Resources: Financial Planning: Planning for College

Planning for College

One of our clients’ most frequently asked questions concerns paying for college costs. Often, the best approach is a combination of strategies. While there is no one-plan-fits-all answer, this article points to some options that may be of help to parents faced with mounting college costs.

Transfer of Assets

In many cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $26,000 a year (as of 2010) in cash or assets to each child with no gift tax consequences. For children 14 years and older the income from the assets is taxed entirely to them at their lower tax rates (10% in most cases). However, income for children under 19 (and dependent full-time students under 24) may be taxed at your rates. Under the “kiddie tax” rules, unearned income greater than $1,900 (adjusted annually for inflation) will be taxed at the parents’ rates.

A variety of trusts or custodial arrangements can be used to place assets in your children’s names. Note that it is not enough just to transfer the income to your children, e.g., through dividend checks. The income would still be taxed to you. You must actually transfer the asset that’s generating the income into their names.

Savings and Investments

Tax-exempt bonds

One way to achieve economic growth while avoiding tax is simply to invest in tax-exempt bonds or bond funds. Because interest rates and degree of risk vary on these, care must be taken in selecting your particular investment. Some tax-exempts are sold at a deep discount from face value and don’t carry interest coupons. Many are marketed as college savings bonds. A small investment in these so-called “zero coupon bonds” could 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 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 is used for qualified expenses, only that part of the interest is exempt. But there is a danger — if your adjusted gross income (AGI) is too high, the exemption is phased out. As of 2009 - for taxpayers filing joint returns, the exemption starts to “disappear” when your AGI hits $104,900 and is gone entirely if your AGI is at $134,900 or higher. For those who file single returns, the phase out begins at an AGI of $69,950 and the exemption is gone when AGI reaches 84,950. These amounts are adjusted annually for inflation. So, for many taxpayers the savings bond exemption offers no tax savings.

Qualified Tuition Programs

Section 529 of the Internal Revenue Code allows states and some colleges to offer tax-advantaged “qualified tuition plans” (QTPs), often called 529 Plans. There are two types of QTPs. Prepaid tuition plans allow the purchase of tuition credits for a child, essentially paying for tomorrow’s tuition at today’s prices. Many states already offer prepaid tuition plans. Beginning in 2002 private colleges will also be allowed to establish these plans. College savings plans permit investors to make contributions to an account set up specifically to meet a child’s future higher education expense. These plans are offered by many states to both residents and nonresidents.

Contributions to these programs aren’t deductible; they are treated as taxable gifts to the child. However, the contributions are eligible for the annual $13,000 (in 2010) gift tax exclusion. (Annual gift tax exclusion may be adjusted annually for inflation.) Also, 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 five-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. Effective in 2002, distributions from a state-sponsored plan that are used for higher education costs will be federal tax-free. Similar distributions from a collegiate plan became tax free in 2004. 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.

The designated beneficiary may access QTP funds only for qualified higher education expenses. This safety feature plus the favorable federal tax treatment have contributed to a rapid increase in the popularity of these plans. Most states now offer QTPs, with about half of them allowing nonresident participation. College savings plans offer market-based returns and greater flexibility concerning college choice than prepaid tuition plans. The guaranteed tuition promised by the prepaid plans appeals to more conservative investors. Financial aid formulas treat the savings plans more favorably than the prepaid plans.

Coverdell Education Savings Accounts (CESA)

Formerly known as an Education IRA, a CESA is another tax advantaged way to save for educational costs. Although the contributions are not deductible, funds in the account aren’t taxed, and the distributions are tax-free if spent on qualified education expenses. Beginning in 2002, CESA contributions of up to $2,000 annually per a beneficiary will be allowed. The age 18 restriction will be eliminated in cases where a beneficiary has “special needs.” The right to make these contributions phase out for taxpayers with AGI of $95,000–$110,000 (for singles) and $190,000–$220,000 (on a joint return). If the income limitation is a problem, the child can make a contribution to his or her own account.

CESA funds may be used to pay for qualified educational expenses, including post-secondary tuition, fees, books, supplies and equipment. In 2002, an expanded definition of “qualified education expenses” takes effect. Elementary and secondary school tuition, room and board, uniforms, computers, and extended day program costs are allowable expenses. If the child doesn’t use the CESA toward education, the money must be withdrawn when the child turns 30. Any earnings will be subject to tax and penalty, but unused funds can be transferred tax-free to an CESA of another child in your family.

Other Ways to Handle College Costs

There are numerous other ways to finance an education, and each has its own tax implications. Scholarships, student loans, financial assistance from relatives, federal tax credits, and employer sponsored education programs usually can’t cover the expense alone, but in conjunction with other funding options, they can lessen the burden.

Deduction for Qualified Higher Education Expenses

A new deduction for qualified higher education expenses took effect in 2002. This is an above-the-line deduction, meaning it is available even to taxpayers that don’t itemize. In 2009 the maximum deduction was $4,000 for single filers with an AGI of $80,000 or less and joint filers with an AGI of $160,000 or less.

Tuition tax credits (information is as of 2009)

The Hope Credit allows taxpayers a credit of up to $3,000 a year per student or the first two years of college (a 100% credit for the first $2,400 in tuition and a 50% credit for the second $2,400). The Lifetime Learning Credit is a tax-credit of up to $2,000 per family for every additional year of college or graduate school (a 20% credit for the first $10,000 of tuition. Both credits are phased out for couples with joint income between $100,000 and $120,000 in 2009 and single filers with income of $50,000 to $60,000 in 2009. The amount of tuition on which the Lifetime Learning Credit is based does not include tuition of an individual for whom a Hope Credit is allowed for that year. These credits may be claimed in the same year in which tax-free distributions are made from a Coverdell Education Savings Account, provided they don’t involve the same educational expenses.

Deduction for student loan interest

Interest paid on student loans is tax deductible, up to a maximum of $2,500 per a year. The student loan interest deduction may be claimed whether or not a taxpayer itemizes. The deduction begins phasing out when AGI exceeds $60,000 for single filers and $120,000 for joint filers as of 2009.

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 must be used for tuition, fees, books, supplies and similar items (not including room and board).

Employer educational assistance programs

If your employer pays your child’s college expenses, the payment is a fringe benefit to you. It is, therefore, taxable to you as compensation, unless the payment is part of a scholarship program that’s “outside of the pattern of employment.” In that case, the payment would 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, the 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 $13,000 as of 2010 ($26,000 in the case of married donors who consent to split gifts). If that 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 exclusion applies only to direct tuition costs. There’s no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc.

Bank loans

You may of course take out loans to pay for your child’s educational expenses. The interest on such loans is personal interest, which is 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

Qualified retirement plans and IRAs represent the largest cash resource of many taxpayers. IRA funds can be tapped at any time and you can pull money out of your IRA to pay college costs without incurring the 10% early withdrawal penalty that usually applies to withdrawals from an IRA before age 59½. But 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 regulations name a college education as such a need.

To the extent that 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. As discussed above, IRA funds can be withdrawn to pay for college costs without incurring this penalty.

A younger plan participant may avoid triggering the penalty tax by annuitizing payouts from an IRA or a SEP. This method doesn’t apply to 401(k) type plans. The strategy works by avoiding the penalty tax 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).

Important note: This is a summary, and as such, it is not intended as a complete explanation of all applicable situations. Many exceptions, definitions, and special rules in the law have been paraphrased, simplified and/or omitted. Readers should not take specific action based on this summary without first consulting the statute and regulations or seeking advice from a qualified professional.

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Overview Business Financial Planning Elective Deferrals Your Financial Paperwork First Time Homebuyer and IRA Withdrawals Funding Health Care Expenses Planning for College Roth IRA – Is it the Best IRA for You? Individual QuickBooks Other		Planning for College One of our clients’ most frequently asked questions concerns paying for college costs. Often, the best approach is a combination of strategies. While there is no one-plan-fits-all answer, this article points to some options that may be of help to parents faced with mounting college costs. Transfer of Assets In many cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $26,000 a year (as of 2010) in cash or assets to each child with no gift tax consequences. For children 14 years and older the income from the assets is taxed entirely to them at their lower tax rates (10% in most cases). However, income for children under 19 (and dependent full-time students under 24) may be taxed at your rates. Under the “kiddie tax” rules, unearned income greater than $1,900 (adjusted annually for inflation) will be taxed at the parents’ rates. A variety of trusts or custodial arrangements can be used to place assets in your children’s names. Note that it is not enough just to transfer the income to your children, e.g., through dividend checks. The income would still be taxed to you. You must actually transfer the asset that’s generating the income into their names. Savings and Investments Tax-exempt bonds One way to achieve economic growth while avoiding tax is simply to invest in tax-exempt bonds or bond funds. Because interest rates and degree of risk vary on these, care must be taken in selecting your particular investment. Some tax-exempts are sold at a deep discount from face value and don’t carry interest coupons. Many are marketed as college savings bonds. A small investment in these so-called “zero coupon bonds” could 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 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 is used for qualified expenses, only that part of the interest is exempt. But there is a danger — if your adjusted gross income (AGI) is too high, the exemption is phased out. As of 2009 - for taxpayers filing joint returns, the exemption starts to “disappear” when your AGI hits $104,900 and is gone entirely if your AGI is at $134,900 or higher. For those who file single returns, the phase out begins at an AGI of $69,950 and the exemption is gone when AGI reaches 84,950. These amounts are adjusted annually for inflation. So, for many taxpayers the savings bond exemption offers no tax savings. Qualified Tuition Programs Section 529 of the Internal Revenue Code allows states and some colleges to offer tax-advantaged “qualified tuition plans” (QTPs), often called 529 Plans. There are two types of QTPs. Prepaid tuition plans allow the purchase of tuition credits for a child, essentially paying for tomorrow’s tuition at today’s prices. Many states already offer prepaid tuition plans. Beginning in 2002 private colleges will also be allowed to establish these plans. College savings plans permit investors to make contributions to an account set up specifically to meet a child’s future higher education expense. These plans are offered by many states to both residents and nonresidents. Contributions to these programs aren’t deductible; they are treated as taxable gifts to the child. However, the contributions are eligible for the annual $13,000 (in 2010) gift tax exclusion. (Annual gift tax exclusion may be adjusted annually for inflation.) Also, 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 five-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. Effective in 2002, distributions from a state-sponsored plan that are used for higher education costs will be federal tax-free. Similar distributions from a collegiate plan became tax free in 2004. 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. The designated beneficiary may access QTP funds only for qualified higher education expenses. This safety feature plus the favorable federal tax treatment have contributed to a rapid increase in the popularity of these plans. Most states now offer QTPs, with about half of them allowing nonresident participation. College savings plans offer market-based returns and greater flexibility concerning college choice than prepaid tuition plans. The guaranteed tuition promised by the prepaid plans appeals to more conservative investors. Financial aid formulas treat the savings plans more favorably than the prepaid plans. Coverdell Education Savings Accounts (CESA) Formerly known as an Education IRA, a CESA is another tax advantaged way to save for educational costs. Although the contributions are not deductible, funds in the account aren’t taxed, and the distributions are tax-free if spent on qualified education expenses. Beginning in 2002, CESA contributions of up to $2,000 annually per a beneficiary will be allowed. The age 18 restriction will be eliminated in cases where a beneficiary has “special needs.” The right to make these contributions phase out for taxpayers with AGI of $95,000–$110,000 (for singles) and $190,000–$220,000 (on a joint return). If the income limitation is a problem, the child can make a contribution to his or her own account. CESA funds may be used to pay for qualified educational expenses, including post-secondary tuition, fees, books, supplies and equipment. In 2002, an expanded definition of “qualified education expenses” takes effect. Elementary and secondary school tuition, room and board, uniforms, computers, and extended day program costs are allowable expenses. If the child doesn’t use the CESA toward education, the money must be withdrawn when the child turns 30. Any earnings will be subject to tax and penalty, but unused funds can be transferred tax-free to an CESA of another child in your family. Other Ways to Handle College Costs There are numerous other ways to finance an education, and each has its own tax implications. Scholarships, student loans, financial assistance from relatives, federal tax credits, and employer sponsored education programs usually can’t cover the expense alone, but in conjunction with other funding options, they can lessen the burden. Deduction for Qualified Higher Education Expenses A new deduction for qualified higher education expenses took effect in 2002. This is an above-the-line deduction, meaning it is available even to taxpayers that don’t itemize. In 2009 the maximum deduction was $4,000 for single filers with an AGI of $80,000 or less and joint filers with an AGI of $160,000 or less. Tuition tax credits (information is as of 2009) The Hope Credit allows taxpayers a credit of up to $3,000 a year per student or the first two years of college (a 100% credit for the first $2,400 in tuition and a 50% credit for the second $2,400). The Lifetime Learning Credit is a tax-credit of up to $2,000 per family for every additional year of college or graduate school (a 20% credit for the first $10,000 of tuition. Both credits are phased out for couples with joint income between $100,000 and $120,000 in 2009 and single filers with income of $50,000 to $60,000 in 2009. The amount of tuition on which the Lifetime Learning Credit is based does not include tuition of an individual for whom a Hope Credit is allowed for that year. These credits may be claimed in the same year in which tax-free distributions are made from a Coverdell Education Savings Account, provided they don’t involve the same educational expenses. Deduction for student loan interest Interest paid on student loans is tax deductible, up to a maximum of $2,500 per a year. The student loan interest deduction may be claimed whether or not a taxpayer itemizes. The deduction begins phasing out when AGI exceeds $60,000 for single filers and $120,000 for joint filers as of 2009. 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 must be used for tuition, fees, books, supplies and similar items (not including room and board). Employer educational assistance programs If your employer pays your child’s college expenses, the payment is a fringe benefit to you. It is, therefore, taxable to you as compensation, unless the payment is part of a scholarship program that’s “outside of the pattern of employment.” In that case, the payment would 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, the 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 $13,000 as of 2010 ($26,000 in the case of married donors who consent to split gifts). If that 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 exclusion applies only to direct tuition costs. There’s no exclusion (beyond the normal annual exclusion) for dormitory fees, board, books, supplies, etc. Bank loans You may of course take out loans to pay for your child’s educational expenses. The interest on such loans is personal interest, which is 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 Qualified retirement plans and IRAs represent the largest cash resource of many taxpayers. IRA funds can be tapped at any time and you can pull money out of your IRA to pay college costs without incurring the 10% early withdrawal penalty that usually applies to withdrawals from an IRA before age 59½. But 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 regulations name a college education as such a need. To the extent that 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. As discussed above, IRA funds can be withdrawn to pay for college costs without incurring this penalty. A younger plan participant may avoid triggering the penalty tax by annuitizing payouts from an IRA or a SEP. This method doesn’t apply to 401(k) type plans. The strategy works by avoiding the penalty tax 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). *Important note*: This is a summary, and as such, it is not intended as a complete explanation of all applicable situations. Many exceptions, definitions, and special rules in the law have been paraphrased, simplified and/or omitted. Readers should not take specific action based on this summary without first consulting the statute and regulations or seeking advice from a qualified professional.

Resources | Financial