Americans Abroad – How to Cope With Tax Reform & Save for Education

President Trump’s tax reform was signed into law on December 22.  My blog post last week detailed how the newly revised “kiddie tax” rules will take a big bite out of a young person’s investment income, thwarting many parents’ plans to save for a child’s later education in a tax-efficient manner. Starting this year, thanks to the new “kiddie tax” rules, successful investments will now carry a very heavy tax cost for young people.  Today’s blog post will examine a possible option for maximizing educational savings for children without having the funds eaten up by the voraciously hungry “kiddie tax.”

Educational savings is very often a top priority for parents. One possible option is to consider so-called 529 plans.  (The plans get their name from US Internal Revenue Code Section 529). These plans can be used by Americans living and working abroad as a tax-efficient way to save for their children’s education. Every US state has at least one 529 education savings plan.  No state imposes any residency restrictions on 529 plan account owners.  Thus, while a US person living abroad might not be considered to be a resident of any particular state, he or she is still able to create a 529 college savings plan.

Here are a few facts about such plans:

  • First, prior to President Trump’s tax reform, money in the 529 plan could be used for undergraduate or graduate studies at any accredited two- or four-year campus in the United States and certain educational institutions overseas.  The new law just signed by President Trump now allows 529 plans to be used for Kindergarten – Grade 12 education expenses, and based on the statutory language, it is not fully clear if schools located abroad that provide K-12 education can qualify.  I suspect the IRS will issue further guidance on this point in the near future. The 529 plan can be used for “expenses for tuition in connection with enrollment or attendance at an elementary or secondary public, private, or religious school.”  (Homeschooling expenses are not permitted).  Beginning this year, 529 plans can pay up to $10,000 a year for K-12 educational expenses. With the newly expanded benefits of 529 plans, this might be an option to more seriously consider when saving for a child’s education.  The latest list of eligible schools can be found at 2018-2019 Federal School Code List in Excel Format.
  • A 529 college plan is an educational savings plan generally operated by a state or state agency. It often works similarly to other types of savings plans – contributions are invested into mutual funds or other investment vehicles; the value of the account will fluctuate based on the performance of the selected investments. The plans permit one to save for a child’s education tax-free through a variety of investment options.  Again, the account owner need not be resident in the US to open such a 529 plan.
  • Some investment packages associated with the 529 plan are age-based and initially place funds in aggressive investments when the child is young. As the child approaches college age, the package will automatically switch funds to more stable options.
  • Savings in a 529 plan are considered to belong to the parent, not the child. Thus, the parent can change the beneficiary of the plan (for example, if the child named on the plan decides not to attend college).
  • Gains earned in the plan are tax-deferred and generally are not subject to tax when used to pay for the qualified education expenses of the designated beneficiary.  Generally, the permitted expenses are tuition, school fees, books, computer and room and board. Distributions of earnings form the 529 plan that are not used for qualified education expenses are subject to income tax plus a 10% penalty tax.
  • Contributions to a 529 plan are not deductible.
  • Contributions to a 529 plan that exceed annual gifting amounts (generally $15,000 for 2018) may be subject to US Gift Tax.  Tax-efficient planning is nonetheless possible if you wish to make a contribution larger than $15,000. Under special rules that are unique to 529 plans, you can gift a lump sum amount in a particular year up to a maximum of $70,000 for individual gifts and $140,000 for gifts made jointly by spouses, and avoid federal gift tax. This is accomplished by making a special election on the Gift Tax return (Form 709) to treat the gift as if it were made evenly over a five-year period for gift tax purposes. This allows you to utilize as much as $70,000 ($140,000 for joint gifts) in annual exclusions to shelter a larger contribution from gift tax.

Challenges for the American Abroad

According to my colleague Vince Truong, a CFP  based in Dubai, opening a 529 plan when you’re not resident in the US can be challenging as some plan providers will not open accounts for US expats.  According to Vince, US providers are concerned about their ability to conduct proper due diligence under Know Your Client principles and have been gradually limiting access to expats over the last few years.  He also adds that US persons married to a non-US person may potentially have other tax-friendly investment options that won’t require a 529, and that they should also understand how the 529 could work with non-US universities, should their children opt not to study in the US.  Vince has helped a number of my clients and has been a useful resource for many based in the Gulf.  If you contact Vince and mention you read about him on my US tax blog, he may provide a brief courtesy discussion for you.

More information on 529 Plans from the IRS can be found here.

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