If you are a parent (or grandparent) with college-bound children (or grandchildren), you are or will soon be concerned with either setting up a financial plan to fund for futurecollege costs, or, if the children are already college age, with paying for current or imminent tuition, etc. bills. Here are some suggested 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 $22,000 a year 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 2003) 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 is 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 is 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 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 do not 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 2003, the exemption starts to disappear when your (joint) AGI hits $86,400 for joint return filers ($57,600 for singles) and is gone entirely if your AGI is at $116,140 ($72,600 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 $11,000 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.
Distributions for college costs which are made from the funds are also tax-free. Refunds are available under certain circumstances--for example, if the child dies before entering college, becomes disabled, or receives a scholarship. Refunds of the income earned for any other reason are subject to a income taxation and penalty.
Coverdell Education Savings Accounts (formerly Education IRAs. You can establish a Coverdell education savings account and generally may exclude from gross income earnings on the amount contributed to the account as long as these earnings are used for qualified expenses. Qualified education expenses are expenses for tuition, books, supplies and equipment required for the designated beneficiary to attend an eligible education institution. Room and board are considered qualified expenses for a student enrolled at least half time.
Contributions on behalf of any one beneficiary for the taxable year are limited in the aggregate to $2,000. No deductions are allowed for contributions. Qualified expenses are reduced by other education benefits that are excluded from income. of up to $500
Qualified education expenses include qualified elementary and secondary education expenses, as well as expenses for higher education.
Paying College Expenses
You may be able to take a credit for some of the child's tuition expenses or write off some of the interest on education loans. There are also tax-advantaged ways of getting the 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 $10,000 in tuition). Both credits are phased out for couples with incomes (modified AGI) between $83,000 and $103,000 (or singles with income between $41,000 and $51,000). (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 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 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 $11,000 ($22,000 in the case of married donors who consent to split gifts). If the other person pays your child's school tuition directly to an educational institution, however, there is 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 is 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 is 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 $2,500, which is not indexed for inflation. However, for 2003 the deduction phases out for couples whose AGI is between $100,000 and $130,000 ($50,000 and $65,000 for singles).
Some student loans contain a provision that all or part of the loan will be canceled 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 will not 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.
Qualified Higher Education Expense Deduction. Beginning in 2002, there is a new temporary deduction for qualified higher education expenses. Taxpayers with adjusted gross income of $65,000 or less ($130,000 for married couples filing jointly) can deduct up to $3,000 of qualified tuition and related expenses paid during a tax year for educational expenses of the taxpayer, the taxpayer's spouse, or any individual for whom the taxpayer is allowed to claim a dependency deduction. This deduction expires, unless it is extended by legislation. This deduction is an above-the-line deduction and is thus available even for taxpayers who do not itemize.
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) that 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 59 1/2. However, the distributions are subject to tax under the usual rules for IRA distributions. Some qualified plans either do not 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-IRA. This method does not work for 401(k) type plans. The strategy works because the penalty tax does not 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 careful planning to determine which should be used in any given situation.
