of the largest financial burdens they will incur in their lives. Over the past 20 years, college tuition costs have increased almost 400%. Recently, however, help has arrived through federal legislation, which has created new types of programs and IRAs that make it easier to save for a higher education. To successfully use these programs and accounts, you must realize their investment, tax, retirement, and estate planning implications and incorporate them into your financial planning.

State tuition programs

Qualified state tuition programs (QSTP's) are a very popular way to save for college. These programs, also known as 529 plans after the IRC section that authorizes them, are offered by 34 states. State tuition programs are popular because they are available for children of any age and families of any income level and are an effective way to save for future college costs.

Types of plans. States have a lot of discretion in crafting the tuition programs, so features vary greatly; however, they generally fall into two categories: prepaid tuition plans and savings plans.

Prepaid tuition plans. These state-operated trusts provide residents of the state with a good way to hedge against tuition inflation. Under these plans, states offer contracts where they agree to pay future tuition at in-state public institutions at prices pegged to current tuition levels.

Savings plans. Tuition savings plans are very similar to mutual funds, except they are sponsored by a state. The contributor's account is intended to grow over time and thus keep up with or surpass the increasing costs of college. The risk is if the investments made with the account money don't keep pace with the tuition increases. Many savings plans lower the risk by managing the investments more conservatively as the designated beneficiary approaches college age. Most state programs are savings plans that offer more flexibility, and more and more states are opening their programs to both residents and nonresidents.

Tax consequences of QSTP's. Contributions to a QSTP are not deductible, but the earnings are taxed only on withdrawal. The withdrawal is divided into two parts: the initial investment and the earnings. The initial investment portion is nontaxable, and the earnings are taxable. The QSTP computes the taxable portion of any withdrawals made during the year under the annuity taxation rules found in IRC section 72 and reports it to the IRS as ordinary income on Form 1099-G.

Another advantage of QSTP's is that earnings are taxed at the income tax rate of the beneficiary of the account (i.e., the child) and not the owner of the account (the parent). This is usually a lower income tax bracket; most college students are in the zero or 15% bracket. This rule is true as long as the funds withdrawn are used to pay for a qualified higher education expense. These consist of tuition, fees, required books, supplies, equipment, and some room and board expenses, at an eligible educational institution. Generally, this includes any accredited postsecondary educational institution in the United States, undergraduate or graduate.

If the funds are withdrawn and not used for a qualified higher education expense (called a nonqualified withdrawal), then the earnings are taxed to the distributee (usually the parent) and not the beneficiary, so any savings due to the student's lower tax bracket are lost. In addition, nonqualified withdrawals are subject to penalties, which may equal at least 10% of the earnings of a nonqualified withdrawal, not the entire withdrawal.

Rollover options. Another advantage of QSTP's is the ability to change the designated beneficiary to another member of the family at any time. QSTP's also allow you to make a withdrawal and re-contribute it to a QSTP account for another family member beneficiary. If the re-contribution is done within 60 days, it is treated as a tax-free rollover. The definition of family members includes parents, grandparents, children, and grandchildren, but does not include cousins.

Contribution limits. Section 529 does not impose contribution limits; it requires only that a QSTP have adequate safeguards to prevent contributions that exceed what the beneficiary may need for qualified higher education expenses. The proposed regulations provide a safe-harbor limit; the limit is determined by actuarial estimates and takes into account all tuition, fees, and other qualifying expenses that a beneficiary would have for five years of undergraduate enrollment at a qualifying institution with the highest cost. A qualifying institution in this case is one allowed under the specific state program. Some programs limit the total amount that can be contributed to the account, while other programs have annual contribution limits.

When determining whether to contribute to a QSTP, remember that it is the state program and not the account owner that determines how the funds are invested.

Estate and gift tax considerations. For some, the best feature of QSTP's is the estate and gift tax treatment they receive. Generally, under estate tax rules, if the decedent names a beneficiary to certain assets but retains control over the assets, the assets will be included in the decedent's estate. However, a QSTP account can be controlled by the owner, while the value of the account is shifted from the owner's estate to the beneficiary and will not be included in the owner's estate. This feature can be a helpful estate planning tool. A grandparent who would like to fund a grandchild's college education, but does not want the child to have full control of unused funds, can use a QSTP.

QSTP's also get favorable gift tax treatment. A contribution to a QSTP qualifies for the $10,000 annual gift and generation-skipping transfer tax exclusion. An added plus: Donors can use a special election that allows them to treat a QSTP contribution as if it had been made over five years. This allows a donor to contribute up to $50,000 in year one to a beneficiary's account (subject to state limits), have it treated as if he or she had made five $10,000 contributions over five years, and qualify for the annual exclusion.

Other options

QSTP's are only one way to save for higher education costs; other options include Education IRAs and Roth IRAs.

Education IRAs. These IRAs must be created exclusively to pay the qualified higher education expenses of a named beneficiary, such as a child or grandchild. Generally, the earnings on the funds in the IRA won't be taxed until a distribution from the IRA is made, and distributions from the IRA won't be included in gross income. The annual contribution is limited to $500 per beneficiary, and can't be made after the beneficiary reaches 18. And you can't contribute to an Education IRA in the same year in which you contribute to a qualified state tuition program on behalf of the same beneficiary. Eligibility for Education IRAs phases out for single taxpayers with modified AGI's between $95,000-$110,000 and between $150,000-$160,000 for joint returns.

Note: You can claim only one of the following for each student in any given year: the Hope Scholarship credit, the Lifetime Learning credit, and the exemption for the Education IRA earnings withdrawal.

Roth IRAs. Roth IRAs are a great way to save for college, because withdrawals used to pay education expenses are excluded from the 10% excise tax on early distributions. Roth IRAs are also good because the withdrawals are first considered a nontaxable return of investment. This helps those who would like to use part of the Roth IRA to pay for college and let the earnings remain in the account to continue to grow for retirement. Another plus: The distributions at retirement are tax-free. The disadvantages to Roth IRAs are that the annual contributions are limited to $2,000, the contributor must have earned income, and eligibility is phased out for individuals with AGI's over $95,000 and for married couples with AGI's over $150,000.

Conclusion

Paying for college can be a daunting financial task, but the burden can be eased with some careful planning early on. Using one of the QSTP's or IRA accounts can make saving for higher education easy and effective by letting parents or grandparents put aside money each year for higher education and reap certain tax benefits while doing so.


The Lighter Side: More Resumania

Resumania is a term coined by Robert Half, founder of Accountemps, to describe the bloopers that appear in resume's, job applications, and cover letters. Below are some of the blunders, demonstrating the importance of careful preparation at every stage of the job search process.

Worked party-time as an office assistant.

I am entirely thorough in my work; no detail gets by me.

Thank you for meeting me for an interview.

Computer illiterate.

My qualifications are above reproach.

You have nothing to loose by calling me for an interview.

Outside activities: A bell ringer for the Salvation Army.

More is sometimes less

At times, applicants give too much information on their resume's or applications; below are some examples:

Reason for leaving: I did not have enough idle time.

Willing to relocate to residence in upscale neighborhood on waterfront with easy access to mass transit.

Prefer to work alone in maximum privacy.

Reason for leaving: Sick and tired of being a human punching bag for my boss.


The Dependency Exemption: A Tricky Problem in Divorce Situations

Under IRC section 152(e), the custodial parent, as a result of a divorce, is generally entitled to take the dependency exemptions for the children. This applies as long as both parents provide more than half the children's support and the children live with either or both parents for more than six months each year.

However, the non-custodial parent may claim a child if the custodial parent agrees not to claim that child as a dependent for a particular year, and signs Form 8332, Release of Claim to Exemption for Child of Divorced or Separated Parents. The non-custodial parent then attaches the signed form to his or her tax return.

On Form 8332, the custodial parent can choose to release a claim for the deduction in the current year, specified future years, or all future years. The custodial parent need sign the form only once, but the non-custodial parent must attach it to his or her return every year. However, problems can arise because the form contains no cancellation date, and there is no way to nullify the form. For example, a custodial parent may waive the exemption for specified future years because the non-custodial parent is providing child support. But if the non-custodial parent stops making child support payments, yet continues to claim the exemption, it can be very difficult for the custodial parent to void the release.

According to IRS legal memorandum no. 200007031, the only way a custodial parent can void Form 8332 and claim the child on his or her own tax return is to get the non-custodial parent to forgo claiming that child as a dependent. If the two former spouses cannot agree and both claim the same child, then the IRS steps in and calls for an audit.

To avoid such situations, custodial parents should agree to the release of the deduction on an annual basis and not for the long term.


Reporting and Valuing Property Donated to Charity

Many types of items can be donated to charitable organizations; most of them, such as used articles and clothing, have little value, but can be counted as part of your charitable deduction if you itemize. However, other types of items, such as paintings, antiques, and coins, have significant value and not only provide the donor with a current deduction, but can also save the donor capital gains taxes that would have been paid if the property had been sold.

Deduction amount. The amount of the deduction depends on how the property will be used by the charity. If the property is to be used by the organization (e.g., a painting donated to a museum), the deduction is the fair market value (FMV) of the property. If the property is to be immediately sold by the organization, then the deduction is limited to FMV or the cost, whichever is less. Property donations of assets with values over $5,000 must be appraised by qualified appraisers to ensure the assets are not overvalued.

Reporting requirements. For each contribution of property over $5,000 (except publicly traded securities), an appraisal summary is needed (section B of Form 8283). The summary should be signed by someone at the charitable organization to acknowledge receipt of the property.

Even if you think you will never make such a significant charitable contribution, you may still have to comply with reporting requirements. If the total non-cash charitable contributions of property are valued over $500 (e.g., you donated several pieces of used furniture in the same year), certain reporting requirements need to be met. The donor must file IRS Form 8283, non-cash Charitable Contributions. Information required by the form includes the name and address of the charity and the FMV of the donated property.

The appraisal. If the contributed property is valued over $5,000, then an appraisal should be done. The appraisal should include the following: a detailed description, including physical condition and a photograph; FMV on the date of transfer; the date or expected date of the contribution and the date the property is valued; the appraiser's name, address, telephone number, and taxpayer identification number (TIN); the appraiser's qualifications; and the method used to determine the FMV.

Even if an appraisal is submitted, the IRS may decide to make its own determination of value through an IRS appraiser, the IRS Art Advisory Board, or independent dealers and appraisers.

Penalties. If the FMV is overstated, penalties of 20% to 40% of the tax underpayment may apply. The 20% penalty applies if the underpayment is more than $5,000 and the deduction amount was between 200% and 400% of the actual value of the donated property. The 40% penalty applies if the deduction amount was 400% or more of the actual value and the tax underpayment is more than $5,000.


Tax Calendar

May 1

Employers. For Social Security, Medicare, and withheld income tax, file Form 941 for the first quarter of 2000. Deposit any un-deposited tax. (If the total is less than $1,000 and not a shortfall, you can pay it with the return.) If you deposited the tax for the quarter in full and on time, you have until May 10 to file the return. For federal unemployment tax, deposit the tax owed through March, if more than $100.

May 10

Employees who work for tips. If you received $20 or more in tips during April, report them to your employer. Use Form 4070.

Employers. File Form 941 for the first quarter of 2000. This due date applies only if you deposited the tax for the quarter in full and on time.

May 15

Employers. For Social Security, Medicare, withheld income tax, and non-payroll withholding, deposit the tax for payments in April if the monthly rule applies.

June 15

Individuals. Make a payment of your 2000 estimated tax if you are not paying your income tax for the year through withholding (or will not pay in enough tax that way). Use Form 1040-ES. This is the second installment date for estimated tax in 2000.

Corporations. Deposit the second installment of estimated income tax for 2000.

Employers. For Social Security, Medicare, withheld income tax, and non-payroll withholding, deposit the tax for payments in May if the monthly rule applies.


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