RPF0106-Coverdell

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00:00:30.000 | Hey, Radicals. This is Joshua Sheets.

00:00:31.600 | Real quick, before we begin, I just finished recording today's show.

00:00:34.400 | It's an epic. It's two and a half hours long, as you'll hear in just a moment.

00:00:37.360 | And it's about the topic of the Coverdell Educational Savings Account.

00:00:41.360 | But I felt I needed to come back here and just give you a bit of a reason to listen.

00:00:44.560 | Would you like to pay for your kids' homeschool expenses with tax-free money, tax-free growth?

00:00:52.960 | Would you like to pay for your 16-year-old's iPad with tax-free money?

00:00:58.880 | Would you like to provide for your disabled child without

00:01:03.680 | dealing with some of the restrictions of setting up a trust?

00:01:08.000 | Would you like to be in a situation where you can invest in real estate

00:01:13.120 | for the purpose of your child's education, and pay for that, and get all tax-free money

00:01:18.640 | coming off of that real estate when paying for your child's education?

00:01:22.000 | Would you like to pay and invest for your child's education by buying and selling options,

00:01:29.360 | or trading in precious metals, maybe gold coins, or that type of thing?

00:01:35.360 | That's what today's show is about. And I want you to really give this a shot,

00:01:39.520 | because many of you are going to find some ways to save a lot of money in today's show.

00:01:44.480 | There are some really great planning deals in this situation.

00:01:49.520 | And all of this stuff, when I say education, it applies to elementary school, it applies to high

00:01:54.240 | school, it applies to all of this. There's one of you in the audience, at least, who's a real

00:01:58.320 | estate investor who can use the information in today's show to set up a deal that's going to

00:02:03.760 | pay for your child's private school tuition in elementary school, high school, and college,

00:02:09.040 | all with the information in today's show. I'm sure it's possible.

00:02:12.000 | So this show is big, though, and it's deep, and it's hardcore. We get into some real nitty-gritty

00:02:17.280 | with financial planning. But I want you to give it a shot. And I really worked hard on it, and I

00:02:22.240 | hope you like it. It's long, and it's involved. Split it up, if you need to, and take it into

00:02:27.200 | different episodes. Spread it out so that it's not too much for you. But there are a lot of

00:02:34.080 | planning ideas in here, and I've never found someone else who's put this together for you,

00:02:38.560 | especially not in an audio format. So I hope you'll give it a listen.

00:02:41.680 | If you're intimidated by it, I'm going to talk a lot about some detailed financial planning stuff.

00:02:47.120 | We talk about bankruptcy protection. We talk about college tuition protection and financial

00:02:52.400 | aid benefits. We talk about taxes and all of this stuff in today's show. Give it a shot,

00:02:59.520 | even if you are not a financial planner, and even if you're kind of a neophyte to the world of

00:03:04.400 | financial planning, because you need to be exposed to some of this more in-depth stuff.

00:03:09.200 | And even if you don't understand everything that I cover in today's show, please give it a shot,

00:03:13.840 | because over time you'll start to understand more. So when we're talking about annual gift tax

00:03:19.520 | exclusion amounts, you may not know what that means today, but you can look it up,

00:03:23.600 | and then you'll start to see as we go forward. And I want to take you beyond the elementary

00:03:27.920 | concepts. If it's too hardcore for you today, if the depth is too great, skip to one of my fluffy

00:03:33.360 | shows. But don't skip it forever. Dig into shows like this, and you'll start to see where the

00:03:39.760 | really good stuff is. I think you'll really benefit from it. I think you'll really find

00:03:44.800 | some deals in here, and some of you guys are going to use some of the concepts in this show

00:03:48.480 | to save yourselves a couple hundred thousand bucks. Let me know what you think. I hope that

00:03:54.000 | it is a little—it's a lot. I warn you that up front, but I think it's worth it, and I think I

00:03:59.200 | gave you really good content in the best format I was able to. And again, I've never found anybody

00:04:05.920 | bring this information together on this subject, especially if you're interested in college

00:04:10.000 | planning or high school planning or elementary school planning, this is going to be useful for

00:04:15.600 | you. So with that intro, here's the show. Today on the show, I'm going to bring you a legitimate

00:04:23.680 | epic on a topic that you've probably not thought that much about. And even if you've read some or

00:04:33.120 | thought about this subject some, you probably aren't going to believe some of the information

00:04:38.000 | that I bring you, because I'm probably going to destroy just about every article you've ever read

00:04:43.200 | on this topic. And it's on the wonderful, amazing, exciting topic of the Coverdell Educational

00:04:53.760 | Savings Account. Welcome to the Radical Personal Finance Podcast. My name is Joshua

00:05:14.240 | Sheets, and I'm your host. Thank you for being with me. Today is Thursday, November 20, 2014.

00:05:20.080 | And today's show is indeed going to be an epic. Not only epic, but it's going to be an epic.

00:05:27.600 | But it's an epic that's going to save you possibly tens of thousands,

00:05:32.800 | for some of you, hundreds of thousands of dollars of taxes.

00:05:43.840 | We're going to be talking about the Coverdell Educational Savings Account,

00:05:47.040 | and we're going to be talking about it in detail. And I want to sell you on the idea of listening

00:05:51.200 | to this show first. This show is not going to be short. It's not going to be easy. But it does

00:05:56.240 | legitimately have the potential to save you tens of thousands, for many of you, hundreds of tens

00:06:02.560 | of thousands of dollars, for many of you. For some of you, it may be hundreds of thousands of dollars

00:06:06.880 | of taxes. And you won't know whether or not it's going to be appropriate in your situation unless

00:06:12.560 | you listen to the show. I've laid out for myself a task today that I think I can do,

00:06:18.960 | but it's probably going to be unlike any other financial resource that you've ever come across.

00:06:24.160 | Because I'm going to try to cover in depth the topic of this account and explain to you how it

00:06:29.040 | works with a level that many people, that few people ever bring together. But hear me out.

00:06:38.640 | Give me a shot, whether you're brand new to the topic of finance or personal finance,

00:06:43.200 | if you've stumbled into this show just simply because somebody told you, "Hey, you know you

00:06:47.200 | should do an ESA, a Coverdell Educational Savings Account, and you're not familiar with the terms

00:06:51.280 | of financial planning," give this show a listen. And if you are an expert, perhaps you're a

00:06:55.680 | financial planner, perhaps you've been dealing with these for years, give this show a listen.

00:06:59.680 | And I think I've got a few ideas that at least will be helpful to you. I'm going to try to do

00:07:03.840 | this in one show. And this is the type of thing that many people have advised me not to do.

00:07:08.000 | They've advised me to take things, a show like today, and break it up into six or seven or eight

00:07:13.280 | different audio files. But frankly, that would annoy me to try to listen to. And I don't think

00:07:18.960 | it's the best thing for you, the listener. Some of today's show is going to go over your head.

00:07:23.120 | If you're new to this, or even if you're intermediately knowledgeable in this area,

00:07:26.880 | it may go over your head. But it's still important for you to be aware of some of the information

00:07:31.440 | that I'm going to share with you, even if it goes over your head. And you can come back and

00:07:35.120 | listen to this again. I also think it's important to deliver content like the way I'm doing it today

00:07:41.280 | so that you can develop a larger picture of the subject. Because you don't ever find, at least

00:07:50.080 | I have a very difficult time finding content like this where it's cohesive. It's all brought

00:07:56.000 | together and it's comprehensive. I'm going to kick off with just an article, reading to you

00:08:01.760 | just an article that I think is an example of what we usually find in today's media world.

00:08:09.760 | It comes from Forbes magazine, from the website for Forbes magazine, published on

00:08:15.440 | February 28, 2013. The title is called "Paying for College Coverdell Accounts." First line,

00:08:23.120 | written by the eminent William Baldwin, evidently, who writes about investing and taxes. His first

00:08:29.840 | line, "These are stupid. A Coverdell, aka an education savings account, allows you to accumulate

00:08:37.520 | investment earnings tax-free. As with a 529 account, you get no federal tax deduction for

00:08:42.640 | contributions to a Coverdell. As with a 529, a withdrawal is tax-free if it is used on education."

00:08:48.480 | And he goes into four short differences and he concludes with, "In short, there's differences

00:08:54.560 | between the Coverdell and the 529." And let me read them to you. This is only a half a page. He

00:08:59.200 | says, "First, a Coverdell contributions are limited to $2,000 a year. 529s are pretty close

00:09:04.880 | to unlimited. If you bump into a limit on the 529, it's on the account balance and it's likely to be

00:09:10.160 | between $250,000 and $400,000. Second, the right to contribute to a Coverdell is phased out as the

00:09:17.040 | parent's income passes $190,000. The 529 has no income rules. Third, there's a good chance you'll

00:09:23.920 | get a state tax deduction on a 529 contribution. You won't get one on a Coverdell. Fourth,

00:09:29.760 | Coverdells have time limits. They have to be started before the beneficiary turns 18 and

00:09:34.400 | used up by age 30. In short, there's nothing a Coverdell can do for college costs that a 529

00:09:40.160 | can't do better. Coverdells can also be used for K-12 private schools, but even there seem rather

00:09:45.840 | pointless. Your accumulation time is necessarily shorter and the $2,000 a year you're putting in

00:09:51.600 | is maybe a tenth of a year's tuition bill. Invest in a Coverdell if your main objective in life is

00:09:56.560 | to enrich your accountant. This is common to what you see. You either see articles like this in the

00:10:01.440 | financial press or you see comparisons of six bullet points between a 529 account and a Coverdell

00:10:06.480 | account. If you read those things, you go away scratching your head more confused than ever.

00:10:11.520 | Over the course of today's show, I will destroy three of his points and show that this man

00:10:18.480 | doesn't know what he's talking about, has obviously never read the rules, and then I will give a

00:10:23.920 | caveat. The only point of his that is valid is the third point, which is there's a good chance

00:10:29.840 | you'll get a state tax deduction on a 529 contribution, but you won't get one on a

00:10:33.840 | Coverdell. That's the only one of these four points that I think is valid. I'll just destroy

00:10:38.000 | the other three for you. Here's a guy. He's a very knowledgeable guy for all I know. It looks

00:10:42.080 | like he's an enrolled agent, a practicing accountant, an investment commentator, writing for

00:10:47.520 | one of the most well-respected Forbes magazines, very well-respected as far as a professional

00:10:53.440 | publication. I've just said I'm going to destroy all of the points of his article. It's funny. I

00:10:58.080 | didn't mean to do this. I was doing my preparation in today's show, but I actually ran into this guy

00:11:02.400 | in an argument I was having the other day in a forum that I subscribe to, a private forum. I'm

00:11:07.360 | arguing with the guy who hosts the forum. He cites this guy's work, and it's about long-term care

00:11:13.440 | insurance. I came back, and I had to destroy his argument there. It's not him. I don't have

00:11:18.000 | anything against him. I don't know anything about him. I had to destroy his argument about why

00:11:23.280 | nobody should ever buy long-term care insurance and everybody should buy deferred fixed annuities

00:11:27.680 | instead, which is certainly a valid consideration, but it's not a valid consideration for the topic

00:11:34.000 | because he clearly doesn't understand the financial planning problem. If you understand the

00:11:38.400 | financial planning problem that you're trying to solve, then you just look at all of these things

00:11:41.760 | as a tool. So you can come back, and after you listen to today's show—maybe I'll finish up with

00:11:46.640 | this after the end of this lengthy episode—you come back and you consider his arguments, and I'll

00:11:53.920 | show you how to debunk each and one of his arguments. I'm not mad at him or even the popular

00:11:59.200 | press. I understand why the popular press does what they do, but it really bogged me down, and

00:12:05.200 | this is the thing you've got to be aware of. You cannot say that a Coverdell is better than a 529

00:12:10.400 | or that a 529 is better than a Coverdell. It may be better for you in your circumstances,

00:12:17.120 | but that is not the same thing as it being better because in other circumstances,

00:12:22.080 | the opposite is going to be better. That is how financial planning is and how it works.

00:12:32.720 | So bear with me in today's show and give it a shot. Don't be intimidated by the length

00:12:40.000 | stretch this out into multiple episodes or multiple listening experiences, but I believe

00:12:45.280 | that if I do this in one audio file, it's going to be far more useful to you and far more helpful

00:12:51.840 | to understand. So give me a shot. Real quick as we get started on today's show,

00:12:59.680 | sorry this wasn't out yesterday. I'm a day late on this. I had this planned out and then sat down

00:13:05.840 | to record and knew that I couldn't finish. I had a busy day yesterday with several meetings. I

00:13:09.040 | didn't have the time to record it and I didn't want to do it an injustice of giving it a rushed

00:13:14.240 | treatment. So I apologize for that to those of you who tune in each day as I release them.

00:13:18.960 | I also want to just make a quick comment. I'm going to go into a lot of detailed information

00:13:27.280 | on this topic and I'm going to be touching on things that are very specialized areas of financial

00:13:33.200 | planning. So for example, I'm going to be talking about the basics and introductory, but I'm also

00:13:37.920 | going to be talking about some detailed investment topics. I'm going to be talking about some

00:13:42.800 | detailed bankruptcy law. I'm going to be talking about some detailed estate tax scenarios and I'm

00:13:48.320 | going to be talking about some details on financial aid calculations and how an educational savings

00:13:56.480 | account matters from the perspective of financial aid calculations. All four of those disciplines

00:14:02.800 | that I just mentioned are very specialized and rightly so, very specialized areas of financial

00:14:07.600 | planning. I am not an expert in each of those areas. If you find something that is a mistake

00:14:13.280 | in today's show, please let me know. I believe I'm accurate with everything. I've carefully

00:14:17.040 | researched this and prepared for this. But many of you who are experts might catch me saying

00:14:21.120 | something that's wrong. Please let me know. All of the show notes for today's show can be found

00:14:25.760 | at RadicalPersonalFinance.com/Coverdell, C-O-V-E-R-D-L-L, or if you can't spell it,

00:14:34.160 | you can also find them at RadicalPersonalFinance.com/106, 1-0-6 or slash Coverdell.

00:14:42.160 | Please comment there and correct something. If you're going to take action on the information

00:14:46.160 | that I'm presenting in today's show, the first thing you should do is go to that website and

00:14:50.080 | look to see if anything that I mentioned in today's show was corrected in the comments by

00:14:55.120 | somebody who is more of an expert on this area than I am. All right. Preamble done. Let's get

00:15:00.960 | into the content. So I'm going to start with just a big picture overview of what is a Coverdell

00:15:06.560 | educational savings account and how does it work. Essentially, this is an account which the tax law

00:15:13.680 | has authorized that permits you to save for college. And if the investments grow, you can

00:15:19.920 | avoid the tax on the growth of your investments as long as those investments are used for college.

00:15:25.440 | From a taxation perspective, this account works similar to the way that a Roth IRA works. If

00:15:32.880 | you're familiar with the way a Roth IRA is taxed, where you earn a dollar of income, you go ahead

00:15:38.320 | and you pay your income taxes on that money, and then you invest what's left over after you pay

00:15:44.480 | the income taxes. Then that investment grows, and then as long as you take the money in a Roth IRA

00:15:49.840 | out and spend it on the allowable expenses, retirement in the case of a Roth IRA, then

00:15:59.120 | the money comes out with no tax on the investment growth. So there is no upfront tax deduction,

00:16:06.000 | but the investment grows and comes out tax-free. So from a tax perspective, this is the same as a

00:16:14.000 | Roth IRA. It's also the same as a Roth IRA. Let's just leave it at that. Keep it simple.

00:16:20.640 | This, for me, for years was actually a major misconception that I had even when I was a

00:16:27.360 | new financial advisor. For some reason, I had in my head that a Coverdell educational savings account

00:16:34.560 | was tax deductible upfront and then on distribution was tax-free also, which would be a double

00:16:42.240 | benefit. That is not the case. The only thing for which I'm aware of that's the case is actually

00:16:47.520 | long-term care insurance, but we'll leave that one for a different day. So a Coverdell, there's no

00:16:53.840 | upfront deduction, but the benefit can come out tax-free. So from that perspective, for federal

00:17:00.640 | income taxes, the Coverdell educational savings account and the 529 account are taxed the same.

00:17:07.360 | There's no benefit from one versus the other. That's important to you. Now, oftentimes, many

00:17:13.520 | of you will have never heard of the educational savings account, and there are many reasons for

00:17:18.160 | that. Probably the number one reason is the low contribution amounts that are permitted.

00:17:23.120 | You are not permitted to put more than $2,000 into this account in any given year. So that's a

00:17:28.640 | relatively low number, and especially in a world where the majority of us receive financial advice

00:17:33.760 | through the services of a financial advisor, it's tough, and especially if that financial advisor

00:17:38.640 | is compensated on commissions, it's tough to get a financial advisor to be willing to take the time

00:17:45.280 | to sit with you and talk about an account that you can contribute $2,000 per year to.

00:17:51.280 | This is just the truth as I see it. When I was a practicing financial advisor, unless you had

00:17:57.680 | other accounts with me or unless there was some way that I was being compensated purely for my

00:18:02.720 | time through the form of an hourly fee, or again, unless you're a big client, I can't afford to sit

00:18:09.360 | down and spend time talking with you about an account that you can put $2,000 per year into,

00:18:15.040 | because it's not possible for me to make enough money for that to be worth my while.

00:18:19.600 | I don't personally see that as a problem. I just see it as important to mention it so that you can

00:18:24.720 | do this for yourself, because you have to do this area of planning yourself. You can enlist the

00:18:29.680 | services of an advisor for the implementation of it if you want to, but you have to be aware of

00:18:36.240 | this yourself and see if it's going to fit your needs. That's why I'm creating this audio resource

00:18:41.040 | for you. Incidentally, this is another problem also even with 529 accounts. In the years that

00:18:47.200 | I was a financial advisor, not a single time did I ever open a Coverdell account for a client,

00:18:51.520 | and it was only a few times that I ever opened a 529 account. I wouldn't accept 529 account clients

00:18:58.080 | unless they were also a client for something else, simply because there's not enough assets for it

00:19:06.400 | to be worth my time, and you as a client are better off just going online. So I would try to give you

00:19:10.640 | an online resource and say, "Here, go and search this out." Now, that makes a lot of people upset,

00:19:15.760 | but you need to be aware of that. That's the facts as I see them, simply due to the incentives.

00:19:20.800 | The way that you can get around this is if you're willing to pay your advisor a high hourly fee,

00:19:26.480 | or if you're willing to pay your advisor with other accounts where he or she has enough other

00:19:32.320 | assets under management where it's worth his or her while to service these accounts for you. So

00:19:38.480 | be aware of that. I don't think it makes your advisor a bad person. You just need to be aware

00:19:42.320 | of that from the perspective of the incentive for the advisor. The other aspect to this discussion,

00:19:48.480 | even with regard to compensation of the advisor, which is one thing, but the other reason,

00:19:53.920 | well, the reason I never did one of these accounts was not only that there was not a lot of financial

00:20:00.160 | incentive, because if that were the only reason, I would personally have a moral problem with that

00:20:05.280 | myself from an ethical perspective of how I worked with clients, because I would have to

00:20:09.120 | encourage them to do this. But the other problem is that very few people, in my opinion, in the

00:20:14.000 | mainstream of the United States should be using this type of account to save for their kids'

00:20:18.720 | college expenses. Most people are behind for other financial goals, especially retirement savings,

00:20:26.800 | and most people are not fully taking advantage of their other retirement savings accounts.

00:20:33.200 | And you should start there, because when it comes to saving for your child's college,

00:20:38.720 | there are many, many other options that if you don't do that, that your child can do.

00:20:44.160 | For one, why would he or she go to an expensive college? There are so many cheap ways to get a

00:20:50.000 | college degree today that you've got to consider those as being primary. If I were doing it over

00:20:54.800 | again, it's hard for me to say, because I really benefited from my college experience at an

00:20:59.840 | expensive private university, but at least today, being a different person than I was at 18, which

00:21:05.360 | how would you even know who you were at 18? But today, I would make a different decision. I would

00:21:09.760 | not spend the $20,000 per year. Now, I'm glad I did it when I was 18, because I think it probably

00:21:17.440 | was one factor in saving my soul from going into the world and sin, but today, I would have to

00:21:28.080 | really reconsider that. So, you always have to question the expense, first and foremost. Is this

00:21:32.800 | even worth making as an expense? So, most parents, no. The answer is no, you shouldn't be saving for

00:21:38.320 | your kid's college. You should be saving for your retirement. And then, if nothing else, your best

00:21:42.880 | plan is simply, in the years that your children are in college, stop saving for retirement and

00:21:47.520 | just pay that money towards their college expenses. That's what most families will wind up doing.

00:21:52.320 | The other problem with these accounts is that, okay, once we've settled retirement,

00:21:56.800 | they're really tough to use to actually make an impact on the expenses, because the contribution

00:22:05.760 | amounts are so low. So, you have to keep this in mind when you are approaching the subject to say,

00:22:11.280 | "All right, if I'm going to save $2,000 a year into a Coverdell Educational Savings Account,

00:22:16.080 | and I'm going to do this for 10 years, and I'm going to earn, let's say, 8% interest on my money,

00:22:21.120 | starting with nothing, how much money do I have? I have $31,290 in the account."

00:22:26.640 | What that means, however, what benefits me from using the account is that I save the difference

00:22:33.280 | between that $32,000 and the $20,000 that I contributed that would be interest income that

00:22:40.000 | I don't have to pay the tax on if I use it for a qualified educational savings expense.

00:22:45.360 | So then, basically, what I'm saying is I'm saving the tax on $12,000 of income. Well,

00:22:50.720 | what's the tax on $12,000 of income? Depends on the rate, but if we say a 20% rate, that's $2,400

00:22:57.520 | of tax. It's not that big of a savings for most people, and many people don't invest the money

00:23:03.360 | effectively enough to where it's really going to be a major benefit at all. So you need to keep

00:23:08.000 | that in mind all the time when you're looking at this account and say, "Is there a way that I can

00:23:12.880 | actually use this account to benefit myself to a degree where it's going to be worth it?"

00:23:18.880 | Keep that in mind. It's really, really important. The problem with college savings accounts is you

00:23:26.720 | face the factor of low contribution amounts with an educational savings account. You have a high

00:23:31.920 | contribution amount with a 529 account, which we'll deal with another time. You have a low

00:23:35.680 | contribution amount that's a permitted, so that means your total maximum savings are probably

00:23:40.400 | pretty small. You have a relatively short time horizon. You can use the Coverdell account to pay

00:23:45.920 | for elementary school or high school, private high school or college, but most people are not,

00:23:50.560 | when their child is one day old, setting aside for a college tuition 18 years from now. That's

00:23:56.240 | not how most people function. If that's you, this show is going to save you a lot of money,

00:24:02.240 | but most people aren't. Because you can't front load this account in the same way that you can

00:24:07.360 | with a 529 plan, you can't just toss in 50,000 bucks up front. You're even more limited by the

00:24:15.520 | Coverdell and by the actual potential savings from a tax perspective. Then even worse is because you

00:24:22.000 | have a short time horizon, relatively speaking, you have to figure out how to fund this with

00:24:27.200 | investment accounts that are going to solve your needs, that are going to provide for you

00:24:31.840 | the income that you need to cover the expense. If you are concerned with volatility and you

00:24:39.040 | don't have a plan to control the volatility, then you're going to be in a situation where

00:24:47.280 | you have to get a lower return because you're investing for safety instead of for growth,

00:24:52.400 | and then your potential savings on tax are even smaller. Because the rate of return,

00:24:56.320 | if you're investing, and let's say you're buying CDs over 10 years, starting with nothing,

00:25:03.360 | and you're getting a 3% interest rate, keeping pace with inflation, then what you wind up with

00:25:08.800 | in that scenario is you wind up with a future value of $23,615 after 10 years of savings.

00:25:17.680 | It can grow a little bit beyond that, but now you've got $3,000. All you're avoiding is the tax

00:25:24.720 | on $3,615 of income, which at, say, a 20% rate would be $723 of tax. You've got to keep that

00:25:33.360 | in mind when you're thinking about the Coverdell Educational Savings Account, and you've got to

00:25:37.520 | figure out a way to solve those problems. Because if you can't solve those problems,

00:25:41.360 | then this account is useless, and then Mr. Baldwin is right with his assessment, and you're better

00:25:46.240 | off with another account. But there are potentially some huge advantages for the Educational Savings

00:25:52.800 | Account. One of the biggest ones is that this can be used before college. We can use this to fund

00:26:00.080 | the elementary school, private elementary school, middle school, high school. There's a great degree

00:26:05.440 | of flexibility with regards to what we can pay for. And then there's a tremendous flexibility

00:26:12.880 | with what we can invest in. So at the end of the show, I'm going to show you how to use this account

00:26:17.120 | to invest in real estate and pay to invest in alternative investments. This account can do that.

00:26:23.680 | The 529 plan, more properly called a qualified tuition plan, cannot do that. So you need to keep

00:26:32.400 | that in mind. But within that context, we can understand how this account works and how we can

00:26:38.240 | use it. It's really important. Now, what I'd like to start with is I want to give you a little bit

00:26:42.960 | of the history of the Educational Savings Account. And I like to do this because I always struggle

00:26:48.240 | when it comes to figuring out. People often ask me questions. "Joshua, could the rules change?"

00:26:53.200 | So for example, "Could the rules for IRAs change? Could the rules for Roth IRAs change?" The answer

00:26:58.480 | to that is yes. A lot of people are concerned about, "Well, could the government change the

00:27:03.440 | rules? Could they take my money? Could they nationalize the accounts?" All of that is

00:27:07.760 | certainly possible. That's a risk that you face. And if you're going to subject your money to that

00:27:12.720 | risk, you need to be certain that the payoff and the reward is worth it. And that will change for

00:27:18.400 | different ones of you. The answer of whether that actually does work or doesn't work,

00:27:24.960 | that will be different for each one of you. So you've got to consider this in your situation.

00:27:28.960 | But let me give you the legislative history of where did this account come from, how was it

00:27:33.840 | started, and where did it actually come from. What we currently know as the Coverdell Educational

00:27:38.800 | Savings Account did not start by being known as that. This account came into being with the

00:27:44.080 | Taxpayer Relief Act of 1997. Pay attention to the names of this legislation when I give it to you

00:27:50.880 | because you'll find it funny when you pay attention to it and you start studying

00:27:54.240 | financial history. So the Taxpayer Relief Act of 1997 came out with something called the Educational

00:28:00.160 | IRA. And the idea was that you could contribute to this account and it would be used for the

00:28:06.640 | purposes of higher education. Originally, the contribution amount was limited to $500 per year,

00:28:13.680 | and it was exclusively available for higher education, for college education. So it was a

00:28:22.080 | very limited account when it first came out and it was called the Educational IRA. That was where

00:28:27.520 | it came from. Now, there were some major updates that happened with the Economic Growth and Tax

00:28:33.920 | Relief Reconciliation Act of 2001. So we started with the Taxpayer Relief Act of 1997. Then we

00:28:43.200 | moved on to the Economic Growth and Tax Relief Reconciliation Act of 2001, which made these

00:28:49.600 | changes. As an aside, notice that all of these are designed to stimulate the economy. And notice

00:28:55.440 | that regardless of the political mumbo jumbo, the political parties spout, the Democrats and

00:29:01.200 | Republicans, which are the same party practically, but you get this idea that, "Oh, cutting taxes is

00:29:06.240 | bad. We have to stop that." But when times are tough, everyone seems to agree and pass these

00:29:12.720 | bills. 1997, that passed under Bill Clinton. Then there was 2001 under George Bush. Then 2010

00:29:20.960 | under Barack Obama. Then 2012, those are the four pieces of legislation that have affected this

00:29:25.040 | account under Democrat presidents and Republican presidents and Democrat houses of Congress and

00:29:31.520 | Republicans. So just notice that. So moving on. So what did the Economic Growth and Tax Relief

00:29:36.160 | Reconciliation Act of 2001 say about this account? This one brought the biggest changes that have

00:29:41.840 | persisted till now. So in that law, the annual contribution on limits was increased from $500

00:29:49.280 | to $2,000. So that was a big increase. The accounts were renamed instead of being the Education IRA,

00:29:58.560 | because IRA is Individual Retirement Arrangement, what the IRS calls it, and we call it Individual

00:30:03.520 | Retirement Account. But instead of being named an IRA, it has nothing to do with retirement,

00:30:08.000 | so they renamed that, although the moniker still stands for some people. And they renamed them to

00:30:12.800 | be called the Coverdell Education Accounts, the Coverdell Education Savings Account, in honor of,

00:30:18.080 | I think it was Senator Coverdell from Georgia. He died, I think he had a heart attack in Congress

00:30:25.120 | or in Senate, something like that. This law also expanded the definition of what the qualified

00:30:32.960 | education expenses were, and it included in that elementary and secondary school expenses.

00:30:38.960 | Additionally, it raised the dollar restrictions for how much money you could make before you could

00:30:46.000 | do it. So previously it was low for married taxpayers. It raised the phase-out, what it's

00:30:51.360 | called, of when you can't participate, to be $190,000 to $220,000 for taxpayers married filing

00:30:59.360 | jointly. It also changed, it also removed the age limitations in case of special needs beneficiaries.

00:31:08.000 | And so this account became applicable and was able to be used for special needs beneficiaries

00:31:14.320 | without any restrictions on the age. It also clarified the fact that corporations and other

00:31:23.760 | entities, including tax-exempt organizations, were now permitted to make contributions to

00:31:28.640 | these accounts regardless of the income of the corporation or entity during the year of the

00:31:33.760 | contribution. That's going to be very important. It also permitted the beneficiary to claim a hope

00:31:39.440 | credit or lifetime learning credit for a taxable year, and then to exclude from their gross income

00:31:45.280 | the amounts that were distributed from the education IRA for that same student, as long

00:31:50.800 | as the distribution wasn't double-counted and used. But it was claimed, the education expense

00:31:55.520 | was claimed both as a credit and also as a distribution from the Coverdell account.

00:32:00.320 | Additionally, it repealed the excise tax that formerly existed on contributions that would

00:32:05.680 | be made by any person to a Coverdell account on behalf of the beneficiary during any taxable

00:32:12.640 | year in which any contributions are made by anyone to a qualified state tuition program.

00:32:17.200 | Originally, you couldn't contribute to both a qualified state tuition program and the Coverdell

00:32:21.440 | account on behalf of the same beneficiary. Additionally, it allowed a rollover of the unused

00:32:28.080 | funds to other family members as long as they are under the age of 30 without any penalties.

00:32:33.280 | That became effective for all taxable years after December 31, 2001. That continued.

00:32:41.200 | The next piece of legislation, the $2,000 number, was only due to be in force for a certain amount

00:32:49.280 | of time. And it would have gone into what they call "sunset." You'll hear this word "sunset"

00:32:54.160 | when you talk about tax legislation, which means that this is a temporary provision under which

00:32:58.560 | we're going to allow these contributions. Well, the law was scheduled to sunset, but the Tax

00:33:03.440 | Relief, Unemployment Insurance Reauthorization, and Job Creation Act of 2010 extended that $2,000

00:33:11.680 | contribution amount for one year. So it extended that up till the date of December 31, 2012. Now,

00:33:19.520 | this is recent history. And if you remember back, this is all the blustering between the different

00:33:23.360 | parties and the Houses of Congress in 2012 and 2013. This was a majorly difficult time to be

00:33:28.960 | involved as a financial planner because the tax law was so uncertain. And you had all these things

00:33:33.360 | going on with the estate tax law, with this as just one minor component of all of these tax laws

00:33:37.680 | that were changing, the Bush tax cuts, all this kind of stuff. So that act in 2010 extended the

00:33:44.240 | $2,000 number for an additional year. And then Congress passed and the President signed the

00:33:50.160 | American Tax Relief Act of 2012. They actually passed it on January 1, 2013. So take that and

00:33:58.800 | figure that one out. And that permanently extended the $2,000 number into the future.

00:34:04.320 | So the way the law sits right now, that $2,000 contribution amount has permanently existed,

00:34:11.200 | and to the best of my knowledge, is not indexed for inflation like some of the other ones are.

00:34:14.880 | It's just going to be a level $2,000 going forward. Of course, it's likely that in the future,

00:34:20.800 | Congress could adjust that number for inflation if they wanted to fit their purposes. So that's

00:34:25.600 | the history of the law. And that brings us to where we are today. So if some of those things

00:34:31.200 | didn't make sense to you in the beginning there, then we're going to go through those

00:34:37.840 | in detail today. Anytime you're looking for tax planning info, I would encourage you to start

00:34:43.760 | with the IRS publications. And the IRS publication that you want to check on today is IRS publication

00:34:50.560 | 970. And 970 is the publication that deals with how to pay for college and all the different

00:34:57.040 | aspects that are available. Chapter 7 of the publication deals with the Coverdell Educational

00:35:01.760 | Savings Account. And for the first part of this show, I'm going to be using that as my general

00:35:07.440 | outline, but I'm going to be expanding the information that's in it with some additional

00:35:12.240 | planning ideas for you. So the first thing I want to talk about is who can contribute. Well,

00:35:19.280 | the first limitation that you'll see is, as far as who can actually contribute,

00:35:24.320 | is that the person who's contributing, their modified adjusted gross income, and I'll explain

00:35:29.040 | what that number is in a little bit, just here, modified adjusted gross income has to be less than

00:35:34.240 | $110,000 per year if they are a single individual taxpayer. If they're filing a joint return,

00:35:41.680 | it has to be less than $220,000. And so as long as you have under those coverage amounts,

00:35:47.680 | then you can establish the Coverdell Educational Savings Account in order to pay for the qualified

00:35:52.960 | education expenses of the designated beneficiary. Now, right here on the front, you're going to see

00:35:58.160 | how in some ways the tax law makes sense, in other ways, it makes absolutely no sense. And

00:36:03.360 | the first thing is, that is the most easily circumvented rule, period. And I'm going to,

00:36:08.240 | because I can, you make $5 million a year, I can easily have you contribute and set up one of these

00:36:14.000 | accounts. Now, it's probably not going to be at all meaningful in your tax planning, but I'll show

00:36:18.480 | you how to do that. And basically the rule is you either give the money to the kid, stick the money

00:36:22.720 | in a trust and have the trust make the contribution or use one of your companies to make the

00:36:26.320 | contribution. And in all three of those, there's no income allowances. So if you're a financial

00:36:30.560 | planner, for the CFP exam, you need to be aware of $110,000 for an individual, $220,000 for a joint

00:36:38.240 | couple. If you're actually doing financial planning for a family though, that is the most utterly

00:36:44.080 | pointless number because it's so easily circumvented, it's ridiculous. This is what

00:36:47.120 | happens when politicians write laws, or excuse me, sign laws that they don't have a clue what's in

00:36:51.600 | them and they don't go together. It's frustrating. The next big thing that you need to be aware of

00:36:59.440 | is that the benefit can be used not only for college expenses, but also for elementary and

00:37:04.960 | secondary expenses. And that's a big, big benefit. When the money goes in, the money is not tax

00:37:11.040 | deductible, but it grows tax free until it comes out. That includes also, I think, you need to

00:37:18.960 | check your state. I've checked this with as many states as possible, but that also allows you to

00:37:24.080 | avoid your state income tax on the distributions as well. The state laws are a little funky because

00:37:30.320 | there's some laws with 529 accounts and things like that. So you need to check your individual

00:37:34.480 | state. But it should be that in all the states, at least that I was able to find in preparation,

00:37:40.400 | checking my facts in preparation for the show, I do not believe you will ever have to pay

00:37:45.120 | state income tax on the distributions. So check that out. Who can actually have a Coverdell

00:37:53.280 | account? Well, anyone can have an account as long as they're under the age of 18,

00:37:57.680 | or if they're a special needs beneficiary. So in order to have this, in order to be able to

00:38:02.880 | contribute to it and have it, you have to have the money. And in any beneficiary, it has to be put in

00:38:08.800 | as long as they're under the age of 18. The money has to be put out of the account by the age of 30,

00:38:14.000 | but that's also easily circumvented. And I'll show you how to do that.

00:38:17.280 | To be treated as a Coverdell educational savings account, the account must be designated as a

00:38:25.440 | Coverdell educational savings account when it is created. And there has to be a document that

00:38:30.160 | creates this account. It must be in writing, and it has to satisfy these requirements for the IRS

00:38:36.560 | to approve it. This is what defines it as being a Coverdell account, which when we get to some of

00:38:42.480 | the interesting planning opportunities, then you're going to hear about, then you'll see how

00:38:49.360 | we can use this as long as we establish, we fit these rules, we can use this in all kinds of

00:38:54.320 | interesting ways. Number one, the trustee or the custodian for the account must be a bank or an

00:39:02.160 | entity approved by the IRS. Number two, the document must provide that the trustee or custodian

00:39:11.200 | can only accept a contribution that meets all of these following conditions. The contribution must

00:39:16.960 | be in cash. The contribution must be made before the beneficiary reaches the age of 18, unless the

00:39:23.120 | beneficiary is a special needs beneficiary. And the contribution must not result in total

00:39:28.400 | contributions for the year, not including rollover contributions, of more than $2,000.

00:39:33.760 | Those are, that's what the document must state. We'll come back to those contributions and revisit

00:39:38.880 | those in just a moment. The money in the account cannot be invested in life insurance contracts.

00:39:44.160 | So you cannot use a life insurance contract in this account. Next, money in the account cannot

00:39:49.680 | be combined with other property, except in a common trust fund or common investment fund.

00:39:57.200 | So you can't commingle the assets unless they're being commingled in a common trust fund or common

00:40:03.440 | investment fund. That's going to be important when we get to some of the ways to use this,

00:40:07.360 | with the example being, how do I buy rental houses in my IRA and also make sure that I use that same

00:40:13.280 | money that's in my educational savings account? The rules do permit this, at least in my opinion.

00:40:20.160 | And then number five, the balance in the account generally must be distributed within 30 days

00:40:25.440 | after the earlier of these two events. Either the beneficiary reaches age 30,

00:40:31.040 | unless the beneficiary is a special needs beneficiary, or in case of the beneficiary's death.

00:40:36.800 | So it must say that in the establishment documents in order for this account to qualify.

00:40:45.680 | As long as all five of those conditions are established in the document, then you can

00:40:51.200 | indeed establish a Coverdell educational savings account. Now, next area, what is a qualified

00:40:59.360 | education expense? So you put your money into this account and the money grows and now you're

00:41:04.560 | going to take it out. Well, if you take it out and you spend it on a qualified educational expense,

00:41:09.680 | then you will be able to use those proceeds and use that growth without paying any income taxes,

00:41:17.360 | federal income or state income taxes, on the growth in the money. This will allow you to avoid this.

00:41:22.960 | So, qualified educational expenses. Generally, these are expenses which are required for the

00:41:29.600 | enrollment or attendance of the designated beneficiary at an eligible education institution.

00:41:36.320 | For purposes of Coverdell educational savings accounts, the expenses can be either qualified

00:41:43.680 | higher education expenses or qualified elementary and secondary education expenses.

00:41:50.560 | The designated beneficiary is the individual who is named in the document creating the trust

00:41:57.120 | or custodial account to receive the benefit of the funds in the accounts. And one guaranteed

00:42:03.680 | qualified education expense is a contribution to a qualified tuition program. One of the things

00:42:12.320 | that when you're dealing with tax deferred accounts, you always need to keep in mind is,

00:42:16.000 | what's my exit plan? So I did the show last Monday on how do I get money out of a retirement

00:42:20.320 | account early without paying the penalty. If you're interested, go back and find that show.

00:42:24.480 | It was pretty in-depth. I talked about the four different ways to get the money out without paying

00:42:32.320 | the penalty. One of the ways you need to be thinking about is, if I set up an educational

00:42:36.720 | savings account and I don't use the money, what do I do with it? And one of the key easiest exit

00:42:43.920 | plans that you can possibly use is that you can just simply transfer the money into a qualified

00:42:50.000 | tuition program, which you would probably know as a 529 plan. Now with the educational savings

00:42:58.480 | account, the funds are forced out by the age of 30 for the beneficiary. You can change the

00:43:04.160 | beneficiary, you can change the owner of the account, or you can just simply move the money

00:43:08.720 | into a 529 account. We're going to go over all those details so that you can see how flexible

00:43:13.040 | this could be. But what you could do, I could establish this account for my son, and then the

00:43:18.480 | money can grow, grows for him, he reaches the age of 30. We could easily change the beneficiary on

00:43:24.480 | the account to be his son if he had a son at that time. Or easiest of anything, we could just move

00:43:29.440 | it into a 529 plan. And now we have a massive, massive flexibility in who can be the beneficiary

00:43:36.640 | of the account. And this is one of the areas that these Coverdell accounts are incredibly valuable,

00:43:43.280 | is they're incredibly valuable if you're doing multi-generational planning. And you should be

00:43:50.320 | doing multi-generational planning for yourself. You should be thinking about your great-grandkids.

00:43:55.600 | I think about it in terms of five generations. I think, "What can I do for my family in five

00:44:00.000 | generations?" For me, a big part of that is, "How do I live a life that's worthy of respect? How do

00:44:04.640 | I train my children in such a way that they're going to train their children?" But I also recommend

00:44:09.440 | consider it financially, because all of the great... The Rothschild family at one point

00:44:15.200 | was started by one person who built an empire for his family. So just consider that. And I don't

00:44:22.960 | personally care that much about the financial empire, but you may. And so I would encourage

00:44:27.280 | you to consider that. Next here, what is an eligible education institution? So it says here,

00:44:35.600 | "Qualified education expenses are the expenses that are required for enrollment or attendance

00:44:40.240 | at an eligible educational institution." What is that? Well, "For the purposes of the Coverdell

00:44:45.120 | Educational Savings Account, an eligible educational institution can be either an

00:44:50.800 | eligible post-secondary school or an eligible elementary or secondary school." An eligible

00:44:59.280 | post-secondary school. So college, what is an eligible college? "This is any college, university,

00:45:05.360 | vocational school, or other post-secondary educational institution which is eligible

00:45:12.240 | to participate in a student aid program that is administered by the U.S. Department of Education.

00:45:17.760 | It includes virtually all accredited public, non-profit, and proprietary,

00:45:26.400 | privately owned, profit-making post-secondary institutions. The educational institution

00:45:32.960 | should be able to tell you if it is an eligible educational institution. Certain educational

00:45:38.480 | institutions located outside the United States also participate in the U.S. Department of Education's

00:45:43.840 | federal student aid programs." So with regard to what college or eligible post-secondary school,

00:45:49.600 | it's an incredibly broad definition, which includes vocational schools, which includes many,

00:45:54.320 | many different types of schools. The primary thing that is probably the most important thing for you

00:46:00.640 | to recognize is that it's an institution which is eligible to participate in a student aid program

00:46:07.040 | administered by the U.S. Department of Education. So if you're thinking, "Well, will this apply to

00:46:11.440 | this school?" Ask yourself that question. Easiest is call them and ask them, and they can tell you.

00:46:17.360 | Now, what about for non-college schools? What about elementary or secondary schools?

00:46:26.320 | Well, what is an eligible educational institution that is an eligible elementary or secondary school

00:46:33.600 | is any public, private, or religious school that provides elementary or secondary education,

00:46:41.040 | defined as kindergarten through grade 12, as determined under state law. That's very important.

00:46:48.800 | So first, mainstream. If your child is in a public school or you desire to send your child

00:46:54.400 | to a private school of some sort, doesn't matter whether that's religious or non-religious,

00:46:58.960 | any public, private, or religious school, you can use the money in this account for

00:47:03.200 | qualified expenses from that eligible educational institution. Now, many of you know that I am

00:47:09.520 | personally not really planning or in favor of sending my children to a large, normal, mainstream

00:47:19.520 | public or private school. It doesn't really strike me as being that great of an option.

00:47:23.600 | So, what about homeschool? Well, that's why the state law question is important. So the

00:47:29.040 | IRS publication here says, "Any elementary or secondary education, any school that provides

00:47:35.360 | elementary or secondary education as determined under state law." So what about homeschool? Well,

00:47:41.920 | here is where the state law is important. You need to consider what state you are in.

00:47:46.320 | Different states have different laws regarding home education and how that is established and

00:47:50.640 | whether or not a homeschool environment is considered to be a school, whether a home

00:47:57.120 | educating environment is considered to be a school or not. And so, one of the key things that you

00:48:01.840 | want to think about is, "What state am I in?" If you live in a state that defines a homeschool

00:48:08.320 | as a private school, then you can use the money in this account to pay for eligible expenses for

00:48:15.840 | your child's homeschool. That can be very useful to some of you. The states that are on the list

00:48:23.760 | currently are Alabama, California, Illinois, Indiana, Kansas, Kentucky, Louisiana, Michigan,

00:48:35.840 | North Carolina, Nebraska, Ohio, Tennessee, and Texas. I think that's, what, 14 states?

00:48:47.120 | So if you are in one of those states, then you can just simply pay for all of your homeschooling

00:48:52.240 | expenses out of this account. Pay attention to that. That can be very useful to you.

00:48:57.840 | Some states have a rule where if there's a group of homeschoolers that meet together,

00:49:06.080 | they would call that as a private school. There are five of these states. So these five states

00:49:11.920 | would be Colorado, Florida, Maine, Virginia, West Virginia, and Utah. If you are in one of those

00:49:21.840 | five states, those five states recognize groups of homeschoolers as private schools,

00:49:27.520 | but individual homeschools do not qualify under this rule. So what you would want to do in those

00:49:35.360 | schools, in those states, is you would want to ask yourself, "Am I part of a homeschool group?

00:49:39.920 | And if not, is there a homeschool group that I could be a part of that would then entitle me to

00:49:44.480 | be able to use this account to pay for the eligible expenses and avoid the tax on those expenses?"

00:49:51.200 | So I would encourage you to check that out in your state and figure that out in your situation.

00:49:57.680 | I forgot one note. In some states, the first 14 states I listed, there are more where more than

00:50:05.440 | one option is provided. The homeschooler may use the educational savings account only if they

00:50:11.600 | operate under the option which establishes the homeschool as a private school. So check your

00:50:17.040 | state law. That can be very valuable to some of you. Many of you, however, will not live in those

00:50:21.920 | states, and that is something that you just want to consider. So that's a big deal for you as far

00:50:27.200 | as homeschool. So what is an eligible expense that can be paid for with this health savings

00:50:34.160 | account? What would that be? What would the examples be? Well, it's different depending

00:50:37.760 | on whether we're talking about higher education, college, or elementary and secondary education

00:50:43.920 | expenses. If we're working in higher education, here are the expenses that are qualified for the

00:50:51.440 | tax-free treatment of distributions from the account. Qualified higher education expenses

00:50:57.440 | are expenses that are related to enrollment or attendance at an eligible post-secondary school,

00:51:04.320 | that list that we just said, as shown in the following list. To be qualified, some of the

00:51:09.520 | expenses must be required by the school, and some must be incurred by students who are enrolled at

00:51:17.360 | least half-time. So there's a difference. Some of these expenses must be required, and some must

00:51:24.240 | simply be incurred. So let's start with this, with the ones that must be required. These expenses

00:51:31.120 | must be required by the school for enrollment or attendance of the beneficiary at the school in

00:51:37.680 | order for them to be eligible expenses. Tuition and fees, and books, supplies, and equipment.

00:51:45.120 | So any tuition or fees or books and supplies and equipment that are required by the school

00:51:52.240 | can be paid for out of this account tax-free.

00:51:56.240 | Next, expenses for special needs services needed by a special needs beneficiary must be simply

00:52:05.360 | incurred in connection with enrollment or attendance at an eligible post-secondary school.

00:52:11.120 | So if you are in a special needs scenario, expenses for special needs must simply be

00:52:18.800 | incurred in connection with enrollment or attendance at an eligible post-secondary school.

00:52:23.360 | Number three, expenses for room and board must be incurred by students who are enrolled at least

00:52:31.200 | half-time. And half-time is defined as a student that is enrolled for at least half the full-time

00:52:37.440 | academic workload for the course of study the student is pursuing as determined under the

00:52:42.560 | standards of the school where the student is enrolled. Remember, this is all college. This

00:52:45.840 | is not elementary and secondary expenses. So the expenses for room and board must be incurred by

00:52:52.560 | the student if they're enrolled at least half-time. And the expense for room and board qualifies only

00:52:59.200 | to the extent that it is not more than the greater of the following two amounts.

00:53:04.320 | A, the allowance for room and board as determined by the school that was included in the cost of

00:53:11.920 | attendance for federal financial aid purposes for a particular academic period and living

00:53:17.440 | arrangement of the student. Or B, the actual amount charged if the student is residing in

00:53:23.280 | housing owned or operated by the school. So let me give you some plain language on this. Your

00:53:27.920 | student, your child may or may not, if they go to college, they may or may not choose to stay on

00:53:34.320 | campus. So question, is it permissible that you can purchase a house and have your child pay the

00:53:41.040 | mortgage and rental cost for the house, let's say you own a house, and you desire for your child to

00:53:46.960 | rent the house from you while they're at school so that you can take the income from that, pay it

00:53:53.840 | tax-free out of your educational savings account and collect it in terms of your rental house?

00:53:58.640 | Well, maybe. But you've got to follow this rule. They cannot be paying more rent than the

00:54:06.240 | allowance for room and board that the school says is normal for federal financial aid purposes.

00:54:10.960 | Or if they're paying more than that, it has to be because they are paying it directly to the school.

00:54:18.000 | And then you also want to make sure anytime you're doing a transaction like that with an account that

00:54:23.360 | you, with a qualified account, a 529 account, something like that, you would want to make sure

00:54:27.440 | that whatever the rent is that they are paying would be market rent. So as an example, if the

00:54:31.760 | market rent for your house that you were renting out was $500 a month and your child was paying

00:54:37.040 | you $1,000 a month just so you could get the money out of the educational savings account,

00:54:41.120 | that would not pass the test. It would need to be market rent. Always make sure,

00:54:45.280 | anytime you're dealing with the IRS, find out what the market price is of a certain expense

00:54:49.600 | that you are doing. Okay? That's college. So if you're going to pay for tuition, fees,

00:54:57.920 | books, supplies, and equipment, you can only pay for tuition, fees, books, supplies, and equipment

00:55:01.840 | that are required by the school. So if your child wants to read a novel for fun that's not required

00:55:08.400 | by his or her English class, that is not an eligible expense. If the novel is required by

00:55:14.160 | the English class, that would be an eligible expense. Special needs services just simply

00:55:18.480 | need to be incurred in connection with enrollment. They don't need to be required.

00:55:22.320 | And then if we're talking about room and board, that just needs to be incurred in connection with

00:55:26.800 | the school, but it needs to be at the rates that the school sets. That's for college. So those are

00:55:31.520 | the eligible expenses that are available out of the account for college. What about for elementary

00:55:37.200 | and secondary education expenses? These are expenses related to enrollment or attendance

00:55:43.280 | at an eligible elementary or secondary school. As shown in the following list, to be qualified,

00:55:48.960 | some of the expenses must be required or provided by the school. There are special rules for

00:55:55.200 | computer-related expenses. So there are three different sections of this, and these are very

00:55:59.760 | important, so pay close attention. These expenses must be incurred by a designated beneficiary in

00:56:06.160 | connection with enrollment or attendance at an eligible elementary or secondary school in order

00:56:12.000 | to be qualified expenses. Tuition and fees, books, supplies, and equipment, academic tutoring,

00:56:21.040 | special needs services for a special needs beneficiary, any of those are fine as long as

00:56:30.240 | they are incurred in connection with enrollment. So tuition and fees, books, supplies, and equipment,

00:56:35.440 | academic tutoring, and special needs services. So the best example would be academic tutoring.

00:56:40.400 | If your child needs academic tutoring for ninth grade math, that's not probably going to be

00:56:45.760 | required by the school, but that is an eligible expense. If there are books, supplies, and

00:56:50.560 | equipment that you're buying in connection with your child's enrollment at the school,

00:56:55.040 | that would be an eligible expense even if they're not required by the school. So the way that I

00:57:01.680 | would read that if my child were studying Spanish and they needed to purchase a set of Spanish

00:57:07.120 | novels to help their language comprehension, I would consider that to be an eligible expense

00:57:12.160 | because it's related in connection with their enrollment at Spanish class. That's useful. Now,

00:57:17.280 | these expenses must be required or provided by an eligible elementary or school connection in order

00:57:23.840 | to be qualified elementary or secondary school expenses. Room and board or uniforms. So the

00:57:30.400 | example, excuse me, room and board, uniforms, transportation, and supplementary items and

00:57:36.400 | services, including extended day programs. So if you are concerned saying, "Well, listen, I drive

00:57:42.320 | my child to school every day and that costs me a certain amount in gas and whatnot. Can I pay for

00:57:48.800 | that out of my educational savings account?" The answer is you can only do that if it's required

00:57:54.160 | or provided by an eligible elementary or secondary school. So what I would do is if

00:57:59.120 | I had to pay an extra fee for the bus that's provided by the school, I would pay for that

00:58:04.080 | out of the educational savings account. But I wouldn't necessarily say, I wouldn't say that

00:58:08.640 | my school does not require me to drive my child to school. So that wouldn't pass my smell test.

00:58:13.920 | You would have to think through it. Or supplementary items and services,

00:58:18.880 | including extended day programs. If your child is required to be involved in a supplementary

00:58:24.400 | extended day program, then that would be something that I would pay. But if it's simply an option

00:58:29.200 | that you're choosing, you can't use this account to pay for the optional afterschool care.

00:58:34.000 | I wouldn't consider that football practice or football fees for my child to play football.

00:58:42.880 | I wouldn't consider that to be an appropriate expense because it's not required by the school

00:58:50.800 | and that's a supplementary item or service. So those are the first two and they're important.

00:58:56.400 | The first section, tuition fees, books, supplies, equipment, academic tutoring,

00:58:59.280 | and special needs services. They don't have to be required by the school, just simply incurred in

00:59:03.200 | connection with enrollment. However, room and board, uniforms, transportation, supplementary

00:59:07.760 | items and services have to be required or provided by an eligible elementary or secondary school.

00:59:14.160 | The other example, I skipped over room and board, but I would use this as an example of the

00:59:18.800 | difference between boarding school versus the school around the block. If my child were in

00:59:23.200 | school around the block, then it would not be appropriate for me to pay myself rent.

00:59:28.960 | Say the child owes me a market rate of rent in exchange for the room that they're staying in,

00:59:37.760 | that is not an appropriate expense. But it might be an appropriate expense if my child is going off

00:59:43.040 | to boarding school, excuse me, it would be an appropriate expense because it's provided by the

00:59:46.880 | school and now I could pay for that expense out of my educational savings account.

00:59:51.360 | Now the third category of eligible expenses is very interesting. And this is basically with

00:59:56.960 | regard to computers. And this is different of whether your child is in elementary or secondary

01:00:01.440 | school or whether your child is in college. So number three, eligible expense. The purchase of

01:00:08.240 | computer technology, equipment, or internet access and related services is a qualified elementary and

01:00:16.160 | secondary education expense if it is to be used by the beneficiary and the beneficiary's family

01:00:23.840 | during any of the years the beneficiary is in elementary or secondary school.

01:00:29.360 | This does not include expenses for computer hardware designed for sports,

01:00:35.440 | games, or hobbies unless the software is predominantly educational in nature.

01:00:42.000 | This one may be useful for many of you. If you have purchased for your child a computer or

01:00:47.360 | computer equipment or internet access and related services in connection with their enrollment at

01:00:54.640 | an elementary or secondary school, then in my opinion, that would be a qualified expense.

01:01:01.920 | And to me, it seems pretty clear. So if you've purchased or are planning to purchase a computer

01:01:08.400 | for your child, then I would encourage you to consider this. Now, what is a computer?

01:01:13.360 | Well, I would bet, I don't know that the IRS has issued guidance, I haven't found any,

01:01:19.120 | but many students, that would be a desktop. Some students, that would be a laptop.

01:01:23.360 | Some students, that would be an iPad. Maybe that would be an iPad mini.

01:01:27.120 | Internet access, make the choice. I personally, if I were going to do this, if my child were

01:01:34.000 | having a cell phone and they were using that as internet access, I would use them having an iPad

01:01:38.240 | mini or something with a data connection. I guess that's changing in the world of the iPhone 6. But

01:01:42.880 | to me, as long as that's predominantly used for educational expenses,

01:01:46.400 | and for predominantly educational nature, not for sports, games, or hobbies, then to me,

01:01:54.400 | that would be valuable. So if you're buying a computer and it does not have to be for the

01:01:59.280 | exclusive use of your one child, it specifically says here that it has to be used by the beneficiary

01:02:08.000 | and the beneficiary's family during any of the years the beneficiary is in elementary

01:02:12.640 | or secondary school. So this is a big one because in business tax deductions,

01:02:17.040 | one of the things that's very important is if I have a business computer that I keep in my office,

01:02:21.680 | I must not allow my children to play computer games on that business computer, or I will not

01:02:27.840 | be able to deduct the full cost of the computer. I would have to do a pro rata deduction based upon

01:02:32.480 | some formula of how much they're using it for their personal use or for their business use.

01:02:37.200 | I must not deduct a computer if I'm using it for personal purposes. It has to be for business

01:02:41.520 | purposes. But that's not the case here with regard to using the educational savings account

01:02:46.960 | to pay for computer expenses. That can be very useful to you. Now, what if your child is in

01:02:51.840 | college? Well, it clearly says here, in the language from the publication from the IRS,

01:02:58.560 | clearly says here, "During any of the years the beneficiary is in elementary or secondary school."

01:03:07.040 | So you need to be careful here. If you're going to use this account,

01:03:10.000 | if the college requires your student to have a computer, pay for that computer out of the

01:03:16.800 | educational savings account because it would be required by the college, which would in the

01:03:21.680 | previous section fall in under the following expenses must be required for enrollment and

01:03:27.120 | its book supplies and equipment. So a computer would be equipment that's required for enrollment.

01:03:31.440 | If your kid just wants a fancy new MacBook just because they're going to school, but the school

01:03:35.280 | doesn't require them to have a computer, then I would say that that would not be an eligible

01:03:40.320 | expense. Think that out carefully. Now, when you get to the topic of expenses from an account,

01:03:46.000 | you get to some interesting timing ideas. And I want to talk with you for just a moment about

01:03:49.920 | the timing of expenses. This is useful. And there are some things that you always, when people are

01:03:55.200 | very proactive about tax planning, and if you're looking for ways to exploit things, by the way,

01:03:58.880 | the average person isn't organized enough around their expenses to be able to know how to do this.

01:04:09.280 | But you can be. There's a difference between when the money comes out versus when the expense has

01:04:17.040 | to be incurred. You don't have to necessarily use the money from a Coverdell account in order to pay

01:04:24.160 | the specific expense at the time that you take it out. But you do need to have the same expense

01:04:29.520 | in the same year that you take a withdrawal. So as an example, let's say that you have one of

01:04:34.960 | these Coverdell accounts and you're going to take the money out and you need to do something like

01:04:38.960 | buy a car for your child. And your child is going to school in the fall, but it's January and they

01:04:43.440 | think that they're going to actually need to buy a car. Well, in January, you can take $5,000 out

01:04:49.280 | of the Coverdell account and you can simply use the money to buy a car for the student, for the

01:04:54.000 | beneficiary. That would not be a qualified education expense. But in, say, September,

01:04:59.680 | when they enroll at university, you go and you take out a student loan in order to pay the $5,000

01:05:05.440 | in tuition for the beneficiary of that account. And in that scenario, the February withdrawal

01:05:14.240 | would be tax-free because the expenses came in the same year, even though you didn't directly

01:05:19.920 | use the money for the tuition payment. That can be a useful planning tip for some of you,

01:05:25.200 | so pay attention to that. If you need to, go back and listen to it again. It can be very useful.

01:05:29.520 | Anytime we're dealing with distributions, if we can adjust, and we'll get to contributions in a

01:05:33.920 | minute, but if you can adjust timing and distributions, that in some scenarios can

01:05:38.480 | be useful for you, so pay attention. I think I would be careful here to make sure this happens

01:05:44.880 | in the same calendar year. I can't prove this to you, but I would be careful to do this in the same

01:05:49.920 | calendar year. Even though the specific connection of an expense to a distribution is not required,

01:05:56.880 | I would be nervous about, in, say, November, taking a distribution to buy the car for my child,

01:06:02.800 | and then in January, going ahead and enrolling in tuition. I wouldn't do that. I would keep

01:06:07.920 | them in the same calendar year to keep things clear. Now, what if you take a distribution from

01:06:13.120 | the account, and you're not in a scenario where you're able to take that and actually pay the

01:06:19.360 | tuition? Let's say that you take a distribution in January to cover—January 1st, you take a

01:06:24.480 | distribution for the Coverdell account to cover your child's spring and fall tuition payments,

01:06:29.280 | but you find yourself in a scenario where you are unable to—for whatever reason, your child goes to

01:06:34.800 | school in the spring and then decides to take off for Europe, and they don't re-enroll in the fall.

01:06:38.640 | So now, you maybe took $5,000 out of the account, and you were planning to pay it on tuition,

01:06:43.280 | but now you don't have a qualified thing that you can do with it. What do you do? Well, here's an

01:06:50.240 | easy way to avoid that one. It's just simply put the money into a qualified tuition program account,

01:06:55.600 | aka a 529 plan. So just simply open a 529 plan and contribute it into a 529 plan with a beneficiary

01:07:02.640 | for the same beneficiary. So if you took the distribution from the ESA in January,

01:07:07.440 | then in December, you went ahead and made the contribution to the 529 plan, you can avoid the

01:07:12.560 | penalty tax on the distribution. That may be useful to some of you or to some of you financial

01:07:17.840 | planners when you're in a scenario where your client has taken an unqualified distribution,

01:07:23.360 | and you're looking for, "How do we fix it?" Just put the money in the 529 plan. That's always your

01:07:27.440 | exit plan, easy, easy exit plan from an educational savings account problem. Super easy to always just

01:07:34.080 | stick the money into a 529 plan. Useful. I hope it's useful to you anyway. Contributions. So how

01:07:42.240 | do we contribute and who can contribute? Any individual, including the designated beneficiary,

01:07:49.840 | pay attention to that, including the designated beneficiary, can contribute to a Coverdell

01:07:55.280 | educational savings account if the individual's modified adjusted gross income, which I'll define

01:08:01.520 | in just a moment, for the year is less than $110,000. For individuals filing joint returns,

01:08:08.960 | that amount is $220,000. Organizations such as corporations and trusts can also contribute

01:08:16.720 | to Coverdell educational savings accounts. There is no requirement that an organization's income

01:08:22.240 | be below a certain level. So when I said in the beginning that the article that the guy wrote

01:08:30.000 | in Forbes, when he says, "Oh, Coverdell, you can't do it because you can't contribute once the

01:08:35.120 | parent's income is phased out after $200,000 and the 529 plan doesn't have those rules." Yes,

01:08:40.720 | that is correct, but it is absurdly easy to just simply get around the rule. The easiest way,

01:08:47.280 | just give the money to your kid. All you need to do is just simply say, "Here, son, here's $2,000."

01:08:51.920 | Now, you have your son stick the money into the account. As long as your son doesn't make more

01:08:58.000 | than $110,000, that's easy to do. Now, if your son does make more than $110,000, what do you do then?

01:09:04.480 | Well, just take the money out of your company. Take the company, make the contribution from the

01:09:08.560 | company. It doesn't matter whether your company makes $10 billion a year. There is no requirement

01:09:12.480 | that an organization's income be below a certain level. You could do this with a corporation. You

01:09:16.720 | can also do it with a trust. Organizations such as corporations and trusts can also contribute to

01:09:21.920 | Coverdell educational savings accounts. There is no requirement that an organization's income be

01:09:26.400 | below a certain level. Again, why do politicians bother with this stuff? I don't know, but they go

01:09:33.120 | back and fix the law. What's the point of having an income limitation when it's that easy to get

01:09:37.360 | around? It's what happens when people don't have a clue what they're doing, write laws.

01:09:43.760 | This opens up, however, some interesting planning ideas in my opinion,

01:09:47.360 | is that with regard to who can contribute, and then also we're going to get in just a second to

01:09:52.960 | the timing of the contribution. When you get to who can contribute and you open up the world of

01:09:57.760 | people being able to contribute who are businesses, for many of you who make a lot of money, this is

01:10:02.800 | all you need right here, is just use the money out of the business. Now, again, is $2,000 really

01:10:07.760 | going to make a big difference to you? No, it's not really going to make that big of a difference,

01:10:11.600 | but it's better than nothing, and especially when you get to what can you invest it in,

01:10:15.360 | you could do some interesting stuff with this. But with regard to using a business, this can

01:10:21.840 | open up a lot of things. So could you use this as a simple bonus program for yourself? Yes.

01:10:29.600 | If you make over $110,000 a year as an individual or $220,000 a year filing jointly,

01:10:35.680 | just simply bonus yourself the money out of your company and stick it into the ESA,

01:10:40.160 | and you can do this $2,000 each year for each of your kids. And whatever growth you get on that

01:10:45.760 | account, that will save you on the cost of the tax. Now, it's not going to save you on some of

01:10:51.760 | your taxes, so it's not going to save you on employment taxes. This is still going to be wages.

01:10:57.360 | Depending on the type of corporation that you own, that's going to dictate what type of

01:11:01.600 | distribution this is. I'm not an accountant. Talk to your CPA or to your accountant about this

01:11:06.320 | question. If I were doing it for myself, if I owned an S corporation, then I would do this either

01:11:12.080 | as a shareholder distribution on $1,120,000 or as a non-deductible expense. So I would do this as

01:11:19.600 | either of those. They're both taxed the same. Those are wages, so you're going to pay the taxes

01:11:23.600 | on them. It doesn't save you on your employment taxes. But you could also set this up from the

01:11:35.280 | perspective of your employees. So if you wanted to use something like this as a benefit for your

01:11:42.720 | employees, this would be fairly easy to do. If you want to reward your star employee, Joe, and

01:11:48.720 | you know that Joe has kids, all you need to do is contribute the $2,000 into his ESA for his kids.

01:11:57.360 | Easy to do. It may be a useful bonus program that you could set up for you.

01:12:02.320 | I think you could discriminate on this one. You don't have to set it up for everything.

01:12:05.520 | You could just simply discriminate among employees easily without any problem there.

01:12:09.520 | What you would do in that situation is you would just simply record it on the employee's W-2.

01:12:16.480 | And this would be subject to their payroll taxes. Or you could offer it as a deduction. So if you

01:12:22.800 | wanted to offer this as an option as a deduction, and then at the end of the month or the end of

01:12:27.920 | the year, you send it into their educational savings account, that would make it easier for

01:12:33.680 | the employee to fund the account and it might be useful for you. This is not going to be a tax-free

01:12:39.520 | benefit to the employee. So this is not a fringe benefit that you can set up to be a tax-free

01:12:45.680 | benefit. So this is not being done for the savings of tax. So in many ways, I think this is

01:12:49.520 | relatively useless as a bonus program. But it can be very important and helpful for you as an option

01:12:57.440 | to do it in your own company. So that's what I would encourage you to do.

01:13:05.840 | You know, I just caught myself. I'm not sure the answer. If some of you accountants could comment,

01:13:11.280 | if you had an S-corporation, is a shareholder distribution or a non-deductible expense,

01:13:18.640 | do you pay employment taxes on that money? I'm not sure the answer. So if some of you

01:13:24.000 | accountants could help me out on that, I would appreciate that in the show notes. I may have

01:13:27.040 | made a mistake in what I just said. So come by the show, radicalpersonalfinance.com/coverdell,

01:13:32.320 | and let me know whether I'm right or wrong on that. I would assume, because it's not deductible

01:13:36.320 | for the employee, I would assume that would be applied also to an S-corporation. That's where I

01:13:41.920 | get my logic on that. But come by and correct me. So hopefully that's helpful as far as contributions,

01:13:48.880 | is that that can be very useful to many of you as far as how to contribute to the account. And

01:13:53.520 | that's why even though this is another one of those things, for years I thought, "Oh,

01:13:57.440 | it's just about the limit." No, that limit is so bogus because it's so easy to walk around it.

01:14:01.520 | There are some limits that are hard to walk around. There are some limits that are easy to walk

01:14:04.640 | around. Next, what is a contribution and what are the requirements of how a contribution looks? Well,

01:14:11.440 | the IRS says here that there are three requirements that it must meet. Number one, the contribution

01:14:16.640 | must be in the form of cash. So this is important because many of you, if you're looking to say,

01:14:23.440 | "Well, what can I fund this account with?" You must make the contribution in the form of cash.

01:14:28.960 | Now, to some of you, you're not used to thinking about contributions to accounts in terms of

01:14:32.880 | property. But for the wealthy, this is the primary way that you think is that, "Why would you put

01:14:38.240 | cash when you could do property?" So you want to contribute sometimes appreciated property,

01:14:42.800 | sometimes depreciated property. You want to essentially, for most of the wealthy,

01:14:47.200 | you're often working with property, with assets, with stock. And you're doing this so that you can

01:14:51.680 | retain the basis of the account or so that you can increase the basis of the account.

01:14:56.720 | In this situation, it's not. You must make the contributions in cash. So if you have an

01:15:02.560 | investment and you want to contribute to that to an ESA, sell the investment and contribute the

01:15:07.600 | cash. Must be made in cash. Number two, contributions cannot be made after the

01:15:13.280 | beneficiary reaches the age of 18 unless the beneficiary is a special needs beneficiary.

01:15:20.400 | So for those of you who aren't doing special needs planning, then in this scenario,

01:15:26.320 | you can't put money into the account after the age of 18. That's important. If you are doing

01:15:32.000 | special needs planning, this might be an important exception for you. So in this scenario, then you

01:15:39.280 | might be able to use this. If there's some sort of qualified educational expenses that are going

01:15:43.760 | to be incurred for your special needs, what's the name for the person for whom you're a guardian?

01:15:49.840 | I can't remember the legal name for it. The person that you're caring for,

01:15:54.000 | then this can be useful for you because you can do this after the age of 18. So useful for you.

01:16:01.200 | This would be one of the things that the author of the Forbes article was right on. He says,

01:16:07.440 | "Coverdells have time limits. They have to be started before the beneficiary turns 18

01:16:11.600 | and used up by age 30." Technically, he's actually not right about that. They don't have to be

01:16:14.880 | started before the beneficiary turns 18. You have to just be able to put contributions in before

01:16:20.720 | the age of 18. So if you have an account that, let's say, that your 30-year-old son doesn't need,

01:16:25.680 | but you have a 23-year-old daughter who's going to graduate school, then all you can do is you

01:16:30.800 | can simply transfer that account from the 30-year-old son to the 23-year-old daughter.

01:16:34.720 | That is entirely permissible. So they don't have to be started before the beneficiary turns 18,

01:16:39.600 | but they do have all the contributions have to be in by the time the beneficiary is the age of 18.

01:16:45.840 | And then the last requirement for the contributions. The contributions must be made by

01:16:51.440 | the due date of the contributor's tax return, not including extensions. So this is useful because

01:16:58.640 | in the accounting world, there are certain accounts that when you're sitting there doing

01:17:01.600 | a client's taxes on April 14th, assuming they're not filing an extension, then there are some

01:17:07.920 | accounts that are easy to go to. This is an example of why the SEP, the SEP IRA, Simplified

01:17:14.000 | Employee Pension IRA, is very useful to accountants. It's an accountant's best friend because you can

01:17:19.520 | make a full contribution of the 25% of profits on April 14th and it counts. This is why IRAs are

01:17:26.400 | useful. Why your accountant is always saying, "Do you want to contribute to an IRA for last year?"

01:17:30.560 | That you can file your taxes next year on April 14th, 2015, and you can make a 2014

01:17:37.760 | IRA contribution. You can't do that with a 401(k). Your 401(k) has to be contributed to

01:17:43.120 | before the end of the year. You can do that with an educational savings account.

01:17:48.560 | So if you get to the end of the year and you're saying, "I've got an extra $2,000 here," or,

01:17:53.120 | "I've got five kids, I've got an extra $10,000 here," you might consider going ahead and using

01:17:59.680 | an educational savings account. This might be a good scenario for you. So consider that.

01:18:05.600 | Hopefully that will be helpful to you. It's nice to have these types of accounts that you can use.

01:18:12.480 | Additionally, you can make your contributions to one account or several accounts. As long as

01:18:19.440 | the same designated beneficiary doesn't have total contributions that are in excess of $2,000.

01:18:25.120 | That's what I'm saying as far as you can contribute $2,000 to each of the accounts for your five kids,

01:18:29.360 | as long as nobody else contributes to any money to accounts for those kids.

01:18:34.080 | And then contributions can be made without penalty to both a Coverdell educational savings account

01:18:40.960 | and a qualified tuition program, aka a 529 plan, in the same year for the same beneficiary. So if

01:18:48.080 | you have more money, you have one child, you have $10,000 you need to get rid of, put $2,000 in the

01:18:53.120 | educational savings account if you value the benefits, which you're still getting to like the

01:18:57.040 | investment benefits, and put the rest in the 529. That is entirely permissible. The contributions

01:19:05.120 | are considered to have been made on the last day of the preceding year. So if you make a

01:19:10.160 | contribution in April of 2015, then the IRS considers that contribution to have been made

01:19:16.720 | on December 31, 2014. But it has to have been made by the due date, not including extensions,

01:19:24.160 | for filing your return for the preceding year. Contribution limits. There are two contribution

01:19:30.720 | limits. Number one, there's one limit on the total amount that can be contributed for each

01:19:36.480 | designated beneficiary in any year. And number two, there's a limit on the amount that any

01:19:42.480 | individual can contribute for any one designated beneficiary for a year. So confusing, right?

01:19:48.240 | Doesn't make any sense. So again, why is this law written this way? You would think that the

01:19:52.480 | person writing this law would sit and say, "Let me make this less confusing." But this is—it's

01:19:56.160 | utterly silly. But the rule is that no individual can set aside more than $2,000 for a beneficiary,

01:20:03.840 | and no beneficiary can have more than $2,000 set aside for them. So if—the way the law is written,

01:20:09.840 | it doesn't matter who the person contributing is. So I have—let's say, pretend I have a son named

01:20:14.080 | Joe. I could put aside $2,000 for Joe, the way the law is written. My company or my wife's company

01:20:22.720 | could set aside $2,000 in an educational savings account for Joe. And Joe's grandmother could set

01:20:28.240 | aside $2,000 in the account for Joe. Now, each of those accounts would accept the money, but the

01:20:34.880 | IRS doesn't want that to happen. So we can't set aside—Joe can't have more than $2,000 set aside

01:20:41.920 | for him, period. So I can't put aside $2,001 for him, but if I set aside $2,000, no one else can

01:20:49.520 | put aside $2,000. And so they've tried to fix this in the way they set up the forms, but you don't

01:20:56.160 | actually have to use the forms when you set up a Coverdell account. Most banks and brokerage

01:21:01.440 | accounts and companies are going to use the IRS forms. But the key is that different people could

01:21:07.840 | do different contributions to the account, and no one could know. They could not tell. So if my

01:21:13.920 | grandfather—my father sets something up for my son, unless he tells me, I don't have any knowledge

01:21:20.240 | of it. And so this is a real pain, and that's why there are those two rules that are specified.

01:21:25.040 | It's a real pain. You've got to make sure that no more than $2,000 gets set aside in that account.

01:21:30.560 | And if we find out that more than $2,000 has been set aside, then we've got to pay the 6%

01:21:36.960 | excise tax, which we'll get to in a minute. So big deal. Make sure that no more than $2,000 is set

01:21:42.080 | aside for any individual beneficiary, regardless of the number of accounts and regardless of the

01:21:47.520 | number of account holders. If you're going to put in $500 and Grandma's going to put in $500,

01:21:52.720 | make sure that Aunt Susie only puts in $1,000. She can't do her own account for $2,000.

01:21:58.640 | So hopefully that helps as far as the contributions. Next, what is that number,

01:22:04.320 | the modified adjusted gross income? You'll hear this number in financial planning a lot of times,

01:22:08.880 | and this one always bugged me because I can never figure out what is modified adjusted gross income.

01:22:13.040 | I tried to look at the tax return, and I'm saying, "Where is this MAGI number?" You have

01:22:17.040 | the AGI number. That's easy to find, adjusted gross income. What is a modified number? And

01:22:22.080 | the best I've been able to figure out is that basically the IRS tosses this number in, and

01:22:26.160 | they modify the adjusted gross income number for whatever the planning is that they're doing.

01:22:30.400 | And so with regard to the Coverdell account, then basically for most people, the modified

01:22:36.000 | adjusted gross income is exactly the same as the adjusted gross income. But if you are using a 1040,

01:22:42.720 | then for the purposes of that number, the $110,000, $220,000 number, the modified adjusted

01:22:50.240 | gross income number is your AGI, and then you add back any foreign earned income exclusions that you

01:22:58.960 | have, any foreign housing exclusions that you have, any foreign housing deductions that you have,

01:23:05.280 | any exclusion of income by bona fide residents of American Samoa, and exclusion of income by

01:23:11.440 | bona fide residents of Puerto Rico. So if you are in one of those scenarios, you're doing something

01:23:16.160 | foreign, or you are in American Samoa or Puerto Rico, then you need to be careful about making

01:23:21.760 | sure that you use that modified adjusted gross income number. That would be important for you.

01:23:26.000 | Theoretically, I don't see any reason why this account can't fund some foreign adventure travel

01:23:31.520 | for you. So if you're putting in your kids into a school in Colombia while you're living down there,

01:23:38.800 | I don't see any reason. And it's a private international school. I don't see any reason,

01:23:42.240 | as long as that school matches the elementary and secondary numbers, I don't see any reason

01:23:46.720 | why you can't use this account to do so. What if you put too much money into the account?

01:23:53.040 | So let's say that you run into the problem with the contributions, and you just wind up putting

01:23:56.800 | too much money in the account. What happens and what do you do? Well, in that scenario,

01:24:01.040 | you have excess contributions, and you're going to pay an additional tax. Very nice of the IRS

01:24:06.560 | to call it an additional tax. I call it a penalty. It's an additional excise tax. So the beneficiary,

01:24:12.880 | beneficiary, yes, your one-year-old child, must pay a 6% excise tax for each year on excess

01:24:22.800 | contributions that are in a Coverdell Educational Savings Account at the end of the year.

01:24:28.320 | Excess contributions are the total of the following two amounts. One, contributions to

01:24:35.680 | any designated beneficiary's Coverdell Educational Savings Account for the year that are worth more

01:24:41.600 | than $2,000, or if less, the total of each contributor's limit for the year as discussed

01:24:47.360 | earlier. Or two, excess contributions for the preceding year reduced by the total of the

01:24:53.280 | following two amounts, distributions during the year, and B, the contribution limit for the current

01:24:58.240 | year minus the amount contributed for the current year. So that's mumbo jumbo, but that's the

01:25:03.200 | important thing you need to know. Let me make it simple. If you put too much money in the account

01:25:08.720 | over the $2,000 and you didn't take it out, you owe a 6% excise tax on the money.

01:25:13.600 | Now, I always like to think, when I'm going to pay a penalty tax, is there a way I could make this

01:25:18.560 | work? Not sure, but what if your returns were way in excess of 6%? Theoretically, I bet you there's

01:25:28.640 | a planning idea there. I created a couple scenarios that I thought, "I wonder if I could do this?"

01:25:34.800 | This would not apply to 99.999% of you, but you financial planners out there, think that through

01:25:40.720 | and see if there's a way that you could take advantage of that 6% number. But let's go on.

01:25:44.880 | The excise tax does not apply if the contributions are made during 2013—this is the year I'm reading

01:25:52.480 | the 790 from—and distributed before the first day of the sixth month of the following tax year.

01:25:58.400 | So you've got to get it out before the sixth year, and you have to include any of those

01:26:03.360 | excises in your income. So that's a useful thing, and there actually is a planning opportunity

01:26:09.200 | there. Going back to the timing of the contributions, one of the things that you

01:26:12.880 | could do when you get to the investment opportunity—some of you guys who are super

01:26:16.160 | intense with this stuff and willing to take it on—and when you get to the idea of saying,

01:26:20.240 | "Could I invest in a rental house through this account and use that, or could I buy an option

01:26:26.240 | that is going to be a useful option?" You can take advantage of the timing flexibility of when

01:26:30.960 | your contributions versus your money coming out, and you might even be able to take advantage of

01:26:35.840 | the float that's there versus putting the money in and taking it out. That was the planning idea

01:26:41.680 | that I was trying to work out. Again, this is a tiny percentage of the population that could ever

01:26:46.720 | come up with something like this as far as it being applicable, but theoretically, I think

01:26:52.560 | there's an idea there. We've gotten the basics of the account squared away, and we've said, "Okay,

01:26:59.120 | now I've got money in the account. We've got our contributions in there. We've got our money

01:27:03.680 | growing. I'm going to deal with investments after I deal with getting the money out."

01:27:08.640 | So let's talk about what do you do with the money now that it's grown and you need to get it out.

01:27:13.200 | So you have some questions of, "If I have educational expenses, that's easy. We just pay

01:27:18.080 | for the educational expenses. You get the money out of the account. You've got to get it out by

01:27:21.280 | the time you're 30, but what if you save too much or what if something changes and you don't have

01:27:26.160 | the expenses there? What do you do with the money?" So here we get into the world of rollovers and

01:27:31.440 | transfers, and there are a couple different ways to do this. You can do this with rolling the money

01:27:35.680 | into a new account for a new beneficiary, or you can do this with changing the beneficiary.

01:27:40.640 | So assets can be rolled from one Coverdell educational savings account to another,

01:27:46.560 | or the designated beneficiary can be changed, and the beneficiary's interest can be transferred

01:27:53.040 | to a spouse or former spouse because of a divorce. So there's a lot of flexibility here,

01:27:58.320 | and I'm going to walk you through these numbers. The most useful one in practical everyday planning

01:28:02.640 | scenarios is going to be family members. Any amount distributed from a Coverdell ESA is not

01:28:08.720 | taxable if it is rolled over to another Coverdell ESA for the benefit of the same beneficiary or a

01:28:16.160 | member of the beneficiary's family, including the beneficiary's spouse who is under age 30.

01:28:22.560 | This age limitation does not apply if the new beneficiary is a special needs beneficiary,

01:28:27.840 | because it can be done for later, even after the age of 30 if you're dealing with special needs.

01:28:32.160 | Pay attention, those of you who are doing planning for special needs people, or you are the custodian

01:28:36.720 | of a special needs person. An amount is... I wish I could come up with a legal term for that.

01:28:42.800 | Someone comment on the show notes and tell me what it is. The person for whom you're a guardian.

01:28:46.720 | An amount is rolled over if it is paid to another Coverdell educational savings account

01:28:53.120 | within 60 days after the date of the distribution. So, planning idea. One of the things that I do not

01:29:02.000 | think was addressed... The other day on the show, I talked about the Bowbrow case, where the

01:29:06.560 | exclusion for IRAs was dropped to one IRA per year, instead of the former amount where when

01:29:15.200 | you're doing a transfer from one IRA to another IRA, you can basically have the 60-day window of

01:29:19.840 | free money. Now, you can basically do that same thing, even though we're limited on accounts,

01:29:25.200 | like limited with IRAs, you can do that same thing with an ESA. So, if you have a short-term...

01:29:29.520 | Let's say you have a bunch of money in your kid's educational savings account,

01:29:33.120 | and you have a short-term emergency, or you have a short-term cash flow need,

01:29:37.120 | you can take the distribution from one Coverdell educational savings account. You have use of the

01:29:42.720 | money for 60 days, and then you've got to make sure the money gets put into another account

01:29:47.280 | within another 60 days. So, if you're ever in the need, or if you planners are in the need for a

01:29:51.920 | client and then basically need short-term money, you may be able to use this as a 60-day gap loan,

01:29:58.400 | because we have the same scenario that we can do with IRAs, where we've got that 60-day

01:30:01.840 | limit. We can do that here with the educational savings account as well. Useful tip for you

01:30:07.200 | planners, especially, because you wind up with a client in this scenario. So, if a client has an

01:30:10.560 | ESA, it may help you. The IRS says, "Do not report qualifying rollovers, those that meet the above

01:30:17.440 | criteria, anywhere on Form 1040 or 1040NR. These are not taxable distributions." So, if you do a

01:30:24.880 | qualified rollover in the way that I just said, you don't have to report it on the 1040. That's

01:30:29.520 | useful. Now, you're doing a rollover from one account to another, and you're changing the

01:30:34.400 | beneficiary. Who is the IRS define as members of the beneficiary's family? For these purposes,

01:30:41.280 | the beneficiary's family includes the beneficiary's spouse and the following other relatives of the

01:30:48.320 | beneficiary. Remember, the beneficiary has to be under the age of 30, so that is a limitation,

01:30:56.080 | or has to meet special needs. But if that counts, then we can use this account. It can be a number

01:31:02.880 | one son, daughter, stepchild, foster child, adopted child, or a descendant of any of them.

01:31:13.840 | I'm going to pause here for a moment. That descendant is so important, because remember,

01:31:17.680 | in the beginning, when I talked about the limitations of this account, when we're talking

01:31:20.960 | about the fact that, "Well, it's not useful because you have a limited planning time horizon,"

01:31:25.200 | we can use this for descendants. So, for some of you, that means you're not thinking about your

01:31:31.760 | kids. You're thinking about your grandkids. So, it may still be valuable for you if you have the

01:31:37.440 | cash flow to fund this kind of account, because when we can stretch the time horizon out, now we

01:31:43.440 | wind up with a much more useful scenario. And it says, "or a descendant of any of them." I interpret

01:31:52.800 | me personally, as a layperson, I interpret "descendant" to mean any descendant, including

01:31:56.960 | your grandkids' grandkids. Now, in this scenario, we'd probably want to have a little bit more

01:32:01.280 | control. So, we'd probably want to move into the setting up a trust, maybe some sort of dynasty

01:32:05.600 | trust, that would be a little bit more controlled. But, it's a tool that you might be able to find

01:32:10.480 | useful. Let's say that you could set aside $2,000 into an educational savings account. And for the

01:32:16.320 | purposes of my example, let me use, let's say I put in $2,000 as my payment. And what I'm going

01:32:25.040 | to do is I'm going to pretend that you start this with your zero-year-old child, right when they're

01:32:29.760 | new, and you put in $2,000 per year. And you have 18 years into which you can make contributions.

01:32:35.920 | Then the account sits, and I'm going to assume that you have a younger child, so you can contribute

01:32:40.560 | to that one. And then you're going to flip these before the child is 30 to your grandchildren.

01:32:45.840 | So, in my scenario, just to give you some math on how this can be more valuable for you,

01:32:49.920 | assuming tax law doesn't change, under this law, you could use the ESA in this way.

01:32:55.520 | So, again, I'm dealing within the constraint of the beneficiary has to be under 18. So, I need

01:33:01.840 | one child to start it with, then I need another child who's under 18, but to show you the

01:33:06.320 | mathematical power, if you can extend this out. So, $2,000 per year, let's say I can make

01:33:12.560 | contributions to this account up through the age of 30, so, excuse me, for the next 30 years.

01:33:17.760 | And let's say I use a 10% number for my nominal investment return, and let's start with $0.

01:33:24.960 | Well, now in this scenario, now I've got $361,000 in this educational savings account,

01:33:31.600 | and I contributed 30 times $2,000, I contributed a total of $60,000. So, now I have $300,000

01:33:39.600 | of tax-free gain built up that I can distribute for my grandkids, for my kids, and for my

01:33:46.640 | grandkids' college education, or for their family. That's a much bigger deal, which is what, now,

01:33:52.400 | you can also do that with a 529, but when we get to pay attention to the investment

01:33:56.960 | restrictions of the 529 plan, whereas with the educational savings account, you don't

01:34:01.760 | have the investment restrictions that a 529 plan has. So, that's a big deal, it's a very

01:34:06.560 | big deal. Members of the beneficiary's family. So, these can include the beneficiary's spouse

01:34:12.400 | and these relatives. I'm going to go through the full list now, and look how useful this

01:34:16.000 | could be for some of you when you're thinking about your great-grandkids and kind of your

01:34:19.760 | dynasty as a family. Beneficiary can be changed to any of these people. Son, daughter, stepchild,

01:34:25.760 | foster child, adopted child, or a descendant of any of those people. The beneficiary's brother,

01:34:31.680 | sister, stepbrother, or stepsister. Father or mother or ancestor of either. Stepfather or

01:34:38.560 | stepmother. Son or daughter of a brother or sister. Brother or sister of father or mother.

01:34:44.480 | Son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law.

01:34:49.920 | The spouse of any individual listed above, or the first cousin. We've got to deal with

01:34:56.320 | the age restriction, but basically anybody who's even remotely related to or married into

01:35:01.600 | the family, we can use this account to benefit them. And then remember, we can always get around

01:35:08.640 | the age restriction by dumping the money into a 529 plan. So, we can always use that as our

01:35:14.320 | exit. Really, really useful. So, I think this is an underappreciated tool, especially when we get

01:35:21.200 | to the idea that we can fund this with non-traditional investments. We don't just have

01:35:25.520 | to choose the mutual funds that the state approves to offer in their 529 plan or the prepaid tuition

01:35:31.120 | 529 plan. We can fund this with real estate, we can fund this with business interests, we can fund

01:35:36.800 | this with some more exotic investments, to the best of my understanding. For those of you who

01:35:43.200 | aren't that exotic, all this means is that you can just use the money for your kids. Just set it

01:35:46.960 | aside for your oldest child, and then if your oldest child doesn't use it, you can transfer it

01:35:50.960 | down, you can transfer it down, you can transfer it down. So, I leave you just to think about that,

01:35:56.240 | and you planners, think about the opportunities. I've never seen anybody write much about this,

01:35:59.840 | but to me, unless I've missed something totally wrong and tell me if I have, this is an

01:36:04.480 | underappreciated issue, because everyone gets so focused on the $2,000. I say, focus on the $2,000

01:36:09.920 | and fund it with some investments that you can't hold in the qualified tuition program. So, one

01:36:16.000 | key note, only one rollover per Coverdell educational savings account is allowed during the

01:36:20.640 | 12-month period ending on the date of the payment or distribution. Now, another special planning

01:36:26.400 | note, right here in the 970, or 790, what's this, 970 or 790, it's one of these publications, I'll

01:36:31.760 | list it in the show notes. This rule does not apply to the rollover of a military death gratuity

01:36:38.800 | or payment from service members group life insurance. So, if any of you financial planners

01:36:43.840 | that are working with military members, if your military client, or any of you who are in the

01:36:48.880 | military, if your military client has service members group life insurance, there is a planning

01:36:54.720 | opportunity here. Let me read this to you. Military death gratuity, if you received a military death

01:37:01.040 | gratuity or a payment from service members group life insurance, SGLI, you may rollover all,

01:37:08.480 | or part of the amount received to one or more Coverdell ESAs for the benefit of members of

01:37:15.280 | the beneficiary's family. Such payments are made to an eligible survivor upon the death of a member

01:37:22.560 | of the armed forces. The contribution to a Coverdell ESA from survivor benefits received

01:37:28.880 | cannot be made later than one year after the date on which you received the gratuity

01:37:33.920 | or SGLI payment. This rollover contribution is not subject to, but is in addition to,

01:37:42.640 | the contribution limits discussed earlier under contribution limits. The amount you rollover

01:37:48.880 | cannot exceed the total survivor benefits you received reduced by contributions from these

01:37:54.160 | benefits to a Roth IRA or other Coverdell educational savings accounts. The amount

01:37:59.680 | contributed from the survivor benefits is treated as part of your basis in the Coverdell ESA and

01:38:04.400 | will not be taxed when distributed. The limit of one rollover per Coverdell ESA during a 12-month

01:38:09.840 | period does not apply to a military death gratuity or SGLI payment. So if you're working with a

01:38:14.880 | military member who has died and you have an SGLI payment, consider that you can get a lot of money

01:38:20.720 | into an educational savings account. Hopefully the military member has lots of life insurance.

01:38:26.080 | If they were my client, they would have lots of life insurance. Use the other life insurance,

01:38:30.160 | not the SGLI insurance, to cover the needs of the family and make sure that SGLI payment gets

01:38:35.600 | into an educational savings account. You don't have to be capped at the $2,000. And consider

01:38:42.480 | the power of this from the perspective of a dynasty. Take the idea of a dynasty trust without

01:38:48.880 | all of the hassle of setting one up and consider that with just a simple educational savings

01:38:53.280 | account, you can put in all the insurance money, lump sum, and it can be passed down through the

01:38:58.080 | generations, always tax-free with a simple Coverdell educational savings account. Useful.

01:39:03.440 | Now, next section, changing the beneficiary. The designated beneficiary can be changed.

01:39:10.080 | So there are no tax consequences if at the time of the change, the new beneficiary is under age

01:39:14.560 | 30 or is a special needs beneficiary. So instead of saying, "Okay, I'm going to roll over the money

01:39:19.440 | from one account to another because my child grew to be over the age of 30," you can just simply

01:39:25.680 | change the beneficiary for the account. And that's really, really useful. Or you could,

01:39:31.040 | very, very simple. Transfer because of a divorce. If a spouse or former spouse receives a Coverdell

01:39:38.080 | educational savings account under a divorce or separation instrument, it is not a taxable

01:39:42.720 | transfer. So for those of you financial planners working in the case of divorce, there's no taxable

01:39:47.760 | transfer. We would assume that anyway, but just pointed out as it's useful. Distributions. The

01:39:53.040 | designated beneficiary of a Coverdell educational savings account can take a distribution at any

01:40:00.400 | time. That's useful. You can take a distribution at any time. That's a problem sometimes when

01:40:09.200 | you're dealing with 401(k)s account, things like that, where you can't take a distribution anytime.

01:40:13.200 | You can from IRAs and Roth IRAs, but you can take a distribution at any time from the ESA.

01:40:18.880 | But whether the distributions are tax-free depends in part on whether the distributions are equal to

01:40:26.320 | or less than the amount of the adjusted qualified education expenses defined later that the

01:40:31.760 | beneficiary has in the same tax year. So we've got to look at the same tax year. And that's why I

01:40:36.000 | say be conservative with this in the same calendar tax year and make sure that the amount of whether

01:40:41.120 | it's distributed. That was where that idea about it doesn't have to be forward, it just has to be

01:40:46.240 | in the same tax year. So what are the adjusted qualified education expenses? To determine if

01:40:52.320 | total distributions for the year are more than the amount of qualified education expenses,

01:40:58.560 | reduce the total qualified education expenses by any tax-free educational assistance. Tax-free

01:41:06.160 | educational assistance includes these items. So you take what are the total expenses and then you

01:41:11.280 | take out any of the tax-free basically educational assistance, one is scholarships, that you've

01:41:16.800 | received. The tax-free stuff. And so here are the line items. The tax-free part of scholarships and

01:41:21.840 | fellowships, veterans educational assistance, Pell grants, employer provided educational assistance,

01:41:30.160 | any other non-taxable tax-free payments other than gifts or inheritance received as educational

01:41:36.960 | inheritance, as educational assistance. The amount you get by subtracting the tax-free

01:41:41.280 | educational assistance from your total qualified education expenses is your adjusted qualified

01:41:48.160 | education expenses. Generally your distributions are tax-free if they are not more than the

01:41:55.360 | beneficiary's adjusted qualified education expenses for the year. Do not report your

01:42:01.600 | tax-free distributions on your tax return. A portion of the distributions would generally

01:42:08.800 | be taxable to the beneficiary if the total distributions are more than the beneficiary's

01:42:14.960 | adjusted qualified education expenses for the year. And the publication goes into how to calculate

01:42:19.760 | that. It's not important for the purpose of this podcast. If you're in that scenario, you can

01:42:23.120 | calculate that difference. How about coordination with the American Opportunity and Lifetime Learning

01:42:29.200 | Credits? The American Opportunity or Lifetime Learning Credits can be claimed in the same year

01:42:34.320 | that the beneficiary takes a tax-free distribution from a covered out ESA, as long as the same

01:42:39.040 | expenses are not used for both benefits. This is the the doctrine that applies to all of these

01:42:43.600 | credits and all of these distributions, whether it's 529 coordinating 529 distributions,

01:42:50.640 | or as the IRS would call them, the Qualified Tuition Program distributions, coordinating it

01:42:54.400 | with credits. You cannot take $10,000 of college expenses, take an American Opportunity Credit or

01:43:00.080 | a Lifetime Learning Credit, and then pay for all $10,000 out of a Qualified Tuition Program and

01:43:05.760 | pay all $10,000 out of your educational savings account. Doesn't work. But if you use $4,000 on

01:43:12.080 | one and $6,000 in the other, you can do that. That's the basic doctrine. You don't need to

01:43:16.080 | know anything else, at least for now. If you need more details because you're an accountant,

01:43:20.080 | check the publication. What about losses on the account? This will be useful to some of you. What

01:43:26.000 | about losses on the account? Well, if you have a loss on your investment, many people forget about

01:43:30.960 | the fact that they can claim losses on certain tax qualified accounts. You can claim losses on IRAs.

01:43:36.240 | How does it work? What about if let's just stick with covered out ESAs. If you have a loss on your

01:43:41.360 | investment in a covered out educational savings account, you may be able to deduct the loss on

01:43:46.480 | your income tax return. You can deduct the loss only when all amounts from that account have been

01:43:52.080 | distributed and the total distributions are less than your unrecovered basis. Your basis is the

01:43:58.560 | total amount of your contributions to that ESA. And you claim the loss as a miscellaneous itemized

01:44:04.800 | deduction on Schedule A of your 1040, and it is subject to the 2% of Adjusted Gross Income limit.

01:44:13.280 | So that is a key useful one. I don't want to go deeply into losses, but some of you who are really

01:44:17.360 | good with these numbers are immediately seeing the options. Ah, so put the money in the ESA,

01:44:21.840 | and let's see what happens with the investments. If the investment grows, great. It's a benefit

01:44:26.320 | because I can use the money and the growth tax-free for the tuition. If I have a loss,

01:44:31.120 | I can go ahead and deduct the loss. I didn't lose the ability to deduct the loss, but it is subject

01:44:35.760 | to the Schedule A miscellaneous itemized deduction, and it's subject to the 2% of AGI limit. So that

01:44:43.040 | is a...it's just a fact. That's how it is deductible. Additional tax on taxable distributions.

01:44:50.000 | So if you take a distribution from it, and you don't have it, it's a taxable distribution because

01:44:56.000 | you don't have a qualified education expense, what happens? 10% penalty tax on the amount that's

01:45:02.240 | included in the income. So you get that 10% tax just like you do from the IRA or from the Roth IRA.

01:45:09.440 | What about exceptions? Well, there are some exceptions. So what would the exceptions be

01:45:14.240 | on this account? How does this work? Well, the 10% additional tax does not apply to distributions

01:45:21.360 | that are, one, paid to a beneficiary or to the estate of the designated beneficiary on or after

01:45:29.280 | the death of the designated beneficiary. Useful. So if the beneficiary dies, then there's no 10%

01:45:37.280 | additional tax. Number two, distributions that are made because the designated beneficiary is

01:45:43.680 | disabled. A person is considered to be disabled if he or she shows proof that he or she cannot do

01:45:49.360 | any substantial gainful activity because of his or her physical or mental condition. A physician

01:45:55.920 | must determine that his or her condition could be expected to result in death or to be of a long

01:46:00.240 | continued indefinite duration. I read that as basically equivalent to the Social Security

01:46:04.800 | definition of disability. So those of you who are familiar with that, that's how I read that.

01:46:08.800 | Number three, included in the distribution, the additional tax doesn't apply to a distribution

01:46:14.480 | if the distribution is included in income because the designated beneficiary received

01:46:20.400 | a tax-free scholarship or fellowship, veterans educational assistance, employer-provided

01:46:28.400 | educational assistance, or any other non-taxable tax-free payments other than gifts or inheritances

01:46:35.680 | received as educational assistance. So the way I read this and the way I understand this law to be,

01:46:40.560 | if the money comes into and becomes a taxable distribution because you received other

01:46:45.760 | scholarship, income, veterans educational assistance, employer-provided educational

01:46:49.600 | assistance, or other tax-free payments, then you don't pay the penalty. You're just going to pay

01:46:54.880 | the income tax. It's a taxable payment, but you don't pay the 10% penalty. Additionally, the 10%

01:47:01.200 | additional tax does not apply to a distribution that is made on account of the attendance of the

01:47:05.840 | beneficiary at a U.S. military academy. This exception applies only to the extent that the

01:47:12.080 | amount of the distribution does not exceed the cost of advanced education as defined in this

01:47:17.600 | section of the code attributable to such attendance. So if you're going to a U.S. military academy

01:47:23.040 | and thus there's a distribution and a distribution is not in excess of the costs that are defined in

01:47:28.400 | that certain amount because the cost, as I understand this, the costs are underwritten

01:47:32.080 | by the government, then there's not the penalty. And then number five, included in distributions,

01:47:38.160 | you don't owe the 10% tax on any distributions that are included in income only because the

01:47:42.400 | qualified education expenses were taken into account determining the American Opportunity or

01:47:46.880 | Lifetime Learning Credit. So the way this works, let's say you only have $10,000 of expenses and

01:47:51.360 | you use that $10,000 of expense and it's used to take the American Opportunity Credit or the

01:47:56.480 | Lifetime Learning Credit. Well, now you can't double count that, but you can go ahead and get

01:48:00.960 | money out of the account. It's going to be a taxable distribution, but you're not going to

01:48:05.200 | owe the penalty. And then finally, number six, the 10% additional tax doesn't apply if the

01:48:11.040 | distribution was made before June 1, 2014, because that's the last year's publication I'm reading. I

01:48:18.640 | assume this is every year. So if the distribution is made before June 1 of an excess 2013 contribution

01:48:25.280 | and any earnings on it, but you do need to include the earnings in your gross income for the year in

01:48:31.040 | which the excess contribution was made. So you would file an amended 2013 return. Could be useful.

01:48:37.280 | It's a lot. I told you this is going to be heavy, but we're about done. We're almost done with this

01:48:44.880 | publication and we're going to get to investments, but you need this background because if you

01:48:48.640 | understand this background, then you can understand, "Ah, I see. Here's how these different

01:48:55.520 | things could work together." Next, when must the assets be distributed? Any assets that are

01:49:00.960 | remaining in the ESA must be distributed when either one of these events occurs. The designated

01:49:07.040 | beneficiary reaches age 30. In this case, the assets must be distributed within 30 days after

01:49:13.600 | the beneficiary reaches age 30. However, this rule does not apply if the beneficiary is a special

01:49:18.480 | needs beneficiary. So if you're, again, special needs, this may be useful for some of you.

01:49:22.240 | Number two, the designated beneficiary dies before reaching age 30. In this case, the remaining

01:49:28.320 | assets must generally be distributed within 30 days after the date of death. So that's the key.

01:49:33.120 | If it's still in the account, it's got to get out at 30, but remember, you can just change the

01:49:38.080 | beneficiary or transfer the role over the account. If a Coverdell, there's an exception, if a

01:49:44.320 | Coverdell educational savings account is transferred to a surviving spouse or other family member as

01:49:49.840 | the result of the death of the designated beneficiary, the Coverdell ESA retains its status.

01:49:55.360 | This means the spouse or other family member can treat this Coverdell ESA as his or her own

01:50:01.120 | and does not need to withdraw the assets until he or she reaches age 30. We already know that.

01:50:05.920 | So that is a useful scenario, and that's the IRS publication, and you need that background in order

01:50:13.680 | to properly interpret some of the other options. So you need that background. Now, there are some

01:50:19.040 | other additional issues that this brings up from a financial planning perspective that you need to

01:50:23.120 | be aware of, and none of these fit into a four-bullet-points comparison of the ESA versus

01:50:28.160 | the 529. So consider these scenarios. First of all, what about the issue of control? I won't go

01:50:37.920 | deeply into this, but one of the things that we're always dealing with when we're dealing with tax

01:50:42.080 | advantaged accounts to transfer money for kids' benefits is who has control. So the example would

01:50:47.840 | be something like a UTMA account, a Uniform Transfer to Minors Act, or UGMA, Uniform Gift

01:50:54.080 | to Minors Act. Then in this scenario, if you're having this issue with the control, then—excuse

01:51:02.400 | me, I got tongue-tied there—the issue is that those accounts eliminate the control of the donor

01:51:11.120 | to the account once a certain condition is met. So usually, I'm not a fan of UTMAs or UGMAs,

01:51:16.800 | as we call them, because the donor has no control over it. And this is a real problem,

01:51:22.640 | because if your kid's on drugs and is making a mess of their life, you don't want them to inherit

01:51:27.760 | $100,000 or $400,000 at that age. You want to pull it back. But if you've done that with an UTMA or

01:51:33.920 | an UGMA account, then in that scenario, you've given up control. So you want to maintain control.

01:51:39.440 | The 529 accounts are useful because you can easily retain control. However, the Coverdell

01:51:46.000 | account seems to be a little fuzzy. I don't think that it's been well litigated, and I'm careful

01:51:51.680 | here. My guess is that you can still—I want to be careful here. I just want you to be aware of

01:51:57.680 | this. Maybe it's not been litigated that I'm aware of, and so who knows. If you're very concerned

01:52:03.520 | with control and being able to exercise that control, be careful. The Coverdell account must

01:52:10.080 | be used for the benefit of the named beneficiary, not for you, the donor, or the responsible

01:52:15.760 | individual. If this is a big deal to you, I'd consider you—I would encourage you—consider

01:52:20.080 | the 529 account. Really, the 529 offers the ultimate level of control because there's no

01:52:25.760 | restrictions on your ability just to do any withdrawals or change it, make any changes. So

01:52:30.960 | it's a much stronger account from the perspective of control. So that is one useful scenario.

01:52:42.240 | If you're a grandparent also making this kind of account, most custodians are going to require

01:52:48.800 | that the child's parent or guardian be the responsible individual on the account,

01:52:53.360 | so you might not have the same options that you would be comfortable with with a 529 account.

01:52:59.680 | Be aware of that. That is an important thing in planning. Investment options. Investment options

01:53:07.040 | are exciting, and this is one of the things that's most exciting about the ESA. Maybe I

01:53:10.480 | should have put this up front. In fact, I think I'm going to go record a new intro to the show

01:53:14.640 | and mention this. But the ESA is hurt because it has much lower maximum contribution limits than

01:53:22.880 | the qualified tuition programs, 529 accounts. The reason I do that, in case that annoys you,

01:53:28.320 | I try to use the proper language because people use 529 usually to talk about the 529 savings

01:53:34.320 | programs, and the IRS calls it a qualified tuition program, of which there are two types.

01:53:40.160 | There's a 529 prepaid tuition program and there's a 529 qualified savings program. I do my best.

01:53:46.640 | I go back and forth because we use all this lingo, but I hope it doesn't annoy you. I try to use the

01:53:51.200 | qualified tuition program language that the IRS uses for clarity. What are the differences from

01:53:58.160 | the ESA versus the 529 as regards investments? The big one, ESA has much lower limits,

01:54:06.400 | so you can't get as much money into the account as you can with a 529 account. You can only get in

01:54:10.800 | maybe, again, $2,000 into this account per year. Unlike the 529 where you can front load

01:54:18.560 | contributions and you can get hundreds of thousands of dollars in here depending on the donors and the

01:54:22.480 | contributions right up front, which is powerful for compounding, you can't do that with the ESA.

01:54:28.320 | But the ESA allows a ton of investment choices. An ESA basically allows just about any investment.

01:54:39.040 | Any investment that you can use in an IRA, you can invest in an ESA. Now, for many of you,

01:54:44.800 | this will not matter because you're just going to buy some mutual funds and that's fine. You can

01:54:48.400 | buy some great funds. You can get that in a 529, choose a good fund family, choose some low-cost

01:54:52.800 | funds. Super simple. Your advisor can help you. But for some of you, this will be very useful

01:54:57.680 | because you want to do some more aggressive or exotic investing. So you can use stocks,

01:55:02.560 | bonds, mutual funds, but you could also use all of the other things that you can put it into an IRA,

01:55:07.680 | including individual accounts, including real estate, including you can't do collectibles,

01:55:13.120 | but you could do options. You could do intellectual property. You can do private investments. You can

01:55:18.080 | do all kinds of interesting things. And the key is that, yeah, you can only put the $2,000 in there,

01:55:24.160 | but you're way more flexible. You can invest in any mutual fund, any ETF, any stock or bond,

01:55:31.520 | or even some of the more fun options that many of you would love to be able to do. Many of you get

01:55:37.680 | really upset and annoyed with, "I can only buy this mutual fund," because either you don't trust

01:55:41.920 | the stock market or you're a really great real estate investor or you have some notable skill

01:55:47.920 | or you have a personal bias in one direction or another. So I found two stories when I was

01:55:54.480 | researching this. So here's how you do it. Basically, you need a custodian that's going

01:55:59.920 | to allow you to do this. And you're going to set this up very simply with basically setting up an

01:56:05.840 | LLC and then you're going to invest through an LLC. The way that I would do it is I would set up

01:56:11.040 | an LLC. I would invest through that LLC and I would have that member units in that LLC owned by

01:56:17.840 | my educational savings account. There are lots of people. If you go online, do a DuckDuckGo search

01:56:23.600 | and find some people that can work with. This is specialized. I want to make you aware of the

01:56:27.120 | option, but you're going to want to work with an investment provider who's going to help you with

01:56:30.720 | this. Shop around. There are more of them coming out. As far as how this is useful is that there

01:56:37.600 | are a lot of fun things that many people like to invest in that are hard to do in the traditional

01:56:43.360 | broker-dominated mutual fund world. So if you wanted to invest in real estate here in the US,

01:56:51.120 | or you wanted to invest in a real estate development project in Brazil, or you wanted to

01:56:56.320 | trade options, you wanted to buy and sell notes, you wanted to do liens in real estate, you wanted

01:57:02.160 | to own stock, limited partnership interest, different things, you can do that if you set up

01:57:08.720 | a self-directed account. What you can do is with some of these custodians, what they offer

01:57:13.600 | is they offer you the ability to essentially merge your accounts. So you can set up a self-directed

01:57:18.880 | 401k, you can set up a self-directed health savings account, you could set up a self-directed

01:57:23.600 | educational savings account, and then you could invest in a certain investment through all of

01:57:28.800 | those accounts. The key is, remember, that your funds in an ESA cannot be commingled except if

01:57:35.200 | it's in a common investment option. And so that's what they're doing, is helping you set that up.

01:57:40.320 | You need the legal structure to do it on paper, but you can do it. So I found a couple of stories

01:57:45.680 | as part of the sales stories, and I'm going to read you these stories that I found online just

01:57:49.440 | because it illustrates the point. And supposedly, these are real stories by the custodians who are

01:57:56.080 | vying for your business to set this up for you. But one story says, "One client..."

01:58:03.360 | Okay, so, "With the small contribution limits for Coverdell ESAs, you might wonder how these

01:58:08.000 | investments can be made. Often these accounts are combined with other self-directed accounts,

01:58:12.400 | including traditional, Roth, SEP, and simple IRAs, health savings accounts, and individual 401k

01:58:18.240 | plans to make a single investment. For example, I combined my daughter's Coverdell ESAs with our

01:58:24.320 | Roth IRAs to fund a hard money loan with two points up front and 12% interest per year."

01:58:30.240 | Hard money lending is an interesting real estate deal. We'll get into some other time.

01:58:35.200 | If any of you are experts in the hard money space, I'd love to do that in the form of an

01:58:38.240 | interview. I've never worked in this space. I know some people who do hard money lending,

01:58:41.920 | but if any of you are experts, shoot me an email, joshua@radicalpersonalfinance.com,

01:58:46.560 | and let me know. Continuing with the story, "One client supercharged his daughter's Coverdell ESA

01:58:52.080 | by placing a burned down house under contract in the ESA. The contract price was for $5,500,

01:58:59.680 | and the earnest money deposit was $100. Since the ESA was the buyer on the contract,

01:59:06.080 | the earnest money came from that account. After depositing the contract with the title company,

01:59:11.440 | the client located another investor who specialized in rehabbing burned out houses.

01:59:16.960 | The new investor agreed to pay $14,000 for the property. At closing approximately one month

01:59:23.360 | later, the ESA received a check for $8,500 on its $100 investment. That is an astounding 8,400%

01:59:32.880 | return in only one month. How many people could have done that well in the stock market or with

01:59:37.600 | a mutual fund? But the story gets even better. Shortly after closing, the client took a tax-free

01:59:43.520 | distribution of $3,315 to pay for his 10-year-old daughter's private school tuition.

01:59:50.000 | Later that same year, he took an additional $4,000 distribution. Assuming a marginal tax

01:59:56.080 | rate of 28%, this means that the client saved more than $2,048 in taxes. In effect, this is the same

02:00:03.440 | thing as achieving a 28% discount on his daughter's private school tuition, which he had to pay anyway."

02:00:10.240 | So that's a kind of a fun anecdote. I assume it's true. I don't have any reason to doubt it, but

02:00:14.800 | a lot of times you read the sales copy on some of these people and I just question some of it.

02:00:20.560 | So that's a cool story. And it's a really useful, I think it's a really useful strategy. For some

02:00:25.840 | of you who are investing experts and you are doing a lot of your own stuff self-directed,

02:00:30.960 | consider this because it really can be a useful scenario. And especially, yeah, it can be a useful

02:00:39.120 | scenario. I want to read you one other story here, which was kind of interesting in another one of

02:00:44.800 | these advertising ones for one of the custodians. It's called "Solving High Educational Costs with

02:00:50.400 | Just One Deal." By the way, if you're not familiar with real estate, real estate investors love to

02:00:54.160 | tout these deals and they're awesome when they go. And I think experienced people do get them,

02:00:58.800 | but I would not get into the real estate business thinking that this is not the norm. It's being

02:01:03.120 | reported because it's an amazing deal. So keep that with a grain of salt. It's doable. I've met

02:01:08.560 | investors, talked to them, who've done these deals, but it's still unusual. Doesn't invalidate the

02:01:13.680 | concept, but don't take this as, "Ah, this is what I'm going to do," unless you are already an expert

02:01:18.240 | or plan to become one. Being familiar with real estate investing, the Smiths took full advantage

02:01:23.840 | of the Coverdell ESA's tax-free qualities. Their first year, they used $500 from their account

02:01:30.160 | to purchase an option on a real estate property, selling that option later in the year for $12,000,

02:01:36.720 | a profit of $11,500 tax-free, my note, as long as it's used for educational expenses.

02:01:42.640 | At the end of the year, the $2,000 original contribution plus the $12,000 option sale,

02:01:49.280 | minus $500 in investments, had become a total of $13,500. In just one year, the Smiths had already

02:01:56.800 | stacked away enough money to put their child through college for one year. The Smiths gained

02:02:02.320 | control of their child's educational expenses with just one deal. The second year, the Smiths

02:02:07.600 | continued to contribute the full $2,000 to their Coverdell Educational Savings Account. That year,

02:02:13.360 | they purchased another real estate option for $1,000, which they sold during the year for $11,000,

02:02:18.320 | making another $10,000 in tax-free profits. By the end of the second year, the Smiths contributed

02:02:24.880 | just $4,000, but their account was now worth $25,500, all tax-free if used for education.

02:02:32.320 | After their success with their first two deals, the Smiths continued to do more real estate option

02:02:37.680 | deals, and once the account grew larger, they purchased and rehabbed a property.

02:02:41.920 | When their child turned 18 and was ready to attend college, the Smiths had saved more than $100,000

02:02:47.520 | in their Coverdell Educational Savings Account. With the average cost to attend a public college

02:02:52.080 | being around $13,000 a year, they saved more than enough to put their child through four years of a

02:02:56.800 | college education. It's not difficult to see how Joe and Sally Smith will continue in the future

02:03:01.200 | to gain control. Blah, blah, blah. You get the point. Now, real estate option investing, is it

02:03:06.160 | work? Yeah, it works. Very specialized. I don't have a clue how to do it. I've never done it,

02:03:10.400 | but I've read enough real estate investors who've talked about it. If you are a real estate investor,

02:03:14.640 | I would encourage you, consider this. Consider this as an option,

02:03:19.200 | because there are... As an option, no pun intended. You could do this, and especially if you found a

02:03:25.360 | deal that you were pretty confident in, and it was a small deal like these examples that they

02:03:30.080 | have done, it might be a fit for you, just for a few of you. It might really be a good idea for you.

02:03:35.520 | Some of these guys will help you set it up with a checkbook where your LLC, you set up a self-directed

02:03:41.120 | IRA that owns your LLC, you become the controlling member of the LLC, and you basically have the

02:03:47.920 | checkbook of the company's LLC. To the best of my knowledge, correct me if I'm wrong,

02:03:53.120 | I think this works. I think you could do some fun stuff with this. Real estate is the most

02:03:59.120 | significant, I think. That would be one of the areas I would focus on. If I were doing it,

02:04:05.920 | I would follow all of the rules for investments in a self-directed IRA, which is convenient,

02:04:11.280 | because sometimes some of these custodians seem to be setting it up for you so that, in essence,

02:04:16.960 | you can use your self-directed IRA, your self-directed HSA, and your self-directed ESA,

02:04:22.880 | and you can invest into deals with those because you've set up a common investment fund.

02:04:27.120 | Perhaps they're doing it. I'm not exactly sure. I probably should reach out to somebody and talk to

02:04:31.760 | them, but I assume they're doing it in terms of splitting the member units of the LLC among those

02:04:37.360 | accounts. The accounts are holding the member unit of the LLC, and that's what I would guess

02:04:43.440 | is what they're setting up. But in a self-directed IRA, there are certain things you're disqualified

02:04:49.600 | from investing in. You cannot invest in collectibles, so you can't buy artwork, you

02:04:54.960 | can't buy rugs, you can't buy antiques or metals or gems or stamps or coins or alcoholic beverages

02:05:01.280 | or other tangible personal property in an IRA. You cannot do that in an IRA. There is an exception.

02:05:07.920 | Some of you are like gold and silver bugs, or what do you call yourselves? Gold bugs and silver

02:05:12.080 | stackers, right? I think that's the name that you use for yourselves. You can invest, your IRA can

02:05:17.600 | invest in one, one-half, one-quarter, one-tenth ounce US gold coins or one-ounce silver coins

02:05:24.160 | minted by the Treasury Department. It can also invest in certain platinum coins and certain gold,

02:05:29.120 | silver, palladium, and platinum bullion. So I don't see any problem with some of you guys who

02:05:36.160 | want to invest in physical coins. I don't see any problem in doing that with your self-directed ESA.

02:05:42.080 | And just make sure that you're buying American eagles, either gold eagles or silver eagles,

02:05:46.960 | and American gold or silver eagles are explicitly permitted for self-directed IRAs. That's an

02:05:55.040 | exception. So don't buy your numismatic francs or 1,700 gold sovereigns from wherever in this

02:06:02.240 | account, but just toss your new American gold and silver eagles and use that as part of your,

02:06:08.240 | put it into your allocation. Some of you guys are doing the, let's see, the permanent portfolio.

02:06:13.600 | I would have no problem setting, set this up, have your LLC, rent the safety deposit box to put it in,

02:06:19.920 | or have your LLC buy a safe or do something like that and make sure that your LLC has the ownership

02:06:25.920 | of those assets. And if you feel that they're going to go up in value, great. Now, many of you

02:06:30.480 | who were in that scenario, in that line of thinking are going to say, what's the point

02:06:34.160 | of the tax savings? I can walk down and sell the money and do a cash transaction,

02:06:41.680 | 2,000 bucks. You can easily do $2,000 transactions and it's totally off the books and you could sell

02:06:47.360 | it for kids' college and you're on the black market. I can't argue with your logic. I just

02:06:51.360 | pointed out to you as far as being a scenario that I see the way that you, one option, because a lot

02:06:56.800 | of you are always looking for that and saying, how can I figure out how to do this? But I would

02:07:03.520 | look at it with real estate is what I would probably do. Again, you could do some cool

02:07:09.520 | stuff with it. And this is where we'll get into self-directed IRAs at some point, but you could

02:07:13.440 | do some stuff. You could buy apartments and mobile homes and commercial real estate. You could do tax

02:07:17.600 | liens and notes and all kinds of stuff. So there's no reason why you can't set it up. And again,

02:07:25.120 | remember, you can always start with the ESA and then put excess contributions into the 529.

02:07:29.680 | You cannot do self-directed stuff, to the best of my knowledge, in the 529 account. So that's not

02:07:33.760 | going to work for those of you who are doing that scenario. So last three things and we're done.

02:07:39.040 | Let's talk about bankruptcy protection. Let's talk about college tuition, qualification,

02:07:44.800 | assets and financial aid process. And then we're going to talk about estate taxes and gift taxes.

02:07:49.440 | And then we're done. But these are important aspects to it. And hopefully you're starting

02:07:53.120 | to see, if you're listening to the show and you're two hours in, hopefully you're starting to see

02:07:57.120 | why I started the show and why I'm two hours into an episode and I've still got three other

02:08:02.640 | things to cover. This is the value of a good financial planner. This is why rich people

02:08:07.360 | hire good financial planners. And you may have a situation that's simple enough you don't need to.

02:08:13.360 | In that case, great. Use this knowledge and do something else. But a good financial planner can

02:08:17.680 | save you a lot of money with all of this stuff. Bankruptcy. U.S. bankruptcy laws changed

02:08:23.600 | significantly in 2005. And those laws, what most of you would have read about, was the changes in

02:08:30.400 | basically how easy or difficult it was for people to file bankruptcy with credit card debt or based

02:08:35.680 | upon credit card debt. But there was something important in that law. It was the Bankruptcy

02:08:40.720 | Abuse Prevention and Consumer Protection Act of 2005. There was an important change for

02:08:46.800 | people who were saving for college. And it was additional protection or rather clarifying of

02:08:51.760 | protection for 529 plans and Coverdell educational savings accounts. And so this is important. You

02:08:58.400 | always want to be thinking about bankruptcy protection. Just because you don't borrow money

02:09:02.400 | doesn't mean you can't be forced into bankruptcy. And the problem with bankruptcy planning and

02:09:06.640 | bankruptcy protection is you have to have it in place long before you're ever in a situation where

02:09:11.280 | you're pressured. If you talk to any bankruptcy attorney, I just think constantly, "How can I

02:09:16.480 | protect from bankruptcy? Protect from bankruptcy? Protect from bankruptcy?" You don't want to be

02:09:20.720 | wiped out. So think about bankruptcy from the beginning when things are going well. Because

02:09:25.120 | the bankruptcy law is consistent. You cannot do things last minute to shelter yourself from

02:09:30.080 | bankruptcy. But you can do things up front that are smart and intelligent so that if for some

02:09:35.680 | reason you are forced into bankruptcy, and maybe there can be many reasons, whether it's you had a

02:09:42.160 | negative legal event where your daughter or son kills somebody and you get sued, somebody slips

02:09:49.120 | and falls, and for whatever reason you get a judgment against you, maybe it's a medical

02:09:52.880 | malpractice judgment, maybe it's some kind of issue where you're forced into bankruptcy even

02:09:58.160 | if you're not doing risky investing. If you are doing risky investing, and risky investing is

02:10:02.560 | called starting a business, plan for bankruptcy 10 years before you ever start the business and

02:10:07.360 | take care of yourself. That is prudent planning. Know the laws and take advantage of them. One of

02:10:12.640 | them that you can take advantage of is the creditor protection and the bankruptcy protection

02:10:17.920 | in 529 accounts and educational savings accounts. This was strengthened in that law that was passed

02:10:24.800 | in 2005. It was finally clear federal legislation protecting these college accounts in the same way

02:10:34.240 | that there's clear federal legislation protecting 401k accounts and pension accounts. There's clear

02:10:39.120 | federal legislation protecting college accounts. Coverdell educational savings accounts are

02:10:46.240 | covered. There are some details that you need to be aware of. Basically what you want to do is you

02:10:52.720 | got to fund these things long before you ever get into bankruptcy. What they set up as a scenario,

02:10:58.560 | as far as the rules, is that if you get too close to the bankruptcy date, there's limited protection.

02:11:03.840 | If you set up an ESA for your kids and you put $2,000 in every year for the first 10 years of

02:11:08.960 | their life, and then when your oldest child is 15 years old, you go into bankruptcy, all of the

02:11:14.800 | contributions prior to that time are going to be protected. If you did contributions within,

02:11:21.040 | what is it, 720 days, I think it was 720 days, two years basically. If you made a contribution

02:11:26.240 | in the last two years, only about $5,000 is protected from bankruptcy law. Anything older

02:11:34.800 | than two years is fully protected in case of bankruptcy. Anything in the last two years,

02:11:40.160 | what is it, is either not protected or it's protected only to the tune of $2,000.

02:11:49.920 | So sorry, any funds contributed in the last 365 days, those are available to the bankruptcy court.

02:11:56.640 | Now there are some gotchas, and you got to make sure that you take care of this

02:11:59.680 | with your bankruptcy attorney. Make sure if you're ever going through bankruptcy,

02:12:03.600 | work with a good bankruptcy attorney because the funds that are in an ESA,

02:12:10.960 | in an educational savings account, are excluded from the bankruptcy estate as long as the debtor

02:12:17.760 | files a notice into the record of the bankruptcy case of his interest in the account. So you need

02:12:24.320 | to tell the bankruptcy court about it. If you don't do some of these things, if you don't do

02:12:30.800 | that, then it might be included in the bankruptcy estate, which is available for your creditors.

02:12:35.280 | If you file the notice, as I understand it, I'm not an attorney or a bankruptcy specialist,

02:12:40.080 | as I understand it though, as long as you file the notice, then that is fine.

02:12:44.560 | The other exceptions that might result in the funds being included in the bankruptcy estate,

02:12:49.520 | which is available to your creditors, is if the child was not a child, including stepchildren and

02:12:55.200 | grandchildren, was not a child of the debtor during the tax year that the funds were deposited

02:13:00.080 | into the ESA. So that could occur if a child was adopted after the money was put into the

02:13:05.360 | educational savings account, so you'd be careful there. If the funds are excess contributions,

02:13:12.640 | then those are also going to be available to the creditors, so you want to be careful there.

02:13:18.720 | It's just worth being careful of. So useful from the perspective of if you're doing asset

02:13:25.600 | protection planning, aka bankruptcy planning for a client, this can be a useful account for you.

02:13:31.200 | Next is financial aid, and this is a very, very detailed scenario of financial planning,

02:13:38.480 | because 529 accounts and educational savings accounts do affect your child's eligibility for

02:13:43.760 | financial aid. And this is, as far as my observation, one of the most uncertain, constantly changing

02:13:49.360 | scenarios of financial planning that I'm aware of. And so I would definitely be working with

02:13:55.440 | a specialist if I were doing extensive planning in this area. But in essence, a couple of rules.

02:14:02.880 | It's probably better to keep the money in a 529 account. It is a couple of general rules as I

02:14:08.400 | understand them here in November 2014. If any of you specialists catch something I say wrong,

02:14:13.120 | come by and correct me at radicalpersonalfinance.com/coverdell.

02:14:16.160 | It's always better to put the money in a 529 account or an ESA rather than just to give it

02:14:22.480 | to the child or put it in a custodial account. So that is one useful thing. From the regard of

02:14:26.800 | financial aid, usually what we're talking about here is figuring out the FAFSA, which is the

02:14:31.840 | Federal Free Application for Federal Student Aid form. If you read through the FAFSA, you'll see

02:14:37.120 | that it requests different bits of information. And so you got to be careful there. But if money

02:14:42.320 | is in a college account, it's probably going to be better off to be in a college account than it is

02:14:50.880 | to be in just an account that the child has control over. If you study the FAFSA, I think

02:14:57.600 | you find some planning opportunities if you have grandparents or other people. So for example,

02:15:02.400 | if a grandparent opens an educational savings account for their child or a 529 with the child

02:15:08.240 | as a beneficiary, it may not be reflected on the FAFSA. Some schools do use a different form called

02:15:15.280 | the CSS profile, and that form does reflect balances for any other plan where the student

02:15:22.160 | is simply a named beneficiary, not just as an owner of the account. An educational savings

02:15:28.240 | account, a Coverdell account, is treated as an asset of the account owner. If the account owner

02:15:34.960 | is the student, then that is going to impact their financial aid eligibility. But that changed a

02:15:43.200 | little bit, however, based upon whether the student is a dependent student or not. So the law that

02:15:49.360 | would be referenced by the specialists in this area, the Higher Education Reconciliation Act of

02:15:54.800 | 2005, added a special treatment for Coverdell accounts, prepaid tuition, and 529 college savings

02:16:02.080 | plans that are owned by a dependent student. And the impact on need-based aid for dependent

02:16:10.080 | students will be minimal. If the account owner is the parent, this has a low impact, the ESA has a

02:16:16.720 | low impact on financial aid eligibility. Qualified distributions from a Coverdell account are not

02:16:22.400 | counted as income on the FAFSA, and thus do not reduce financial aid eligibility. So you got to

02:16:28.240 | be careful here as far as what the rates are. And in general, there are usually benefits to having

02:16:35.120 | the money in the parent's name. When you start looking at the details of the Coverdell, you want

02:16:40.320 | to take a look and see which person is the account owner. If the child is the account owner, then

02:16:46.960 | it's a child asset. If the parent is the account owner, then it's a parent asset. So in many cases,

02:16:53.520 | the child is listed as the account owner, but be careful with your paperwork as far as how you

02:16:58.480 | set this up. If the ESA is owned by a student and the student is both the account owner and

02:17:07.600 | the beneficiary, then it's too complicated for me to get into. Spend some time with a specialist

02:17:16.480 | if you're going in this area. I don't want to go any deeper into this simply because I think it

02:17:21.280 | just gets too confusing. In general, I think it's better to have the parent as the owner and the

02:17:26.160 | child as a beneficiary. Oftentimes, if you're doing this kind of planning, then the whole federal

02:17:32.800 | student aid thing is so impossible for me to predict simply because the law is going to change.

02:17:38.000 | It changes all the time. Again, you get into the deal of it's impossible to predict, at least in

02:17:43.120 | my opinion. So you've got to look at your account paperwork and work with your advisor and read

02:17:48.640 | through this. Do some looking online and read through this because you've got some Coverdell

02:17:53.440 | paperwork is going to have the designated beneficiary and a responsible person. Some

02:17:58.400 | are going to have a depositor and you want to make sure that you get that correct. Then,

02:18:03.520 | depending on if you're dealing with the income limits or not, that's going to affect your

02:18:07.120 | situation. It really doesn't matter in many ways because depending on how much money you have in

02:18:17.360 | the account, how much money you're actually planning for, a lot of times these are fairly

02:18:22.080 | clear. The person's not eligible for financial aid or it's minimally eligible or we get into the

02:18:26.560 | world where it's a little bit specialized. I'd encourage you, there's a whole team of financial

02:18:29.680 | planning. I don't even remember the name of the organization right now that specializes in

02:18:32.880 | education planning. I'd encourage you to consider talking to them or to your own planner.

02:18:38.160 | Last thing here is estate taxes. With this, we're going to close.

02:18:42.320 | But estate taxes, you need to be aware of it, especially this is going to be more applicable

02:18:46.480 | to many of you who are financial planners as far as how to use this in your estate tax planning.

02:18:52.000 | There's a really great, I'm just going to read a one and a half page guide here from Kay Thomas

02:18:58.800 | who's writing at fairmark.com. I thought about going through and doing this, but she does the

02:19:03.120 | best summary. I can't improve it, so I'm going to read it and link to this in the show notes.

02:19:07.120 | But it's very clear and it's very useful. If you're not familiar with estate taxes,

02:19:11.520 | just listen and try to absorb the language. But for you planners, this will be useful.

02:19:16.160 | So the special rules that apply to a Coverdell account for estate and gift taxes are favorable

02:19:23.280 | in some ways and unfavorable in other ways. Contributions. A contribution to a Coverdell

02:19:29.280 | account is treated as a completed gift of a present interest. That's tax speak for the

02:19:35.440 | kind of gift that qualifies for the annual gift tax exclusion. Normally, if you make a gift in

02:19:41.280 | a trust and retain the kind of controls you can have in a Coverdell account, the gift will not

02:19:46.400 | qualify for the annual gift tax exclusion. The special rule here allows you to make annual

02:19:52.160 | contributions to a Coverdell account without filing a gift tax return if your total gifts

02:19:57.200 | for the year are within the annual exclusion amounts. However, a contribution to a Coverdell

02:20:03.120 | account does not count as a tuition payment that can be excluded from gift tax treatment.

02:20:08.000 | That means you have to treat this contribution as a gift when you add up your total gifts for

02:20:12.880 | the year to this beneficiary. If the total is greater than the annual exclusion amount,

02:20:17.360 | you'll have to file a gift tax return. So in this scenario, when you're looking at the gift tax,

02:20:21.920 | it is a completed gift of a present interest. So therefore, it is outside of the estate,

02:20:31.520 | which it means it's qualified as a gift, but you can't additionally make the gifts.

02:20:37.760 | It's not a tuition prepayment. So you could have the donor make the payment directly to the

02:20:43.360 | university, and in that situation, it would be excluded from being a gift as long as it's

02:20:48.640 | directly to the university. This doesn't qualify for that. So just be aware of that difference.

02:20:53.520 | This would be counted as part of your annual gift tax exclusion calculations.

02:20:59.840 | Withdrawals. Given that you're making a gift when you put money into a Coverdell account,

02:21:05.280 | you would expect to find out that you're not making a gift when you take money out,

02:21:09.280 | and that's what the law provides. Except in the case of certain changes in beneficiary described

02:21:13.760 | below, there's no gift at the time money is withdrawn from a Coverdell account.

02:21:17.520 | Change in beneficiary. When you change the beneficiary of a Coverdell account,

02:21:22.400 | you're changing the owner. In most cases, this change in ownership is not considered a gift.

02:21:28.240 | Yet a change in beneficiary to someone in a generation below the generation

02:21:33.040 | of the current beneficiary is treated as a gift by the current beneficiary. There are detailed

02:21:39.440 | rules for assigning family members to generations for the purposes of this rule, but the basic idea

02:21:45.680 | is as follows. Treat the beneficiary's spouse as being in the same generation as the beneficiary,

02:21:51.440 | no matter what the difference in age is. For all others, determine the generation by counting the

02:21:56.400 | number of generations from the grandparent of the beneficiary to that person. So you need to be

02:22:00.960 | careful with this when you get to generation skipping transfer tax and just follow the careful

02:22:05.040 | rules. Just research it, but that's the general gist of it. Example, you set up a Coverdell

02:22:11.200 | account for your son, but you never use it for his education. If you change the beneficiary to one of

02:22:17.040 | his brothers or sisters, there is no gift for tax purposes, even though there was a transfer in

02:22:22.640 | ownership of the property. Similarly, there's no gift if the new beneficiary is your son's aunt or

02:22:28.080 | uncle, because they're in a generation above your son's generation. If the new beneficiary is your

02:22:32.960 | son's child or your son's niece or nephew, your son is treated as making a gift and must file a

02:22:37.920 | gift tax return if total gifts to that person for the year exceed the annual exclusion amount.

02:22:43.440 | So, a wordy example, but it does matter, especially when you're talking about what I was

02:22:50.400 | talking before about how you could set this up for multiple generations. Pay careful attention to

02:22:54.880 | this. A gift greater than the annual exclusion amount. When a contribution to a Coverdell account

02:23:00.480 | exceeds the annual exclusion amount, the donor can elect to spread the gift tax treatment over

02:23:05.360 | five years. This rule has no significance for regular contributions to Coverdell accounts,

02:23:10.240 | because the $2,000 maximum is smaller than the annual gift tax exclusion. It's possible that

02:23:16.000 | this rule will apply when a change in beneficiary results in a gift of a Coverdell account that has

02:23:21.280 | grown to a value greater than the annual exclusion amount, but we'll need further guidance from the

02:23:26.000 | IRS before we're certain the rule applies in this situation. And then estate tax. Normally,

02:23:31.200 | if you retain the kind of powers you have in a Coverdell account for your child, the value of

02:23:35.360 | the trust would be included in your estate at death for purposes of the estate tax. Under a

02:23:40.160 | special rule, a Coverdell account is not included in the estate of the person who set it up.

02:23:44.800 | There's one exception. If a gift greater than the annual exclusion amount was spread over five

02:23:50.080 | years, as described in the preceding paragraph, part of the gift will be included in the donor's

02:23:56.000 | taxable estate if the donor dies within five years after making the gift.

02:24:00.240 | What about the beneficiary's estate? Normally, this isn't an issue because you would rarely see

02:24:06.000 | a beneficiary of a Coverdell account with enough assets to worry about estate tax. Where that may

02:24:11.360 | be a concern, though, there's a special rule. The amount included in the beneficiary's estate is

02:24:16.400 | only the amount distributed on account of the beneficiary's death. It appears that if the

02:24:21.760 | account continues after the death of the beneficiary, because another individual was

02:24:26.320 | designated to receive the account on the death of the beneficiary, the account will not be included

02:24:31.200 | in the taxable estate of the deceased beneficiary. Hope I didn't lose all of you people who are not

02:24:38.880 | financial planners at the end, but I did want to make, in order to create a complete resource here,

02:24:42.960 | which is what I'm trying to do, I did want to make sure that I mentioned the estate tax rules.

02:24:46.400 | It really is an interesting account. It really is. And the Coverdell account is often pooh-poohed

02:24:53.280 | by people simply in the same way that it was pooh-poohed by that Forbes writer. It's just said,

02:24:58.240 | "Ah, this is a ridiculous account." That's always what I thought until I started researching it.

02:25:03.200 | Because again, they must know what they're talking about. And then I started researching it and I

02:25:07.440 | found, "Wait a second. None of those things apply. I could figure out a way to use it."

02:25:12.720 | Many people get into this comparison of top 529 account versus educational savings account. And

02:25:17.440 | that is right. As far as the comparison, if I had to make a judgment call, I would say that in many

02:25:25.280 | ways the ESA is going to be more flexible. And depending on how much you're saving, I would

02:25:30.640 | discourage... So let me pause. I would first say, don't save for college. Save for retirement

02:25:36.640 | first. And when you are way on track for retirement, then save for college. That's

02:25:41.200 | going to cut out most of you. Number two, I would say, why would you save so much money for college

02:25:46.160 | that when there's so many cheap options, and why would you want all the money stuffed aside in the

02:25:50.960 | college account? That would get rid of a lot more of you. And it's a lot easier to go to college

02:25:54.240 | for cheaper than save all this money. Now, for those of you to whom college is a big deal,

02:25:58.560 | and you have a lot of money, and we're doing very fancy planning, then I would look at these

02:26:02.960 | accounts. I wouldn't suggest college accounts for the average rank and file, median income,

02:26:08.400 | $45,000 a year family. Just why bother? It's too much hassle for too little reward when you're

02:26:13.520 | putting aside $100 a month. But if we're getting into very fun, sophisticated planning, then go

02:26:19.440 | ahead and get into this. And I think the Coverdell has some advantages, has some disadvantages as

02:26:24.800 | well. But that's actually how I'd answer the question. If I had to go between them, I'd

02:26:29.600 | probably start with the Coverdell account. I like the investment flexibility. The $2,000 number,

02:26:34.720 | though, makes it really tough to get money in. So usually, we're just automatically going to be

02:26:39.840 | doing this and a qualified tuition plan, a 529 savings plan, because we can frontload it so much.

02:26:45.520 | And we'll deal with that in another show on another day. So to wrap up these four things,

02:26:52.320 | let's see if I got them right. First, the problem that I started the show with, the Coverdell

02:26:57.200 | contributions are limited to $2,000 a year. 529s are pretty close to unlimited. He's right.

02:27:02.400 | But that's less of a story, especially knowing that there are some exceptions to that.

02:27:07.600 | For example, the SGLI, the Service Members Group Life Insurance, money can go into that. And also,

02:27:13.520 | the contributions are limited. But once you build them up over time with multiple beneficiaries,

02:27:18.240 | you can start to get some serious money into this if you do. And then the beneficiary can

02:27:22.000 | be transferred. So you could create a process to get money into them. The right to contribute to

02:27:26.560 | a Coverdell is phased out as the parent's income passes $190,000 and the 529 has no income rules.

02:27:31.760 | That's exactly right, except that that's the easiest rule to circumvent that was ever written

02:27:36.320 | into tax legislation. Number three, there's a good chance you'll get a state tax deduction on

02:27:40.880 | the 529 contribution. I admit it to him here. He's right. It's that the 529, you can deal with your

02:27:47.040 | state tax deductions. However, and you don't get that with the Coverdell, but consider the

02:27:51.680 | investment opportunities. And the Coverdells have time limits. They have to be started before the

02:27:55.840 | beneficiary turns 18 and used up by age 30. That's true. But when you can make a qualified

02:28:00.720 | distribution at the age of 30, right into a 529, what's the difference? What's the difference?

02:28:07.360 | Same old, same old. I hope you enjoyed my epic. I know it was a lot and feel free to listen to

02:28:15.200 | this a couple of times. If this show didn't appeal to you, if you didn't understand the language,

02:28:20.720 | I hope you still listen to it because sometimes that's okay. I know when I first got into

02:28:25.520 | financial planning, I didn't, I was like, what's an annual exclusion amount? What's a crummy notice?

02:28:28.960 | All these words. And you start to hear them and all of a sudden you'll start to hear them in

02:28:32.000 | context and they will make a difference for you. But that's my information on Coverdell

02:28:38.560 | educational savings accounts. Hopefully it's useful for you. I've never seen anything like

02:28:43.040 | this brought together, especially not an audio form. You read articles and usually they're a

02:28:47.040 | page or two, but none of them are very complete. So I think that by listening to this, you have

02:28:50.800 | a complete resource and I've created it so that I can send people with questions to this.

02:28:55.520 | This information has been helpful for you. I would love it if you consider joining the

02:28:59.040 | membership program that I've created, the irregulars. That's how I pay the bills here

02:29:04.240 | at the moment is entirely listener support. So if I helped you save some money, again,

02:29:08.560 | this was as a financial advisor, I could never do this because how could I spend two and a half

02:29:12.960 | hours answering someone's question on this, but I could do it in a podcast. So I would be thrilled

02:29:17.360 | if more of you would consider joining the membership program, totally voluntary. If you

02:29:20.640 | can't do it, no big deal. I understand. I mean it. If you found some mistakes, anything I said

02:29:26.240 | today, I need to know about it. I've done the best I can, but even as the disclaimer, which

02:29:30.240 | I'll play in just a moment says I'm one guy sitting down trying to create useful instructional

02:29:36.080 | media for you. So check out, let me know if you're going to act on this information, come by the

02:29:43.520 | show page at radicalpersonalfinance.com/coverdell and take a look at it and see if anybody's

02:29:49.680 | commented and corrected anything in any of the information today. I think that's it. Tomorrow,

02:29:57.280 | I'm going to push David Downey's interview off. I may release it tomorrow for you or I may do a Q&A

02:30:01.440 | show. I'll decide that in the morning. I'm tired.

02:30:08.400 | [music]

02:30:32.720 | Thank you for listening to today's show. This show is intended to provide entertainment,

02:30:38.160 | education, and financial enlightenment. Your situation is unique and I cannot deliver any

02:30:46.720 | actionable advice without knowing anything about you. This show is not and is not intended

02:30:54.320 | to be any form of financial advice. Please, develop a team of professional advisors who you find to be

02:31:04.480 | caring, competent, and trustworthy, and consult them because they are the ones who can understand

02:31:12.000 | your specific needs, your specific goals, and provide specific answers to your questions.

02:31:18.640 | Hold them accountable for your results. I've done my absolute best to be clear and accurate in

02:31:25.280 | today's show, but I'm one person and I make mistakes. If you spot a mistake in something

02:31:30.480 | I've said, please come by the show page and comment so we can all learn together.

02:31:35.120 | Until tomorrow, thanks for being here.

RPF0106-Coverdell_ESA