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TAX Wise Ways To Save For College
Being smart about how you save and distribute college savings, you can cut your tax bill by thousands of dollars.
Financial Aid Implications
Should you save for college at all? The more you save, the less likely you are to receive financial aid. The same is true if your son or daughter has assets or significant earnings in his or her name. If you can afford to save for college, SAVE.
Saving in Your Child's Name
Saving in your child's name can cut your tax bill. The taxable income generated by the account is included on your child's tax return and not the parent's. The tax savings can be significant, because your child will likely be taxed at a 15% rate for ordinary income and 10% for long-term capital gains. The child must be the legal owner of the college fund for this strategy to pass approval with the IRS. Under the Uniform Gift to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) you can give each of your children up to $10,000 per year ($20,000 if both parents make a gift) without any gift tax consequences. The money can go to establish a custodial account in your child's name with the parent as the custodian. With a custodial account, the child will eventually gain unrestricted access to all the money in the account, usually at age 18, 21 or 25 depending on state law and whether gifts were made under UGMA or UTMA. You can also save in your child's name through a prepaid college plan.
The Facts
In saving for college, you really have two fundamental considerations. First you have to develop an asset allocation plan. Second, you have to think about ways to minimize taxes. Here are several strategies to reducing taxes on a college savings fund.
Crummey Trust
Pro: Earnings can be taxed at child's rate while you maintain control |
Con: Watch out for kiddie tax if child is under 14. Lawyer needed to draft the trust. Legal implications if you function as trustee; less control if you don't. After each annual gift, the child has the legal right to withdraw that year's gift (and that year's gift only) within a designated timeframe (30 days is standard). |
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Qualified State Tuition Plan
Pro: Earnings are taxed at child's rate. No kiddie tax problems. May be able to lock in a tuition price. Eventually, withdrawals for college expenses may be tax-free as well. |
Con: Returns may be sub-par. Not available in all states. Some plans only cover tuition. Flexibility and refund policies are concerns. |
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Hire Your Kid
Pro: Great tax benefits. Kiddie tax not a concern. Best used as supplement to other tax-saving ideas. |
Con: You must own a business. Difficult to justify paying enough to cover college expenses. Child must actually work and you will have to depend on child to save for college |
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Custodial Account in Child's Name
Pro: Simplicity. Earnings can be taxed at child's rate |
Con: Kiddie tax is an issue for children under 14. Child will gain unrestricted access to money at relatively young age without spending restrictions |
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Save in Your Own Name
Pro: Simple. Money belongs to parent. If invested to produce long-term gains taxable at the 20% capital gains tax rate. |
Con: No income-splitting tax benefits, except to the extent appreciated securities can be gifted to the child and have him or her pay the tax |
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Education IRA
Pro: Earnings tax-free. |
Con: Contributions limited to $500 per year. Eligibility phases out for donors who are joint filers with AGIs between $150,000 and $160,000 and singles with AGIs between $95,000 and $110,000. Grandparents, godparents and friend who meet the AGI eligibility criteria can contribute. |
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Borrow
Pro: Borrowing via home equity loan offers potential tax break |
Con: Loans must be repaid. |
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Drain Your Retirement Account
Pro: Nobel in concept. |
Con: You can borrow for college expenses, but you cannot borrow for retirement. Although tax rules have recently been liberalized, there may be a tax penalty for early withdrawals from your retirement account. |
The Kiddie Tax
The Kiddie Tax is applied only if your child: (1) is under age 14 and (2) has over $1,500 in 2001 of taxable investment income also known as unearned income. The first $750 in 2001 of income is sheltered. The next $700 is taxed at only 15% (10% for long-term capital gains). Only the excess over $1,400 gets hit with the kiddie tax, meaning that amount gets taxed at the parents' marginal rate. No excess, no kiddie tax.
Financial advisors have suggested investing in low-dividend growth stocks, low-turnover mutual funds or even Series EE U.S. Savings Bonds, whose interest income is tax-deferred until the bonds are cashed in to assure that there is no excess. When the child turns age 14, you can cash out of any of these investments at his tax rate (probably 10% for capital gains). From then on, all dividend income will be taxed at the child's rate, which will probably be 15%.
Saving in Your Own Name
You can also achieve tax-deferral by carefully managing your investments. When you sell stock shares that have gained in value and been held long term to pay college bills, your profit will be taxed at only 20%. If available you should consider selling some stocks that have lost value at the same time. You will reduce your gains and possible end up not owing anything.
By following a buy and hold strategy with low-dividend stocks and tax-efficient equity mutual funds, families should be able to keep the tax bill to just a bit over 20% (the rate for long-term capital gains).
Transferring securities to the child when it's time to pay the college bill can reduce tax bills even further. By transferring appreciated securities in your education fund to an account established in your child's name your son or daughter can sell the shares and pay a 10% capital gains tax which is better than the 20% tax you would pay. Be sure to observe the $10,000 gift rule. Your child can pay school expenses and you can cover the rest with a check to the school. Unlimited payment can made directly to the school each year without violating gift tax rules.
Another way to avoid any current tax liability is by keeping your stock shares and taking out margin loans to pay college expenses. Investing in tax-efficient mutual funds won't result in 100% tax-deferral, but you may be able to come pretty close.
State-Sponsored College Savings Accounts
Another tax-advantaged alternative for families seeking to pay the college bills are state-sponsored college savings accounts. Some allow you to invest as much as $100,000 in a child's account without paying any gift tax. The earnings on these tax-deferred accounts are taxed at your child's rate when withdrawn to pay qualified college expenses.
Education IRAs
Education IRAs (EIRAs) allow total contributes up to a $500 annual maximum for anyone under the age of 18. Contributions are nondeductible and eligibility is unaffected by any amounts contributed to regular IRAs. EIRA eligibility phases out for donors who are joint filers with AGIs between $150,000 and $160,000 and singles with AGIs between $95,000 and $110,000. Grandparents, godparents or friends who meet the AGI eligibility criteria can make contributions. Gains in EIRAs accumulate tax-free and can be withdrawn tax-free for eligible college expenses. Accounts must be closed when the child turns 30 years of age. Unused funds can be used to pay for the college expenses of any family member. If not, income tax and a 10% penalty will be owed on all withdrawals.
You should note, taking tax-free withdrawals from an EIRA will disqualify you from being able to claim the Hope and Lifetime tax credits for that year.
Hire Your Child
Because the formula used for awarding financial aid require a far greater share of a student's assets than of parents, families should be very sure that they would not receive school based financial aid. If your family has determined that they will not receive school based financial assistance hiring your under-18 college-bound child is an option that can be used as a tax advantaged means of paying for college. In order for a family to take advantage of this strategy, they must operate a business as a sole proprietorship or husband-wife partnership. The concept is that the child will save and invest some of the wages for college. The wages are exempt from Social Security, Medicare and federal unemployment taxes, and your child can use the standard deduction to shelter up to $4,550 of 2001 income from income tax. Under these circumstances, your child will most likely owe zero federal tax or no more than 15% on some of his or her wages. It should also be noted that the kiddie tax is inapplicable on earned income.
The family business gets a business deduction for money that will be used to pay college expenses. Your income tax and self-employment tax bills are reduced and your adjusted gross income goes down as well.
Once your child reaches 18, you can continue employing her or him during summer vacation, school breaks and holidays. After age 18, Social Security and Medicare taxes will be applied, but your child's standard deduction still provides shelter from income tax. There's no federal unemployment tax before age 21.
If your business is not a sole proprietorship or husband-wife partnership, the child's wages will be subject to Social Security, Medicare and federal unemployment taxes, regardless of age. The standard deduction will however continue to create an income tax shelter for your child, and your business gets deductions for the wages and payroll taxes.
Your child could also use their earning to fund up to $2,000 in annual Roth IRA contributions. The contributions (not the earnings) can later be pulled out tax-free to help defray his or her college expenses. Please note that the earnings cannot be pulled out tax-free to help pay college bills. Additionally, the earnings provide a jump-started retirement account.
If your child is age 21 or older, no longer a dependent and still in college also an employee of your business and not an owner, you may be able to hand out up to $5,250 in annual education expense reimbursements. This employee fringe benefit is tax-free to your child, and you get a deduction on your business tax return. You should be warned that: (1) graduate courses don't qualify, and (2) if you have other employees you could would have to provide the same benefits for them as well. Consult with your tax adviser to take a careful close look at the rules under Section 127 of the Internal Revenue Code.
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