| Investments / Tax planning for college |  |
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As a parent with college-bound
children, you are or will soon be concerned with either setting up a
financial plan to fund for future college costs, or, if your children
are already college age, with paying for current or imminent tuition,
etc. bills. Here are several approaches that seek to take maximum
advantage of tax benefits to minimize your expenses. (Please note that
the following suggestions are strictly related to tax benefits. You may
have non-tax-related concerns that make the suggestions inappropriate.) Planning for college expenses.
In many cases, transferring ownership of assets to children can save
taxes. You and your spouse can transfer up to $20,000 a year (for 2001)
in cash or assets to each child with no gift tax consequences. For
children over 13, the income from the assets is taxed entirely to them
at their lower tax rates (15% in most cases). For children under 14,
however, income above $1,500 (in 2001) is taxed (under the "kiddie
tax" rules) at your rates. A variety of trusts or custodial
arrangements can be used to place assets in your children's names. Note,
it's not enough just to transfer the income to them, e.g., dividend
checks. The income would still be taxed to you. You must transfer the
asset that's generating the income into their names. Tax-exempt bonds.
Another way to achieve economic growth while avoiding tax is simply to
invest in tax-exempt bonds or bond funds. Interest rates and degree of
risk vary on these, so care must be taken in selecting your particular
investment. Some tax-exempts are sold at a deep discount from face and
don't carry interest coupons. Many are marketed as college savings
bonds. A small investment in these so-called zero coupon bonds can grow
into a fairly sizable fund by the time your child reaches college age.
"Stripped" munis carry similar advantages. Series EE U.S. savings bonds.
Series EE U.S. savings bonds offer two tax-savings opportunities when
used to finance your child's college expenses: first, you don't have to
report the interest on the bonds for federal tax purposes until the
bonds are actually cashed in; and second, interest on
"qualified" Series EE (and Series I) bonds may be exempt from
federal tax if the bond proceeds are used for qualified college
expenses. To qualify for the tax exemption for
college use, the bonds must be purchased by you in your name (not the
child's) or jointly with your spouse. The proceeds must be used for
tuition, fees, etc. (not room and board). If only part of the proceeds
are used for qualified expenses, then only that part of the interest is
exempt. But if your adjusted gross income (AGI) is too high, the
exemption is phased out. For bonds cashed in during 2001, the exemption
starts to "disappear" when your (joint) AGI hits $83,650 for
joint return filers ($55,750 for singles) and is gone entirely if your
AGI is at $113,650 ($70,750 for singles). (These figures are adjusted
annually for inflation.) Qualified state tuition programs.
A qualified state tuition program allows you to buy tuition credits for
a child or to make contributions to an account set up to meet a child's
future higher education expenses. Contributions to these programs aren't
deductible, and the contributions are treated as taxable gifts to the
child but they are eligible for the annual $10,000 (for 2001) gift tax
exclusion, and a donor who contributes more than the annual exclusion
limit for the year can elect to treat the gifts as if they were spread
out over a 5-year period. The earnings on the contributions accumulate
tax-free until the college costs are paid from the funds. At that time
the amounts are taxed to the child at the child's tax rate to the extent
they exceed the amount contributed by the parents. Refunds are available
under certain circumstances—for example, if the child dies before
entering college, becomes disabled, or receives a scholarship. Refunds
for any other reason are subject to a penalty. Education IRAs.
You can establish education IRAs and make contributions of up to $500 a
year for each child under age 18. The right to make these contributions
begins to phase out once your AGI is over $150,000 on a joint return
($95,000 for singles). (If the income limitation is a problem, the child
can make a contribution to his or her own account.) Although the
contributions aren't deductible, funds in the account aren't taxed, and
distributions are tax-free if spent on higher education expenses. If the
child doesn't attend college, the money must be withdrawn when the child
turns 30, and any earnings will be subject to tax and penalty, but
unused funds can be transferred tax-free to an education IRA of another
member of the child's family who hasn't reached age 30. The above are just some of the
tax-favored ways to build up a college fund for your children. If you
wish to discuss any of them, or other alternatives, please call. Paying college expenses.
You may be able to take a credit for some of your child's tuition
expenses or write off some of the interest on education loans. There are
also tax-advantaged ways of getting your child's college expenses paid
by others. Tuition tax credits.
You can take a Hope tax credit of up to $1,500 a year per student for
the first two years of college (a 100% credit for the first $1,000 in
tuition and a 50% credit for the second $1,000). You can take a lifetime
learning credit of up to $1,000 per family for every additional year of
college or graduate school (a 20% credit for up to $5,000 in tuition).
Both credits are phased out for couples with incomes between $80,000 and
$100,000 (or singles with income between $40,000 and $50,000). (Only one
credit can be claimed for the same student in any given year. Also, a
credit cannot be claimed with respect to a student for a year in which
any part of a distribution from an education IRA for the student is
excluded from income.) Scholarships.
Scholarships (if your child qualifies for any) are exempt from income
tax. For this exemption to apply, certain conditions must be satisfied.
The most important are that the scholarship must not be compensation for
services, and it must be used for tuition, fees, books, supplies and
similar items (and not for room and board). (Although a
scholarship is tax-free, it will reduce the amount of expenses that may
be taken into account in computing the Hope and lifetime learning
credits, above, and may therefore reduce or eliminate those credits.) Employer educational assistance
programs. If your employer pays your child's college expenses, the
payment is a fringe benefit to you, and is taxable to you as
compensation, unless the payment is part of a scholarship program that's
"outside of the pattern of employment." Then the payment will
be treated as a scholarship (if the other requirements for scholarships
are satisfied). Tuition reduction plans for
employees of educational institutions. Tax-exempt educational institutions
sometimes provide tuition reduction plans for the children of their
employees—tuition reductions for those children who attend that
educational institution, or cash tuition payments for children who
attend other educational institutions. If certain requirements are
satisfied, these tuition reductions are exempt from income tax. College expense payments by
grandparents and others. If someone other than you pays your child's college
expenses, the person making the payments is generally subject to the
gift tax, to the extent the payments and other gifts to the child by
that person exceed the regular annual (per donee) gift tax exclusion of
$10,000 ($20,000 in the case of married donors who consent to split
gifts) (for 2001). If the other person pays your child's school tuition
directly to an educational institution, however, there's an unlimited
exclusion from the gift tax for the payment. The relationship between
the person paying the tuition and the person on whose behalf the
payments are made is irrelevant, but the payer would typically be a
grandparent. The unlimited gift tax exclusion applies only to direct
tuition costs. There's no exclusion (beyond the normal annual exclusion)
for dormitory fees, board, books, supplies, etc. Prepaid tuition
payments may qualify for the unlimited gift tax exclusion under certain
circumstances. Student loans.
You can deduct interest on loans used to pay for your child's education
at a post-secondary school, including some vocational and graduate
schools. (This is an exception to the general rule that interest on
student loans is personal interest and, therefore, not deductible.) The
deduction is an above-the-line deduction (meaning that it's available
even to taxpayers who don't itemize). It's allowed only for interest
paid during the first 60 months in which interest payments on the loan
are required. The maximum deduction is $2,500. However, the deduction
phases out for couples whose AGI is between $60,000 and $75,000 ($40,000
and $55,000 for singles). (Some student loans contain a
provision that all or part of the loan will be cancelled if the student
works for a certain period of time in certain professions for any of a
broad class of employers—e.g., as a doctor for a public hospital in a
rural area. The student won't have to report any income if the loan is
canceled and he performs the required services. This is an exception to
the general rule that if a loan or other debt you owe is canceled, you
must report the cancellation as income.) Bank loans.
The interest on loans used to pay educational expenses is personal
interest which is generally not deductible (unless you qualify for the
deduction for education loan interest, described above). However, if the
loan is "home equity indebtedness," and interest on the loan
is "qualified residence interest," the interest is
deductible for regular income tax purposes, although not for alternative
minimum tax purposes. If interest is deductible as qualified residence
interest, it can't be deducted as education loan interest. Borrowing against retirement plan
accounts. Many company retirement plans permit participants to borrow
cash. This option may be an attractive alternative to a bank loan,
especially if your other debt burden is high. However, the loan must
carry an interest rate equal to the prevailing commercial rate for
similar loans, and, unless you qualify for the deduction for education
loan interest (described above), there's no deduction for the personal
interest paid. Moreover, unless strict requirements are satisfied, a
loan against a retirement account is treated as a premature distribution
(withdrawal) that's subject to regular income tax and an additional
penalty tax. Withdrawals from retirement plan
accounts. IRAs and qualified retirement plans represent the largest
cash resource of many taxpayers. You can pull money out of your IRA
(including a Roth IRA) at any time to pay college costs without
incurring the 10% early withdrawal penalty that usually applies to
withdrawals from an IRA before age 59 1/2. However, the distributions
are subject to tax under the usual rules for IRA distributions. Some qualified plans either don't
permit withdrawals or restrict them. For example, a 401(k)
cash-or-deferred plan may allow distributions if the participant has an
immediate and heavy financial need and lacks other resources to meet
that need. IRS regs name a college education as such a need. To the
extent they represent previously untaxed dollars and earnings, amounts
withdrawn from a retirement plan are fully subject to tax and are also
hit by a 10% penalty tax if they are made before the participant reaches
age 59 1/2. (Note, however, that you cannot roll over a 401(k) plan
"hardship" distribution into an IRA to set up a later
penalty-free withdrawal to pay college costs.) A younger plan participant may avoid
triggering the penalty tax by annuitization payouts from an IRA or a
SEP. This method doesn't work for 401(k) type plans. The strategy works
because the penalty tax doesn't apply if annual or more frequent
withdrawals are made in substantially equal payments over the life or
life expectancy of the taxpayer (or the joint lives or joint life
expectancies of the taxpayer and designated beneficiary). Not all of the above breaks may be used in the same year, and use of some of them reduces the amounts that qualify for other breaks. So it takes planning to determine which should be used in any given situation. |
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