Under the current tax system, most savings programs, such as IRAs, are incentivized by tax deductions for contributions. However, there are three important savings vehicles, one of which is new, that do not hinge on deductions for contributions; they rely on tax breaks for withdrawals and offer other benefits.
The average cost of a four-year education at a private college for someone enrolling in 2033, which is 18 years from now, is projected to be $323,900 (http://www.savingforcollege.com/tutorial101/the_real_cost_of_higher_education.php). To help students avoid or minimize the need for student loans and the resulting debt, parents, grandparents, and others can save for a child’s higher education in a tax-advantaged account called a 529 savings plan. (There are also 529 tuition plans, which are a form of savings; they are not discussed here.)
Every state offers a savings program. Each state sets its own cap on lifetime contributions. Once an account (contributions plus earnings) reaches the cap, no additional contributions are permitted; the cap can be adjusted annually. For example, the current cap in New York is $375,000; it is $418,000 in Florida and $452,210 in Pennsylvania. However, contributions made in one state usually are not taken into account by another state for purposes of the lifetime cap.
Each plan offers a range of investment options. Investments can be changed once a year.
Contributions are treated as completed gifts for federal gift tax purposes, even if the donor retains control over the account. Contributions qualify for the annual gift tax exclusion. What’s more, under a special rule, a donor can make up to five times the annual exclusion amount without any gift tax (e.g., in 2015 this is $70,000, or $140,000 if a spouse joins in the contribution).
Distributions are tax free if used for qualified education expenses. These include tuition, fees, books, supplies, and equipment required for enrollment. (In the past, computer equipment and technology were qualified expenses, but this is no longer so.) Distributions for non-qualified purposes are taxable under annuity rules discussed earlier; the taxable portion is subject to a 10 percent penalty. To the extent that expenses are taken into account in figuring the American opportunity credit or lifetime learning credit, they cannot also be treated as qualified distributions.
The federal financial aid application (FASFA) counts assets in a 529 plan as a parental asset, even if the account is owned by the student. This means that 5.64 percent of the assets are assessed in determining a student’s Expected Family Contribution (EFC). Also, tax-free distributions from a 529 plan are not part of the “base-year income” and thus do not reduce the next year’s financial aid eligibility.
Who knows how much a person needs to achieve a financially-secure retirement. Health care costs, what is needed and what this will cost, is the great unknown. Individuals with earned income from a job or self-employment can make contributions to a Roth IRA up to set limits (for 2015, the limits are $5,500, or $6,500 for those age 50 and older by year end, assuming earned income is at least this amount) (Code Sec. 408A). Again, contributions are not tax deductible, but earnings grow tax deferred and withdrawals are tax free if certain conditions are met. Earnings are excludable when a distribution occurs more than five years after the start of the year in which the initial contribution to the account was made as long as the contributor is over age 59-1/2 or becomes disabled or dies.
Contributions can be made regardless of participation in a qualified retirement account or the age of the contributor. However, income limits may limit or bar contributions. For 2015, a full Roth IRA contribution can be made only if modified adjusted gross income $183,000 for a married person filing jointly, or $116,000 for singles (including heads of households) (Notice 2014-70, IRB 2014-48, 905). A partial deduction is allowed for joint filers with MAGI between $183,000 and $193,000, and for singles with MAGI between $116,000 and $131,000.
There are no lifetime required minimum distributions for Roth IRAs. Thus, if the account owner does not need the funds, he or she can leave tax-free income to a beneficiary. A beneficiary who is a surviving spouse can rollover the funds to his/her own Roth IRA and continue tax-free growth. However, a non-spouse beneficiary must take required minimum distributions (RMDs) over his/her life expectancy (according to an IRS table for this purpose) even though the distributions are not taxed.
Designated Roth accounts. A 401(k) plan can permit after-tax contributions that are segregated from regular 401(k) accounts; these are referred to as designated Roth accounts. As with other after-tax contribution plans, there is no upfront incentive for contributions (i.e., there is no salary reduction for contributions to designated Roth accounts). Earnings become tax free when a distribution occurs more than five years after the initial contribution to the account and when the contributor is over age 59-1/2 or becomes disabled or dies.
Unlike Roth IRAs, there is no income limit on eligibility to contribute to designated Roth accounts. However, also unlike Roth IRAs, designated Roth accounts are subject to required minimum distribution rules. Lifetime distributions can be avoided by rolling over the designated Roth account to a Roth IRA.
The cost of raising a disabled child to the age of 18 can reach $1 million (https://www.mint.com/blog/planning/the-cost-of-raising-a-special-needs-child-0713) and the needs of a disabled person do not end at the age of majority. Achieving a Better Life Experience (ABLE) Act (H.R. 647, which was part of Division B of H.R. 5771) was signed into law on Dec. 19, 2014, as part of the Tax Increase Prevention Act of 2014 (the “extender bill”). It creates a new type of savings plan for disabled individuals without causing them to lose eligibility for Medicaid and other government assistance programs. Contributions to an ABLE account are not tax deductible, but earnings grow on a tax-deferred basis, and withdrawals for qualified expenses are tax-free (Code Sec. 529A).
An account may be set up for a designated beneficiary by such person, a parent, grandparent, or any other individual. A designated beneficiary is someone who is entitled to benefits based on blindness or disability under the Social Security Act where such disability occurred before the age of 26, or any person who has a disability certification on file with the IRS (details about certification are to be provided by the IRS).
States are authorized to set up programs for ABLE accounts. States can set the dollar limits on lifetime contributions on behalf of a designated beneficiary. Only residents of a state can participate in its program.
Contributions to ABLE accounts are treated as completed gifts and qualify for the annual gift tax exclusion (in 2015 it is $14,000, or $28,000 if a spouse joins in the contribution). However, the special gift tax rule applicable to contributions to 529 plans (discussed later) does not apply to contributions to ABLE accounts.
Qualified expenses for which tax-free withdrawals can be made include expenses for health, education, transportation, housing, assistive technology, legal fees, and burial expenses. In addition, the IRS is authorized to add to the list of statutory expenses that are treated as qualified for tax-free withdrawal purposes.
Withdrawals are permitted for non-qualified purposes, but are taxed according to the rules applied to commercial annuities (Code Sec. 72). Thus, the portion of the distribution related to after-tax contributions is tax-free while the portion reflecting earnings on those contributions is taxable. In addition, there is a 10 percent penalty on the taxable portion, regardless of the designated beneficiary’s age.
Rollovers can be made to change designated beneficiaries or savings programs. The same 60-day rollover period and the one-rollover-per-12-month period rules for IRAs apply to ABLE accounts. Investments are restricted, but changes can be made within the account twice a year.
Usually, having assets over $2,000 or income over $700 a month causes a disabled person to lose eligibility for Medicaid and other government programs. However, assets in an ABLE account are ignored for purposes of government programs. But eligibility for Supplemental Security Income (SSI) is lost when the ABLE account balance exceeds $100,000.
The law is effective after Dec. 31, 2014. The IRS is expected to promulgate rules for ABLE accounts, including the certification rules, within six months.
While an upfront federal tax deduction is not available for these savings accounts, they still provide significant tax and other benefits. For example, there may be state income tax incentives (e.g., New York allows a deduction of up to $5,000 per taxpayer for contributions to its 529 savings plan so a married couple can deduct up to $10,000 annually). Look into these and other after-tax savings plans