Arend, Laukhuf & Stoller, Inc.
Many
people are concerned about paying current college costs or setting up a
financial plan for future education expenses.
This summary addresses the tax benefits that may be found in both
planning for college expenses and paying college expenses. However, there are non-tax considerations
that may make the following suggestions inappropriate for any given situation.
Planning for college expenses. Transferring ownership of assets to
children (in 2006 up to $24,000 a year from taxpayer and spouse to a child
without gift tax consequences) can save taxes.
For children over 17, the income from the transferred assets is taxed at
their low rates, but children under 18 are subject to
the “kiddie tax” and income above $1,600 is taxed at
the parent’s higher rate. A parent must
transfer the asset generating the income into the children’s names and this can
be done using a variety of trusts or custodial arrangements. The Tax Increase
Prevention and Reconciliation Act of 2006 raised the “kiddie
tax” age from under age 14 to under age 18 for years beginning in 2006.
Tax-exempt bonds. Another way to achieve economic growth while avoiding tax is
simply to invest in tax-exempt bonds or bond funds. A small investment in
so-called zero coupon bonds can grow into a fairly sizable fund by the time a
child reaches college age. “Stripped” munis carry similar
advantages.
Series EE U.S. savings bonds. The two advantages of these bonds are
that interest is not reported for tax purposes until the bonds are cashed in
and interest on “qualified” Series EE (and Series I) bonds may be exempt from
federal tax if used for qualified college expenses (purchased in the parent’s
name only and used for tuition, room & board). Be aware that for year 2006 that the savings
bond tax exemption begins phasing out when AGI hits $94,700 for joint return
filers and is gone entirely at $124,700 ($63,100, $78,100 for single filers).
Qualified tuition programs. These 529 plan programs allow a parent 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 $12,000 (for 2006) 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 and distributions from qualified
tuition programs are tax-free to the extent the funds are used to pay qualified
higher education expenses, otherwise there is a 10% tax penalty.
Coverdell education savings accounts. This savings account allows parents to make
contributions of up to $2,000 for each child under age 18. The right to make
these contributions begins to phase out once AGI is over $190,000 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 qualified education expenses. If the child doesn't attend
college, the unused funds can be transferred tax-free to a Coverdell ESA of
another member of the child's family who hasn't reached age 30 to avoid a tax
and penalty.
If you
wish to discuss any of the above tax-favored strategies for saving for your
children, or other alternatives, please call our firm.
Paying college expenses. The tax saving provisions involving
current college expenses include credits for tuition paid, writing off some
education related interest, and a deduction on some expenses during 2006. There are also tax-advantaged ways of getting
your child’s expenses paid by others.
Tuition
tax credits. The Hope tax
credit is a 100% credit for the first $1,100 in tuition and a 50% credit for
the second $1,100 (for the first two years in college). The Lifetime Learning
credit is a 20% credit for up to $10,000 in tuition which applies to every
additional year of college. There is a phase out for both credits between $90,000
and $110,000 (or singles with income between $45,000 and $55,000). (The maximum
credit amounts are doubled for students in the Gulf Opportunity Zone in 2005
and 2006) Only one credit can be claimed
for the same student in any given year. However, a taxpayer is allowed to claim
a Hope or a Lifetime Learning credit for a tax year and to exclude from gross
income amounts distributed (principal and earnings) from a Coverdell education
savings account for the same student, as long as the distribution isn't used
for the same educational expenses for which a credit was claimed.
Scholarships. Scholarships (if your child qualifies for any) are exempt from
income tax. However, a scholarship must be used for tuition, fees, books,
supplies and similar items (and not for room and board) and must not be compensation
for services.
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.”
Tuition
reduction plans for employees of educational institutions. If certain requirements are satisfied,
these tuition reductions are exempt from income tax.
College expense payments by grandparents and others. There is an unlimited exclusion from the
gift tax for payments made directly to an educational institution for tuition
expenses. The relationship between the
student and the gifting individual is irrelevant but it must be for direct
tuition costs only.
Student loans. A parent can deduct interest on loans used to pay for their
child's education at a post-secondary school, including some vocational and graduate
schools. The deduction is an above-the-line deduction of not more than $2,500.
However, in 2006 the deduction phases out for taxpayers who are married filing
jointly with AGI between $105,000 and $135,000 (between $50,000 and $65,000 for
single filers).
Bank loans. Typically this interest is not deductible, but 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. 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. Beware that 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. An
individual 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. Even if money
is allowed to be withdrawn from a 401(k), 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.
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.
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. Therefore it takes planning
to determine which 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 call our firm.