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FP511 General Financial Planning Principles, Professional Conduct, and Regulation > Module 8 > Flashcards

Flashcards in Module 8 Deck (47)
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What is generally the three step process to computing education costs / needs for a client?

In the first step, the current cost of college is inflated to reflect anticipated college costs when the student will be attending.

In the second step, an inflation-adjusted present value of an annuity due is calculated. This determines the sum of money that the student will need on the first day of college to pay for all years of attendance at a given school. By using an inflation-adjusted rate of return, both the rising cost of college expenses and the continued earnings from the investment account are taken into consideration in step 2.

In the third step, the result from the second step is discounted back to today’s amount. The present value solution reflects the lump sum savings needed today, which will grow to the specific amount needed in the future. Alternatively, the result from Step 2 could be used to determine the annual savings needed to accumulate the required funds. A third option would be to adjust for any current savings and then calculate the annual savings needed to reach the goal.


Assume that one year’s college tuition is $10,000 today, education inflation is 6%, and the rate of return is 8%. Further assume that Mary is three years old and will begin a four-year college program at age 18. Calculate the amount required to provide higher education funds for Mary.

Step 1 (END MODE) - Calculate the future value of annual college costs when payments begin - $23,965.5819

Step 2 (BEGIN MODE) - Calculate the present value of the annuity due - $93,232.2076

Step 3 (END MODE) - Calculate the present value of the above PVAD - $29,390.6801


Barry and Virginia have a six-year-old son, Daniel. They have plans for Daniel to attend a four-year private university at age 18. Currently, tuition at the local private university is $15,000 per year and is expected to increase at 7% per year. Assuming Barry and Virginia can earn an annual compound return of 10% and inflation is 4%, how much does the couple need to start saving at the end of each year (starting this year) to be able to pay for Daniel’s college education? (Assume their last payment is made at the beginning of Daniel’s first year in college.)

The answer is $6,065.35. They would need to deposit $6,065.35 per year to meet the education funding goal.

Step 1: Determine the future cost of college for the first year: 15,000, +/−, PV „ 7, I/YR „ 12, N „ Solve for FV = 33,782.8738, or $33,782.87

Step 2: Determine the account balance necessary to fund college education:„ BEG mode (money is needed at the beginning of college) „ 33,782.8738, +/−, PMT „ [(1.10 ÷ 1.07) − 1] × 100 = 2.8037, I/YR „ 4, N „ Solve for PV = 129,703.2143 or $129,703.21

Step 3: Determine the required savings payments. „ END mode:„ 129,703.2143, FV „ 12 N (payments continue until Daniel reaches 18) „ 10, I/YR „ Solve for PMT = –6,065.3523, or $6,065.35


What are the four elements of calculating EFC (Expected Family Contribution), what are the protections, and how are they weighted?

1. Parental income. This includes taxable and nontaxable income from two years prior to the award year (two-year lookback) and is reduced by a specified income protection allowance. The percentage of parent income included in the EFC ranges from 22% to 47% and depends on the parent’s AGI from two years prior, number of dependents enrolled in college, marital status of the parents, and special family circumstances.

2. Parental assets. This includes almost everything owned by the parents with the notable exceptions of home equity, cars used for regular transportation, the cash value of a life insurance policy, and the parents’ accrued benefit or account balances in any retirement plans. Most non-retirement assets (e.g., cash, investments, and savings) are assessed from 5% up to a maximum of 5.64% toward the EFC.

3. Student income. This includes taxable and nontaxable income from the year preceding the award year, reduced by an income protection allowance ($6,600 in 2019) and taxes. Student income above the protected amount is included at a rate of 50% in the EFC calculation.

4. Student assets. This includes the value of everything the student owns or that has been saved on his behalf (e.g., a custodial account such as an UTMA or UGMA). Custodial accounts, trusts, and other student-owned assets are assessed at 20% toward the EFC.


Select the parental assets that are excluded from consideration when calculating the Expected Family Contribution (EFC) for federal financial aid.

A. Mutual fund ownership
B. Annual contributions to a retirement plan
C. Rental real estate property
D. The excess of value over the amount owed on a personal residence



What are Stafford Loans and who can use them?

Stafford loans (also known as William D. Ford Direct Stafford loans) are a common type of educational loan. Both direct subsidized and direct unsubsidized loans are offered through the Stafford loan program. Only undergraduates qualify for subsidized Stafford loans. If a student qualifies for a loan based on financial need, the loan generally will be subsidized. The subsidy takes the form of the government paying the interest due while the student is in school and during the six months following graduation. Unsubsidized loans have interest due within 60 days of disbursement of the money.

Any student who is enrolled at least half time is eligible to apply for Stafford loans (part-time students are not eligible).


What are PLUS loans?

Under Parent Loans for Undergraduate Students (PLUS loans), parents may borrow funds for their children’s undergraduate studies. The amount that can be borrowed is unlimited, except the total of all aid received cannot be higher than the total cost of schooling.

Part-time students are not eligible for PLUS funds, but students enrolled in programs that are shorter than an academic year may be eligible for reduced loan amounts. These loans are not need-based.


What are direct consolidation loans?

This program allows for the combination of multiple student loans into one loan. A parent loan cannot be consolidated with student loans and become the student’s responsibility to repay. Currently, for Direct Consolidation Loans, the interest rate remains the weighted average of the interest rates on the loans included in the consolidation, rounded to the next highest one-eighth of 1%.


What are Perkins loans?

Prior to the program end, Perkins loans were low interest rate loans funded by the federal government but administered by individual schools. These loans were available both to undergraduate and graduate students. They were need-based and were available to students who were attending on at least a half-time basis and who had an exceptional financial need.


What are Pell Grants?

Pell Grants are available to undergraduate students only and are distributed on the basis of substantial financial need. All students, including part-time students (students who are attending school less than half time), are eligible for Pell Grants.


What are Pell Grants?

Pell Grants are available to undergraduate students only and are distributed on the basis of substantial financial need. All students, including part-time students (students who are attending school less than half time), are eligible for Pell Grants.


What areFederal Supplemental Educational Opportunity Grants (FSEOGs)?

Federal Supplemental Educational Opportunity Grants (FSEOGs) are funded by the federal government but are administered by individual schools. FSEOGs are available to undergraduate students only and are need-based. These grants may be available to part-time students as well as full-time students.


What is a College Work Study?

Under the Federal Work-Study program, eligible students are provided employment, which may be on or off campus, to help cover the cost of their education. Federal funds are used by individual schools to administer the program. The government and the employer share in the payments made to students. Eligibility is based on financial need. College work study is available to both undergraduate and graduate students and to both part-time and full-time students.


Scott and Barbara have come to you for advice on financing their daughter’s fast-approaching college undergraduate education. They have failed to save enough money to finance their daughter’s education but currently have an annual income in excess of $150,000. Unfortunately, they spend as much as they earn. Select a suitable option for the Johnsons if there is a need to obtain education funds.

A. Subsidized Stafford loan
B. Pell Grant
C. Parent Loan for Undergraduate Students
D. Federal Work-Study Program



Describe Custodial accounts

***The first custodial accounts being consisted of those established under the Uniform Gift to Minors Act (UGMA), although in many states, UGMA accounts were then superseded by those established under the Uniform Transfers to Minors Act (UTMA)

Both accounts suffer from a major practical disadvantage: when the child attained the age of majority, either age 18 or 21 depending on state law, the child could gain access to the funds in the account, regardless of whether the funds were used to pay for a college education.

Each account can only be assigned to one child and cannot be transferred to another sibling or family member.

UGMA and UTMA assets will be included at the child’s rate of 20% when calculating the EFC for financial aid.


Describe Series EE and I Savings Bonds.

To qualify for the exclusion, the bondholder(s) must be at least 24 years old when the bond is purchased and the taxpayer, the taxpayer’s spouse, or the taxpayer’s dependent at certain postsecondary educational institutions must incur tuition and other educational expenses.

Individuals with incomes above certain thresholds may not be eligible to participate.

Eligible educational expenses include tuition and fees (such as lab fees and other required course expenses) required for enrollment or attendance at an eligible educational institution. However, expenses relating to any course or other education involving sports, games, or hobbies are eligible only if required as part of a degree or certificate-granting program. The costs of room and board, as well as books, are not eligible expenses.

A child can be named as a beneficiary on a bond, but the child cannot be a co-owner of the bond. The only eligible owners are the taxpayer (purchaser) and their spouse. Additionally, spouses must file a joint tax return to qualify for the tax benefit. The income phaseout range to determine qualification for the education tax exclusion is $81,100–$96,100 (single) and $121,600–$151,600 (married filing jointly) for 2019.


What is a Coverdell Education Savings Account (CESA)?

The total contributions to all CESAs for a beneficiary, who must be under age 18 when the contribution is made, cannot be more than $2,000 in any year.

Although contributions to a CESA are not deductible, the earnings on the account accumulate income tax free. When a CESA is distributed and used for the payment of qualified education expenses, the amounts distributed are free of income taxes and penalties regardless of the age of the donor.

Qualified education expenses are not limited to higher education expenses in the case of the CESA; expenses for private elementary and secondary education (K–12) are also allowed. In addition to tuition, expenses for room and board are permitted.

The CESA is established either in a trust or custodial account on behalf of the child.

All funds within the CESA must be used before the student reaches age 30. Any remaining funds will be disbursed to the CESA beneficiary, and the earnings will be subject to income tax and a 10% penalty. However, in order to prevent this from occurring, the owner of the CESA has the right to change the beneficiary to another family member of the original beneficiary.

Contributions are subject to phaseout. In 2019, this phaseout amount is $95,000–$110,000 of modified AGI for single taxpayers and $190,000–$220,000 of modified AGI for married taxpayers filing jointly.
Only one rollover for a CESA is allowed per individual per year.


Describe a Section 529 Plan.

What are the two types?

A QTP offers significant income tax benefits, including the ability to make contributions regardless of the contributor’s AGI, tax-free earnings growth, and tax-free withdrawals to the extent they are used to pay qualified higher education expenses.

For distributions after December 31, 2017, qualified education expenses include only tuition at an elementary or secondary public, private, or religious school for a maximum $10,000 tax-free distribution per year. Any distributions above $10,000 would consist of part earnings and part contributions, the earnings portion would be taxed. Once the student reaches college, Section 529 accounts can be disbursed, without limits, for qualified college education expenses.

If withdrawals are not used to pay qualified education expenses, the income portion is included in the gross income of the beneficiary and generally subject to a 10% penalty tax. In the vast majority of cases, the owner of the QTP is the contributor.

Beneficiaries of Section 529 plans do not gain control of the assets at the age of majority as with custodial UGMA or UTMA accounts. In general, if the child for whom the Section 529 plan was established decides not to attend college, the account balance may be rolled over to any family member as defined in the Treasury Regulations for Section 529.

There are two types of Section 529 (QTP) plans:

1. Prepaid tuition plan
2. College savings plan


Section 529 Plan - What is the Prepaid Plan?

Prepaid tuition plans permit contributors (usually parents) to prepay future tuition at today’s tuition rates or purchase tuition credits (units) to apply to future tuition costs. Typically, these plans apply to tuition and mandatory fees only. This type of program also usually requires that the designated beneficiary (usually the contributor’s child) go to any public college or university within the state (or the specific private institution) that established the QTP.


Section 529 Plan - What is the College Saving Plan?

College savings plans may be offered only by states, state-sponsored organizations, and eligible educational institutions. The contribution rules are the same as those for prepaid tuition plans. In this type of plan, tuition is not being prepaid, but, rather, a tax-advantaged savings plan is established from which tax-free distributions are made to pay for qualified education expenses. The investment options offered in college savings plans often include stock mutual funds, bond mutual funds, and money market mutual funds. Some plans offer age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age.

A significant advantage of the college savings plan over the prepaid tuition plan is that it does not restrict where the child beneficiary may attend college.


Name the major differences between a prepaid tuition plan and college savings plan.

Prepaid Tuition Plan

-Inflation-based performance Suitable for risk-averse investor
-May offer state-guaranteed return on assets
-Usually restricted enrollment options
-May restrict out-of-state tuition costs and, if less than in-state, may not refund difference

College Savings Plan

-Market-based performance
-Suitable for risk-tolerant investor
-No state-guaranteed return on assets
-Open enrollment
-Available for out-of-state tuition costs without any refund difference
-Covers tuition and mandatory fees only In addition to tuition and mandatory fees, covers books, required supplies, and room and board (students attending at least half time)


What are ABLE (Achieving a Better Life Experience) accounts?

ABLE accounts provide individuals with disabilities and their families with the ability to fund a tax-preferred savings account to pay for qualified disability-related expenses. Contributions may be made by the person with a disability (the designated beneficiary), parents, family members, or others.


What are the three types of trusts used for education funding?

Trusts used in college education funding come in three basic forms:

1. A minor’s trust, established under the provisions of Internal Revenue Code (IRC) Section 2503(c)
2. A current income trust, structured according to the terms of IRC Section 2503(b)
3. A demand, or Crummey invasion, trust


What is a minor’s trust, established under the provisions of Internal Revenue Code (IRC) Section 2503(c)?

Minor’s trust [2503(c)] A minor’s trust is designed to use the $15,000 ($30,000 for a married couple using gift splitting) annual gift tax exclusion for 2019, although it may permit accumulation of income on behalf of the child under the trust terms. Its form is dictated by IRC Section 2503(c), which provides that a gift to an individual under 21 will not be considered a gift of a future interest as long as the property and its income are payable to the child at age 21. In addition, the minor’s trust permits income to escape the kiddie tax by allowing the trustee to accumulate more income at the trust’s separate tax bracket. Unfortunately, changes in tax law have resulted in the income retained in trusts being taxed at the highest personal rate, even at relatively low levels. Simply put, if money is put into this kind of trust for a child, the potential taxes may be higher than the child’s or parent’s tax brackets. Additionally, the funds generally must be given to the child when he or she reaches age 21.


What is the Current income trust [2503(b)]?

The current income trust must have its income paid out at least annually to the beneficiary with no discretion left to the trustee to accumulate income. This typically presents problems in avoiding the kiddie tax; however, it has a substantial offsetting advantage to many grantors (the persons putting the money in the trusts). The trust property, or principal, need not be distributed to the child at any specified age. This ensures the segregated funds are used only for the purpose they were intended—that is, the child’s college education. With this type of trust, it is important to choose investments that increase in value but do not pay income while the child is young. Without this approach, all of the income earned in the trust will be paid to the child and the fund will not grow.


What is the Crummey invasion trust?

The final form of trust is the demand, or Crummey invasion, trust, which is an effective mix of the best attributes of the minor’s and current income trusts. It transfers money from one individual to a trust for the benefit of another in a way that avoids gift taxes and keeps the money out of the estate of the donor. It permits the beneficiary to withdraw from the trust an amount equal to the lesser of the annual addition to the trust or the annual gift tax exclusion. In addition, rather than requiring trust property to be distributed to the beneficiary at age 21, the demand trust allows distribution at any age chosen by the grantor. However, if the demand trust accumulates income and it is taxed to the trust itself, the tax rates are high.


How can one use retirement plans to fund college expenses?

Under the “substantially equal periodic payment” exception to IRC Section 72(t), a participant can turn some or all of his retirement account (including an individual retirement account) into a period certain or life annuity for preretirement use at any time without the usual 10% premature distribution penalty. As long as the participant withdraws roughly equal amounts from his retirement plan annually for at least five years following commencement of distributions, or until reaching age 591⁄2 (whichever is later), retirement money can be used for any reason. A parent may find this exception useful in meeting current expenses for a college-age child (but at the expense of their own retirement savings). Unless a client is overfunded for retirement, this method is generally not recommended.

An IRA owner may also be able to withdraw money from his or her IRA without incurring the 10% early withdrawal penalty. Funds withdrawn to pay for qualified higher education expenses for the taxpayer, spouse, children, or grandchildren may qualify for this exemption.

Roth IRAs can be excellent sources for accumulation or supplements to Section 529 plans. Contributions to Roth IRAs can always be withdrawn without tax or penalty.


Assume that an adult client is currently in a low marginal income tax bracket and does not anticipate major income increases in the future. He is interested in a low-risk investment purchased in his name that may provide favorable income tax treatment when used for the higher education tuition expenses of his only child. He is also not interested in incurring the expense of establishing a trust when saving for his child’s college education costs. Identify a viable alternative to recommend to the client.

A. An UGMA account
B. A passbook savings account in the child’s name
C. Municipal bonds purchased in the name of the client
D. Series EE savings bond


The answer is Series EE savings bond. Because the client is currently in a low tax bracket and does not anticipate significant income increases in the future, he does not need to worry about the phaseout amounts associated with a qualified savings bond. In addition, to qualify for the tax exclusion on savings bond interest, such a bond has to be purchased in the name of an individual who is at least age 24, unlike the UGMA account, which is the legal property of the child at the time the account is established.


Erin’s grandmother recently established a CESA on behalf of Erin, age five, and contributed $2,000 to the account. Now, Erin’s father wants to contribute an additional $2,000 to the account in this same year. Is this permitted?

A. Yes, because both the grandmother and father are family members of Erin.
B. No, only Erin’s father is allowed to establish a CESA.
C. Yes, up to $2,000 per donor can be contributed on Erin’s behalf.
D. No, $2,000 is the maximum contribution per beneficiary in any single year.


The answer is no, $2,000 is the maximum contribution per beneficiary in any single year. The maximum amount that may be contributed to a Coverdell ESA is $2,000 per beneficiary, regardless of the number of donors or the relation of the donor. The donor does not have to be a family member.


George and Betty wish to establish a Section 529 college savings plan for both of their grandchildren. In 2019, what is the maximum amount that they can contribute without making a taxable gift for federal gift tax purposes?

A. $75,000
B. $150,000
C. $265,000
D. $300,000


The answer is $300,000. Because George and Betty have two grandchildren, they may contribute a maximum of $300,000 (or $150,000 for each account in 2019). However, they may make this contribution only once within a five-year period and must file a federal gift tax return reporting these transfers (even though there is no taxable gift).