Tax planning for wealthy individuals via so-called loopholes in the tax law, have attracted significant media and congressional attention in the past few months.

Unfortunately, there is a misunderstanding of these perceived loopholes. A loophole, in many circumstances, is simply using tax legislation for a purpose for which it was not perceived

The following could be considered by some to be a tax loophole for the middle-income taxpayer.

Education Savings Accounts

Education Savings Accounts, which are also commonly called "529" accounts (the number refers to the section of the International Revenue Code governing the education savings accounts), have been around for about ten years.

The stated purpose of the education savings accounts was to allow a family to put money aside to pay for college tuition for their children, and to have the savings grow on a tax-deferred basis.

Originally, when the funds were withdrawn and used to pay college tuition, the income attributed to the account would be subject to tax at the child's tax rate.

This legislation has now undergone a few changes, and if the child uses the income to pay college tuition, there is no tax on the withdrawal of the funds.

As with all other legislation, we asked ourselves whether this legislation could be used for another purpose. The answer is that an educational savings account can be used as a tax loophole, allowing an individual to defer tax on investment income. How, one might ask?

As an example of using a "529 account" for another purpose, we will take married taxpayers whose children have long ago graduated from college. The taxpayers have income beyond their current needs that is invested, with the investment income being taxed at a 38.6% rate.

The taxpayer is unable to invest more than $11,000 in the employer 401(k) account, and the employer is unwilling to allow the taxpayers to defer salary or bonus.

These taxpayers can set up a "529 account" for themselves, and put up to $22,000 a year into the account without incurring a gift tax. Alternatively, they could pre-fund the account for up to $250,000 without incurring a gift tax.

While the taxpayers cannot get a tax deduction for the contribution to the "529 account", they do realise two tax advantages:

One, the money in the "529 account" is not deemed to be part of their estate, and Two, the income derived from the investment grows tax-free.

What Happens When the Money Is Withdrawn?

It depends on what is done with the money, and several options exist. The "529 account" could be put in the name of a grandchild, and if the grandchild uses the funds for college tuition, there would be no income tax. Or, the taxpayer could go back to college, and there would be no income tax if the funds were used for college tuition.

Or, the taxpayer can simply withdraw the money and use it for whatever. In this case, the income generated over the years would become taxable to the individual, and there would also be a 10% penalty imposed. But, this is not necessarily bad.

As we noted at the beginning, the taxpayer had been paying current income tax at a 38.6% rate on investment income. By switching the investment funds into a "529 account," the investment income grew on a tax-free basis.

We assumed an annual investment of $11,000 a year for 20 years, with the same rate of return as the current taxable income.

When we compared the net after tax income over 20 years from the current investment strategy, to the net after tax income from the withdrawal of the funds for personal use from the "529 account", and taking into the account the 10% penalty, we found that the next after tax from the "529 account" was between 25% and 33% higher, using different scenarios.

In essence, an education savings account can be used by taxpayers as a "loophole", to maximise their after tax return on investment income.

The tax advice given by this column is, by necessity, general in nature. You should, of course, check with your own US tax consultant as to how specific transactions affect you since tax advice varies with individual circumstances.

lJames Paul Sabo, CPA, is the President of ETS Ltd. P.O. Box Hm 1574, Hamilton HM GX, Bermuda. Questions should be sent to: jsaboexpatriatetaxservices.com