Tax planning for college
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 bills. We would like to address both of these concerns by suggesting several approaches that
seek to take the 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 2000) 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 (for 2000) 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. It is not enough just to transfer the income to them, i.e., 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-exempt bonds are sold at a deep discount from face value and do not
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.
However, if your adjusted gross income (AGI) is too high, the exemption is phased out. For bonds cashed in during 2000, the exemption starts to "disappear" when
your AGI reaches $81,100 for joint return filers ($54,000 for singles) and is gone entirely if your AGI is at $111,100 ($69,100 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 are not deductible, and the contributions are treated as taxable gifts to the child,
but they are eligible for the annual $10,000 (for 2000) 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 are not deductible, funds in the account are not taxed, and distributions are tax-free if spent on
higher education expenses. If the child does not attend college, the money must be withdrawn when the child turns 30, and any earnings will be subject to tax and
penalty. 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
contact our offices.
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 stipulation is that the scholarship must not be compensation for services, and it must be used for tuition, fees, books, supplies and similar items (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 is "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 the parent(s) pays the child's college expenses, the person who makes 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 2000). If the other person pays the 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 typically is a grandparent. The gift tax exclusion applies only to direct tuition costs. There
is no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc..
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 do not itemize). It is allowed only for interest paid during the first 60 months in which interest payments
on the loan are required. The maximum deduction is $2,000 for 2000 and $2,500 for 2001 and after. 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 would not have to report the 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 not 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 is 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) and is 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 at any time to pay college costs without incurring the 10% early withdrawal penalty that usually applies to withdrawals from an
IRA before age 59½ . However, the distributions are subject to tax under the usual rules for IRA distributions.
Some qualified plans either do not permit withdrawals or they 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. The IRS regulations 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 59½ . (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. It takes planning to
determine which method should be used in any given situation. If you would like to discuss one or more of the above planning or payment possibilities, or any other
alternatives, in more detail, please contact our offices.
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