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

President Trump’s tax reform (commonly referred to as the “Tax Cuts and Jobs Act”, and also known as “TCJA” was signed into law on December 22, 2017.  My recent blog post detailed how TCJA revised the “kiddie tax” rules and how the new 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.  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.”

Section 529 Plans

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.  You can check to see if you can use your 529 money at the institution you’re interested in attending by doing a Federal School Code Lookup at Savingforcollege.com.  If the institution is in a foreign country, make sure you choose FC for “foreign country” in the drop down box in the STATE field.
  • Under TCJA, 529 plans can 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.  The IRS has announced it will issue further guidance 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).  Currently, 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.
  • 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 from 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 2019) may be subject to US Gift Tax.  With TCJA’s very generous lifetime exemption amount for Gift and Estate tax purposes ($11.4 million in 2019), most individuals will not need to pay an actual Gift Tax to the IRS if the gift exceeds the annual $15,000 amount. Instead, they will draw down some of their lifetime exemption amount.  A Gift Tax return must nonetheless be filed in such a case. The lifetime exemption amount is indexed annually for inflation,  but watch out! The law put in place by TCJA has a sunset provision and remains in place only through 2025. Absent further Congressional action, the current law’s generous lifetime exemption amount would revert to the prior law $5 million base, indexed for inflation.
  • 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 “bunch” of five years of annual $15,000 gifts 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 $75,000 ($150,000 for joint gifts) in annual exclusions to shelter a larger contribution from gift tax.

Challenges for the American Abroad

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.  I understand that 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.  US persons married to a non-US person may potentially have other tax-friendly investment options that won’t require a 529, and they should also understand how the 529 could work with non-US universities, should their children opt not to study in the US.  My colleague Vince Truong, CFP 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.

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