College $avings Strategies
It is important to save for your children’s college as soon as possible—preferably, when they are born. Besides retirement and your home, funding your children’s college will be one of your most expensive life expenditures. Therefore, you must be tax savvy in creating an educational savings plan that meets your family’s needs. Let examine some tax wise investing strategies to get you on your way to success.
Coverdell Education Savings Accounts (CESA) are one of the most flexible tax favored savings programs available to parents. You can contribute up to $2,000 per year for each child in separate CESA accounts. The funds will grow tax free and can be withdrawn tax free to pay for the account beneficiary’s college expenses. The contributions to the CESA is not tax deductible, but, the tax free build up and tax free distributions can make up for it. The funds can be used for more than just college expenses. They can be used for elementary and secondary school (K-12) grades for eligible expenses such as books, tutoring, computers, peripheral equipment, software, and internet access charges. Unfortunately, CESA’s have a phase out based on your adjusted gross income. If you are married and filing jointly, the phase out for 2010 is $190,000 to $220,000 and filing single, head of household or married filing separately the phase out is between $95,000 and $110,000.
If you are over the income limits, a solution around the rules is to have a grandparent or sibling set up the CESA for the kids. You can gift $2,000 to the person establishing the accounts for each child. You are allowed to make up to $13,000 per year gifts to as many people as you choose which will allow you to make the gift without any tax consequences.
Unless Congress acts to extend current provisions, the contribution limit will drop to $500 per child per year in 2011 and funds will no longer be available for secondary school expenses.
State sponsored qualified tuition programs, known as 529 plans, have become very popular. A parent can fund the account and name the child as beneficiary of the account for college purposes. With 529 plans, you contribute funds on an after tax basis. The proceeds grow tax deferred and are allowed to be used for college tax free. There are several investment options including equity mutual funds and bond mutual funds. Some states have state income tax deductions for the contribution. If the money is not used for qualifying education expenses, there will be a mandatory penalty associated with the distribution. The penalty is at the discretion of the individual state. At present, the 5% surrender charge penalty will not be waived if the beneficiary receives a scholarship, dies, or becomes disabled. One major drawback to the plan is that the IRS prohibits the contributor and beneficiary from directing the investment. 529 plans allow greater flexibility of contributing larger sums of money without risk of gift tax. Any contributor may invest $ 65,000 in a single year for the beneficiary, and as long as the individual makes no additional gifts to the same beneficiary there will be no gift tax consequences. The contributor can treat the $ 65,000 as $ 13,000 gifts eligible for the annual gift tax exclusion each year over a 5-year period. If the contributor dies during the 5 year period, a pro rata portion is brought back into their taxable estate for estate tax purposes.
For many years, parents saved college funds in custodial accounts for their children. Unfortunately, the kiddie tax rules have made these plans less desirable. For 2010, the first $950 of unearned income is not taxed, the next $950 is taxed at 10% and then anything over $1,900 is taxed at the parents income tax rate. A further disadvantage of the plan is that at age 18, the child has complete control over the investment account. The account is the child’s with unfettered control of the checkbook. 529 plans and Coverdell Educational Savings accounts with tax incentives are truly the plans of choice.
Grandparents and parents who are high wage earners should consider giving shares of stocks or mutual funds to their children or grandchildren. The federal income tax rate on long-term capital gains is only 5% for those in the 10% and 15% income tax bracket. The tax bracket drops to Zero for 2010. Furthermore, the child pays zero percent on qualified dividends collected after receiving the gift of dividend paying stocks. So, a parent could gift a child in a low tax bracket stock under the annual gift tax exclusion of $13,000.
Parents that own small businesses should consider hiring their children, but these must be legitimate jobs. Suppose the parent is in the highest federal and state income tax bracket (estimate 40%), pays his child $5,000 for work performed and deducts the expense. The teenager owes no federal or state income taxes. The teenager’s income is not taxed due to the standard deduction for 2010 of $5,700. The parents save $2,000 in income taxes. Also, depending on the type of business entity (such as a single member LLC, partnership, or sole proprietorship) and as long as the teenager is under age 18 s/he does not have to pay Social Security taxes, Medicare taxes and federal unemployment taxes. The money saved by the teenager could be invested in a tax friendly investment to prevent the kiddie tax issue.
As a small business owner, if your child is employed by you as the child is completing their undergraduate or graduate degrees, there could be a tax break for “working-condition fringe benefits.” There is a $5,250 tax free employer paid educational assistance benefit. The benefit must be used for training that is job related. The nondiscrimination rules do not apply so you can pick and choose who will get the benefit. The limitations to the benefit must improve or maintain the employees skills needed to perform the employees work. For example, as the future owner of your company, your son is taking courses on computers, marketing and management. Your son’s job responsibilities require broad skills that will allow the tax deduction. However, if your son is taking courses to become a teacher, this will not qualify for the tax benefit.
For lower to middle income families, the Series EE and Series I Government bonds is an excellent method to save for college. The bond interest can be tax free if used to pay for qualified educational expenses for you, your spouse and dependents. Qualified educational expenses are limited to tuition and required fees, therefore, expenses such as room and board do not qualify for the tax free status. Since the tax free status is only for husband, wife and dependents, grandparents purchasing a savings bond for their grandchild will not qualify for the tax exempt status unless the grandchild is a dependent of the grandparent. Furthermore, in order to receive tax free status, you must select at the time of purchase the cash basis accounting which will qualify you for the tax exempt status. If you select the accrual basis, you will pay taxes each year on the interest. Finally, there are income limitation rules to qualify for the tax-free college savings. In 2010, your modified adjusted gross income phase-out range is $105,100 – $135,100 for married filing jointly and for all others it is $70,100-$85,100.
The American Opportunity tax credit provides a tax credit for 4 years of undergraduate college ranging up to $2,500 per student per year for qualified tuition and related expenses on the first $4,000 of qualifying educational expenses. The qualified tuition and related expenses includes expenditures for course materials such as books, supplies and equipment that is needed for the course of study from the educational institution. A laptop computer may be included if it is needed as a condition of enrollment or attendance at the educational institution. There are income limitation rules to qualify for the tax credit. The 2010 phase out rules are $160,000-$180,000 of your modified adjusted gross income if you are married and filing jointly or $80,000 – $90,000 for all other tax payers. The American Opportunity tax credit is only available for the 2009 and 2010 tax years.
The Hope tax credit provides tax relief for college students during the first 2 years of college. The Hope credit provides a tax credit up to $1,800 on the first $2,400 of eligible expenses. There are income limitation rules that will phase out the credit. If you income exceeds the phase out amount, discuss with your CPA about not claiming your child as a dependent. This will allow the child to receive the tax credit to offset taxes paid on jobs and investment earnings. This credit is not available for 2009 and 2010.
The Lifetime Learning Credit is a tax credit for eligible educational expenses such as tuition, books, supplies, and required equipment. The tax credit is equal to 20% of the taxpayer’s out-of-pocket expenses for qualified tuition and related expenses of all eligible family members, up to a maximum of $10,000 in tuition paid, calculated each tax year.
A tax tip with Student Loan interest is that it is deductible up to $2,500 per year on qualified student loan debt. However, there are low income limitation phase-out rules. If you can deduct the interest on the child’s college loan, consider taking out a home equity loan to pay off the student loan. You may deduct interest on the home equity line of credit up to $100,000 of equity debt. This will make the loan completely income tax deductible. However, make sure you run the math on the financing rates to make sure it makes sense. Also, consider having your kids pay off the loan. If the child pays off the loan and they are jointly liable on the loan and if you don claim them as a dependent, they should be able to take a tax deduction for the interest on the loan.
In summary, there are several good tax credits and benefits for middle class taxpayers that can help with college costs. As you can see, receiving the right tax credit and deduction to maximize your savings is complicated. It is going to be difficult to determine which strategy is best for you without receiving professional advice. Appropriate tax planning for college can provide you big savings and enable you to achieve your family’s dreams of a college education for your children. Before putting any strategy in place, please consult your CPA for tax advice and a comprehensive fee based Financial Planner for college strategies.
When you invest for college through a 529 plan, you are investing in securities that could lose money. Please consider the investment objectives, risks, charges and expenses carefully before investing in a 529 plan. Contact your Prudential agent for a program description, which contains this and other important information. Read it carefully before investing. You should also consider before investing, any tax or other benefits that may be available exclusively to residents or their designated beneficiaries through their home state’s 529 plan. It is possible to lose money when investing in securities.
Jeffery Palmer offers investment advisory services as a representative of Prudential Financial Planning Services, a division of Pruco Securities, LLC (Pruco). The Palmer Group is not affiliated with Pruco. Other products and services may be offered by a non-Pruco entity. Neither Jeffery Palmer nor The Palmer Group offer legal, tax or accounting advice. You should consult with your own advisors regarding your particular situation. Neither Jeffery Palmer, The Palmer Group nor Pruco are affiliated with www.sixtysecondparent.com.