Compliments of The Litherland, Kennedy & Associates, APC, Attorneys at Law
Written By: The American Academy of Estate Planning Attorneys
College costs have been steadily rising for years, and there does not appear to be an end in sight. If you are a new parent, you might want to grab some smelling salts: according to current estimates, the total cost for a four-year public university education for your little bundle of joy could top $200,000.
Faced with this financial reality, parents and grandparents are looking for ways to get the most bang for their education bucks. One option is to combine two existing strategies: the education trust and the deferred annuity.
Education trusts are not a new idea. For decades, parents and grandparents have been using them to help finance college education costs for the children in their lives.
Under a typical scenario, parents transfer up to $28,000 per year for each child into an irrevocable trust using each parent’s $14,000 annual gift tax exclusion. This sounds fine, but there’s a problem. It’s hard to accumulate enough funds in the trust because the income tax rates of trusts are “compressed.” For 2013, this means that a trust will pay income tax at the top rate of 39.6% if its taxable income exceeds $11,950. The parents will not pay tax at this rate until their taxable income reaches $450,000.
With rising tuition costs, the search is on for a way to preserve more trust income to apply toward educational expenses. One solution is the deferred annuity.
A deferred annuity is a contract under which an investor pays premiums to an insurance company for a specified period of time in order to receive a steady stream of income later. It has two phases: the savings phase and the income phase.
When a deferred annuity is owned by an individual, things are relatively simple. During the savings phase, the insurance company takes the premiums and invests them. In this phase, you don’t pay income tax on the money that accrues. Later, during the income phase, the insurance company distributes regular payments to you. At this point, you pay taxes on your annuity income.
Trust Ownership of a Deferred Annuity
When you combine a deferred annuity with another entity, like a trust, the rules get more complicated. Ordinarily, if a trust owns a deferred annuity, IRS rules require that income tax be paid on any annual increases in the value – whether or not any money is distributed.
However, when an education trust owns a deferred annuity, the ordinary rules don’t apply. Because the beneficiary of an education trust is a college student (or a future college student), the trust is subject to a special exception that treats it as holding the annuity as an “agent” for the individual beneficiary. Under this exception, a typical education trust may invest in deferred annuities and delay taxation on the income from those annuities until cash is actually distributed. This allows the trust to accumulate significantly more money over the course of a beneficiary’s childhood.
When the time comes to pay for college, the trustee of the education trust withdraws the necessary funds and distributes them. At this point, the distributed funds are subject to income tax at the beneficiary’s lower income tax rate – not at the trust’s compressed rate. (Note, however, that income taxed to a beneficiary who is a full-time student under age 24 may be taxed at their parents’ rates pursuant to the “kiddie tax.”)
If you are planning for your children’s or grandchildren’s college education, talk to your estate planning attorney or financial advisor about how deferred annuities may fit with your plan.