Education Savings - The Self-Directed Way | Episode 106 - a podcast by Bryan Ellis - SelfDirected.org

Want a tax-free way to fund educational expenses for your family?  Today I open the rumor mill, and tell you how some people are diverting the profits of some of their best deals into a highly tax-favored educational fund.  I’m Bryan Ellis.  This is Episode 106.

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Wow!  Education costs a lot.

 

It’s on my mind right now because today, my wife and I are taking my oldest daughter on another college tour.

I’m tempted to launch into a tirade about the cost of higher education, since that’s one of the few industries that CONSISTENTLY increases its prices every year by substantially more than the rate of inflation, while simultaneously, the value of their product – as measured by employment rates and averages starting salaries – continues to decline.  Amazing, huh?  Worth less every year, charge more every year… a total racket.

But I digress.

We spend a lot of time talking about the nebulous concept of investing, and I think for most people, there’s an assumption that “investing” means the same thing as “investing for retirement”.  That’s certainly not true for all of you – I know that quite a number of you are, essentially, professional investors as your entire livelihood comes from your investment proceeds.

But today, we’re going to veer off of the retirement trail and into the murky world of education savings.

There’s a special type of account that can be really useful for this purpose.  It’s known by several names – the Education IRA, the Coverdell Account, or ESA aka the Educational Savings Account – and, if you qualify to have one, can be a really great thing.

The basic idea:  You designate a beneficiary – a student under the age of 18 – and each year, up to $2,000 can be contributed into that account and invested for retirement.  The taxation works like a Roth account – you get no tax break for the contribution, but generally speaking, there are no taxes due on withdrawal if used for educational expenses.

And, by the way, these accounts can be used to fund expenses associated with education expenses prior to college as well.  So if your child – or grandchild or niece or nephew or a broad range of relatives – happens to attend a private elementary school or high school, for example, then these accounts can be used to fund such expenses.

Ok, so far, so good.  Maybe you’ve heard of these accounts before.

But did you know that there’s a SELF-DIRECTED version?  That’s right… if you’ve got a hot investment, you do that investment inside of your child’s ESA account.

Yet, that may not be such a huge benefit, because no more than $2,000 per year can be contributed per child, so you’re options are pretty limited on the investment front.

UNLESS…

If what I hear on the rumor mill is true, this may be a better opportunity than it first seemed.

What I’m hearing of people doing goes something like this:

First, Grandpa (or some family member) opens up an ESA for little Suzy’s benefit at a self-directed account custodian.

Second, Grandpa contributes money to the ESA.

Third, Grandpa happens upon a great real estate deal and places a purchase option on it in the name of little Suzy’s ESA.  So, for example, this property Grandpa found is worth $300,000 but little Suzy’s ESA now has an option on it to purchase for $250,000.

Fourth, when that property sells – presumably to an unrelated 3rd party at a retail cost of $300,000 – the purchase option in little Suzy’s ESA will have to be paid off in order for the buyer to receive clear title.  So, in effect, what happens is that property owner will receive their $250,000 and all of the income above that, net of expenses, goes into little Suzy’s ESA.

So, that’s a pretty cool way for Graandpa to really quickly explode the value of little Suzy’s ESA despite the meager $2,000 contribution limits.

Now, before you run out and redirect your deals into an ESA, take note of something:  I haven’t confirmed that this is kosher with the IRS.  I suspect it would be ok, as from what I can tell, the IRS seems to have a relaxed attitude about this sort of thing – which is, essentially, flipping – so long as you don’t do it very frequently, but that’s merely an impression and certainly not an actual policy.  Before you do it, talk to an attorney.

There’s a small variation of the strategy that walks even closer to the line, and may even step over it.  I’ll explain it to you, not because I’m recommending it, but because I’d really like for you to get good legal advice before you do it, in case it’s something you’re considering.

And that is:  In addition to putting an option on the property in the name of little Suzy’s ESA, Grandpa might take the additional step of subsequently purchasing the property himself, directly from the current owner, at full retail value, rather than waiting for a third-party buyer to come along and purchase the property.

Why would he do this?  Well, clearly, the only reason Grandpa would do so is to have the excess funds – the profit above the option price – land in little Suzy’s ESA.  It’s a clever idea, but… I have a strong suspicion that the IRS would cry foul over this.  It’s really just a back-handed way of making a much, much larger contribution to the ESA than is really allowed.

I’ve sent a note to Tim Berry, a top-tier attorney for self-directed retirement account issues and a friend of this show.  I’ll tell you what he thinks about this soon.

Seems to me that if the fundamental strategy is kosher – the part about putting an option on the property through an ESA and collecting the profits when it’s sold at full retail – then it’s probably not kosher to have a clearly related party be the source of the funds that ultimately lands in the ESA.

Because, folks… all of the prohibited transaction rules that apply to an IRA also apply to the ESA.  And the cost of running afoul of those rules is NOT GOOD!

But regardless… remember that the ESA is a great option for tax-favored education savings and, if you qualify for it, offers some real flexibility through self-direction.

 

My friends… invest wisely today, and live well forever! 

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