Education Planning

Table of Contents

Will your child go to college? If so, the College Board estimates that secondary education costs are rising 7% to 8% annually, a rate much higher than the rate of inflation. To afford the average $7,000 total costs for a state university, you need to start saving $195 a month. Wait until your child is 7 years old and the monthly amount jumps to $240! So, it's smart to put away a little sum each month. A four-year college education at a good private university costs upwards of $100,000 in today's money. If the costs increase only 4% per year, that's equal to a $200,000 bill for any child born this year who enters college in 18 years.

In a recent Roper survey, nearly half of America's parents with children under 18 said that paying for their children's college education was their top financial goal. If you're among that group, you'd better start planning your tax strategy Now.

• 77.7% of parents feel that a college education is essential for a good life for their child
• 25.5% of grandparents think that college is essential for their grandchildren
• 90.7% of parents agree that paying for their child's college tuition is their responsibility
• 25.4% of grandchildren think that they are primarily responsible for paying for their grandchildren's college tuition

• 65.8% want an advisor to help them develop their college savings plan
• 76.4% of grandparents want an advisor to help them develop their college savings plan
• 86.4% have yet to turn to an advisor to do so; only 13.6% have worked with an advisor.
• 90.0% have yet to turn to an advisor to do so; only 10.0% have worked with an advisor.

• 93.0% of parents don't expect to qualify for financial aid
• 75.4% of grandparents don't expect their grandchildren to qualify for financial aid
• 75.5% of parents don't think they'll be able to save enough to cover tuition costs.
• 71.2% of grandparents think their children (the parents) will never save enough to cover tuition costs.
• 67.7% of parents are worried about college bills

• 73.7 of parents feel that if they save Now they won't have the family life they want today
• 56.5% of parents worry that paying for education will eat into their retirement

• 84.1% of parents think their income will keep them from qualifying for savings programs
• 70.3% of grandparents think their income will keep them from qualifying for savings programs
• 72.5 % of parents feel that the current plans don't allow them to put enough money away<
• 82.2% of grandparents of parents feel that the current plans don't allow them to put enough money away

Lifetime Earnings Estimate for College Graduates

Financing your Children's Education

An ever-stressful topic among parents is how to accumulate sufficient resources to meet their children's education funding needs. Ideally, the accumulation of resources for education costs should be based on an investment strategy that incorporates fundamental investment planning principles. Before an investment strategy is formulated a parent may wish to address three basic issues that may be critical to successful planning:

A sound first step is to address the question of who wants control of the assets. If the parent is not comfortable with giving up control of the investment assets that are going to be put aside for their child's education, the investment assets should remain in the parent's ownership. This may cause the investment assets to be taxed at the parent's higher marginal tax rate, but the parent is keeping control of the assets and this may be what is most important. If, on the other hand, the parent has no reservations transferring assets into their child's name, then this can be easily accomplished by utilizing an UGMA/UTMA account. This, of course, comes with the understanding that if their child fails to go to college and instead wishes to become an avid European back-packer, it is the child's money and he/she can do with it as he/she wishes upon reaching the age of majority. Remember that all transfers (gifts) to a child via an UGMA/UTMA account are irrevocable and the parent needs to be aware this really does mean non-changeable.

Second, a parent with a college bound child intending to seek financial aid should consider how assets owned by the child may be treated by colleges and universities during the financial aid needs review. Typically, 35% of assets held in the child's name may be deemed available to meet education expenses while 5% to 6% of the same assets may be deemed available if owned by the parent. The net effect may be potentially less financial aid for the child and, indirectly, the parent if assets are held in the child's name.

Finally, the decision to transfer assets into the child's name should be based upon a good understanding of the "Kiddie Tax" rules and to what extent the parent may derive tax benefits. For children under age 14, the first $750 of unearned income is tax-free, and the next $750 is taxed at the child's rate which is most often 15%. All investment income over $1,500 (for 2001) is taxed at the parent's marginal tax rate, assuming the parent's rate is higher than the child's rate. The age cap of 14 on the "Kiddie Tax" may allow for some potential tax savings depending on the amount of assets the parent is going to transfer into the child's name. For example, if the assets transferred to the child's name generates $1,500 in investment income or less per year the resulting tax burden assessed will be at an effective rate of 7.5%. If the investment income exceeds $1,500, all additional income will be taxed at the parent's marginal tax rate that could be as high as 39.1%.

Beginning in the year the child turns 14, however, the child's unearned income is taxed at the child's rate. Thus, a strategy to shift unearned income to the child beginning in the year the child turns 14 to take advantage of what might be as much as a 24.1% tax bracket differential (39.1% vs. 15%) may be a prudent and beneficial decision. Also, with recent tax law changes, the differential for long-term capital gains is now 10% vs. 20% for most children 14 years or older compared to 15% vs. 27.5%. From a practical standpoint, with the child reaching the age of 14, the parent will start to get a good indication of what type of child they have, studious or European back-packer, and may be more comfortable in making the decision to transfer assets at this point.

Expanded 529 plans

529 plans are plans run by financial institutions under license from each state. Each state plan is different from the others, some states have more than one plan. The plans let you contribute funds for college generally in a set number of mutual funds. The earnings add to the fund tax free. And, better than that, the money is Federal income tax-free when you take it out, (state income tax free in Oregon, Washington has No state income tax.

• Benefits federally tax-exempt if used for qualified expenses.
• Private institutions can offer these plans. Tax-free benefits for withdrawals starting in 2004. Click here for more on 529 plans including Independent plan.
  click here for list of schools by state. Even some foreign universities qualify.
• If child attends in-state school, costs are covered by credits or certificates purchased.
• By buying prepaid tuition credits, you lock in future tuition costs at today's rates.
• There may be state tax breaks when you contribute.
• No investment risk, unless the state mismanages the funds.
• May have limited enrollment period.
• May significantly reduce opportunities for financial aid.
• Limited availability: Typically the donor or beneficiary must be a resident of the state.
• If child attends out-of-state school, some of the costs may Not be covered.

The Coverdell Education Savings Account (formerly the Education IRA)

Congress increased the contribution limit from $500 a year to $2,000 for each child under age 18 into a Coverdell Education Savings Account. The new rules take effect in January 2002. You can take money out of the account - tax-free - when your child enters college. What you get is tax-deferred growth and tax-free withdrawals, much like a ROTH IRA.

If you contribute $2,000 a year via monthly contributions into an Coverdell Education Savings Account for your child from the day she's born If the account earns 7% a year (compounded monthly), you'll have build up a fund of nearly $71,800 by the time your child reaches the age of 18. In a taxable account, for example, earning 8.2% a year in the lowest tax bracket would be the equivalent return.

Your ability to qualify for an Coverdell Education Savings Account phases out if your modified adjusted gross income on a joint return is between $190,000 and $220,000, or between $95,000 and $110,000 for single filers. However, the Coverdell Education Savings Account is per child. If you don't qualify because your income is too high, a lower bracketed grandparent, for instance, may qualify.Click here for more information

Regular IRAs

Your IRA can help too. Moreover, you can Now tap your regular IRA penalty-free to pay for qualified educational expenses. There is no 10% penalty if an IRA Withdrawal is used to pay qualified higher education expenses (college tuition, books, fees, supplies and equipment) of the taxpayer, spouse, child, or grandchild. For a traditional IRA, ordinary income tax will be due on distributions. For a Roth IRA owner hasn't been invested for five years, ordinary income tax will be due only on earnings portion of the distribution.

The 1997 act also allows you to deduct up to $2,500 in interest paid for educational loans as an above-the-line deduction. This deduction begins to phase out at a modified adjusted gross income level of $60,000 for joint filers and $40,000 for all others. These limits are also indexed for inflation.

Tax credits

One of the newest ways to mitigate the financial malaise of college came when Congress created two new tax credits specifically for education in 1997.

Tax-Free qualified withdrawals are subject to potential sunset revisions on December 31, 2010. At this time Congress may change the tax-free withdrawal status for qualified education expenses.

The Hope Scholarship offers a tax credit of up to $1,500 a year for the first two taxable years that your child is in college. The government will give you a dollar-for-dollar credit for the first $1,000 of tuition and related expenses and 50 cents on the dollar on the next $1,000. This credit applies to expenses paid after 1997 for academic periods beginning after that date.

• Taxpayers can deduct 100% of the first $1,000 of qualified education expenses plus 50% of the amount paid over $1,000.
• Maximum credit per student per year is $1,500.
• Can only use credit for two years.
• Can't be used if student has already completed two years of college.
• Can't apply same expenses to both Hope Scholarship and Lifetime Learning Credit.
• Can't claim if modified adjusted gross income is more than $51,000 (single) or $102,000 (married).

The Lifetime Learning Credit applies to expenses paid after June 30, 1998, for academic periods, and can be used any year for an unlimited number of years. It provides a 20% credit on the first $5,000 of qualified expenses (including educational expenses to acquire or to improve job skills) through 2002 and then increases to 20% of the first $10,000 thereafter.

These credits phase out at modified adjusted income levels of between $80,000 and $100,000 for joint filers and from $40,000 to $50,000 for others. These limitations are indexed for inflation. These credits, however, can't be claimed if an Coverdell Education Savings Account distribution is used to pay educational expenses for the same taxable year.

• Taxpayers get a credit on their income tax return of 20% of up to $5,000 for qualified education expenses actually paid. Starting in 2003, the $5,000 limit is increased to $10,000.
• No limit to number of years the credit can be claimed.
• Can't apply same expenses to both Hope Scholarship and Lifetime Learning Credit.
• Can't claim if modified adjusted gross income is more than $51,000 (single) or $102,000 (married).

Taxpayers who fall within certain income limits may be able to deduct money spent on tuition and related education expenses. If adjusted gross income is less than $65,000 (single) or $130,000 (married filing joint), up to $3,000 may be deducted. (The deduction increases to $4,000 in 2004-2005.) A partial credit is allowed if adjusted gross income is less than $80,000 (single) or $160,000 (married filing joint). You can't use the deduction if claiming HOPE Scholarship or Lifetime Learning credit in the same year and you can't use if expenses were paid by tax-free withdrawals from Coverdell Education Savings Account or U.S. Savings Bonds.

Deductible expenses

Starting in 2002, you can also deduct up to $3,000 a year in 2002 and 2003 in qualified educational expenses in 2002 and 2003. It jumps to $4,000 in 2004 and 2005. You can't take the deduction and the credit in the same year for the same student. You can use the credit with one child and the deduction with another. The deduction is limited to taxpayers whose joint income doesn't exceed $65,000 (for singles) or $130,000 for married couples filing jointly.

Saving in the Parents' Names

If you want to maintain control of the assets, have maximum investment flexibility, and have them represent a smaller part of the financial aid equation, then you may want to consider saving a portion (or all) of your college funding money in the parents' names. You avoid the problem of the child owning assets, as the child would in a UTMA/UGMA account or a Coverdell Education Savings Account, and a smaller portion of assets in the parents' names is counted in the financial aid formulas. If your child doesn't go to college, you have the flexibility to use the money for any purpose. You also avoid the expense of setting up a trust.

Savings bonds

The easiest way to get IRS-subsidized tuition payments is with the special U.S. Savings Bond exclusion. You can potentially exclude all or a portion of the interest that accrues on such bonds if you:

1. Pay qualified higher education expenses in the year of redemption;
2. Are Not married and filing separately, and
3. Do Not have income over a certain amount. The maximum income you can generate and still qualify for the full deduction is $81,100 for joint returns and $54,100 for all other returns. The interest exclusion is phased out as your income rises, with No exemptions for couples whose joint income tops $111,100 and for individuals with income of $69,100 or higher.

The bond must be in your name, Not in the name of your child, and you had to buy it, Not a relative or family friend. Once your child's in college, you can't claim an exemption for any bonds that exceed the cost of the education. For example, if that year's educational costs total $25,000, that's the most you can cash in and declare exempt for taxes.

To make the numbers simple, assume you redeem qualified bonds with $10,000 in accrued interest. If you're in the 28% bracket, you'll save $2,800 in taxes that will therefore become available for other needs -- such as college expenses.

• Safe. Backed by the U.S. government.
• EE-bonds purchased after 1989 and all I-bonds allow tax-exempt distributions if used for qualified education expenses (tuition and fees) and if income limits are met (see below).
• Interest exempt from state and local taxes.
• You forfeit three months of interest if you redeem before five years.
• You have to be at least 24 years old to buy the bond.
• If your income is more than $116,400 (married filing joint) or $72,600 (single), you can't exempt the interest even if the proceeds are used for qualified education expenses.
• Only tuition and fees are qualified education expenses.
• Only the bondholder, his/her spouse or dependent get the interest exclusion. If the grandparent holds the bond, he/she can't claim any interest exclusion unless grandchild is dependent.
• The interest exclusion may be reduced by other education tax breaks (Hope Scholarship, Lifetime Learning Credit, scholarships, Education IRA withdrawals, Section 529 plan withdrawals) when used in the same tax year.

Investing in your child's name

While the techniques I outlined above will work, the hoops that must be jumped through make it inappropriate for some families. An alternative is to use the "Schnepper Family Unit" strategy. This technique assumes that the family is a single economic unit. Therefore, it really doesn't matter who makes the money so long as it ends up in the family economic pot. This allows us to take advantage of the nation's progressive tax structure to shift income from a family member who's in a higher tax bracket to a lower bracketed member.

Let's see how this can work. If I'm in the 35% bracket in 2004 and earn $3,900 in interest, I lose $1,365 in taxes ($3,900 x .35). But if that investment was in the names of my three children, the tax bite drops significantly. Let's say we split the $3,900 evenly so that each child gets $1,300. The tax is zero on the first $800 and 10% on the next $500 for a total of $150 in taxes paid ($500 x 3 = $1,500; $1,500 x .10 = $150). By shifting the tax burden to my children, I saved $1,215 in one year ($1,365 - $150) or $12,150 over 10 years. That's a meaningful contribution to my tuition bill.

Children under 14 face a complicated but generally lower tax situation. Right Now, $800 a year in income is tax free. The next $800 is taxed at the child's rate (10%). The amounts over $1,600 are taxed at the parents rate. Once the child hits age 14, he or she can earn up to $29,050 and have it taxed at 10% up to $7,150 and $15% from $7,100 up to $29,050. The difference between a 15% bracket and a 35% bracket on $29,050 is more than $58,000 per child over a 10-year period -- and that doesn't count the earnings on the difference saved.

This technique is not without its drawbacks. The investment has to be in the child's name and that means your child might Not use it for what you want. However, if the investment is put in an appropriately drafted trust, you can still give up ownership without truly losing full control over its ultimate disposition. No trust need be used if you set up a Uniform Gifts to Minors account with your broker or bank, but then the child gets full control over the funds at age 21.

Another problem is that it lowers your child's chances for financial aid. Colleges assume that any funds owned directly by a prospective student should be used to pay for his or her education. They're more lenient on the parents. So if your child is only a couple of years away from entering college, you may Not want to use this strategy because it could decrease the amount of financial aid offered.

Despite the drawbacks, some recommend the technique. They would rather be assured of a sum of money available for their children's education than depend upon the availability of scholarship money in the future.

2503(c) Minor's Trust

This is a separate entity set up to manage money on behalf of a minor. The advantages are that the trustee has ability to spend money on behalf of the minor until they reach age 21; You May contribute an unlimited amount, but amounts in excess of $11,000 per year per beneficiary ($22,000 if gift splitting) may be subject to gift tax. (May be able to use unified credit to offset gift tax.); The trust can continue after child turns 21 if child agrees; and the trustee can invest in a wide variety of investment vehicles. The disadvantages are that the trust may be expensive to set up; Gift to trust is irrevocable; Income taxed at trust rates; the child gains control at age 21; the trust may decrease chances of receiving financial aid. and there is no guarantee of investment results.

Hire your Children

If you're self-employed or have any self-employment income (for example, a teacher might earn self-employment income by tutoring), your income shifting opportunities are greatly expanded. The Tax Court has validated a parent hiring children as young as 7 years old. Such income is Not subject to the limitation on "unearned" income as described previously and is normally not subject to federal/state unemployment taxes or Social Security taxes (as long as the child is under age 18 and you are not incorporated).

Let's see how this works. Assume I'm in the 28% bracket and have three children who work for me. They essentially act as my secretaries, filing papers, typing letters and handling other office-related tasks. I pay each child $10,000 or a total of $30,000. They each put $2,000 in an IRA and each pays a tax of $315 ($10,000 less the $2,000 for the IRA and a standard deduction of $4,850 is $3,150. The tax at 10% is $315.) The total tax for the three of them in 2004 is $945.

Let's see what I have saved. Had I Not paid them, I would have paid a tax of 28% on $30,000, or $8,400. I have saved $7,455 in one year ($8,400 - $945). In addition, since this $30,000 expense reduces my income for Social Security and Medicare purposes, I've potentially saved an additional $4,590 (15.3% of the $30,000, ignoring the deduction for one-half the self-employment tax paid) for a total savings of $12,990 in 2004 alone.

Obviously, the numbers above are simplified for example purposes but the magnitude of potential savings is real. Such transactions will Not increase your chances of being audited and will validate your children's employment. You might keep a log of when they worked and what they did. I suggest that you write to your state Department of Labor to ask if hiring your minor child to work in your home office would violate any child labor laws. I know of No state where it would, but the responding letter is important as an independent third party validation of the reality of the transaction. Write checks to your children and have the money deposited into their accounts. The key to winning the IRS game is proof that you did what you say you did.

Substantial income tax reductions can be achieved by shifting income to other family members. In the appropriate situation, it's a strategy where the returns are well worth the time and effort. If college is your top financial goal, use all of the tricks available to achieve it.

Last Minute Investing ideas

Tassels, caps, gowns and football season - sights that trigger high school students' dreams of college - often signal a financial nightmare for parents facing college costs estimated to reach as high as $120,000 by many sources within the next few years. There is no miracle solution for financially strapped parents with only a few years to raise funds for their child's college education, but there are several investment vehicles that can help.

For instance, with children more than five years away from college, growth oriented portfolios offer an investment direction and return potential for parents to achieve the necessary education fund. Parents should be careful to keep the assets in the parent's name instead of the child. This keeps the child from spending the money on something other than a college education when the child becomes legally entitled to the funds.

A more conservative investment approach is recommended if a child will attend college in three to five years. It would be an unhappy last summer if college investments took an untimely dip. A balanced portfolio with a mix of equities and bonds is a conservative investment approach that attempts to minimize this risk through diversification.

For families with only a year or two to the first big day, short-term, fixed income investments, may offer the necessary liquidity and safety of principal. If a family needs to protect its principal the best route to take may be short-term investments such as U. S. Government notes, money market mutual funds, and bank CDs that can all provide some assistance in this area.

For families in immediate financial need, a last minute option may include securing a home equity loan, where the interest paid on the loan may be tax deductible. Another option might entail loaning to oneself by borrowing from a 401(k) retirement plan. Of course, this would only be possible if the particular retirement plan allows for it.

Finally, unless the total amount needed to pay for a college education is saved, students should apply for any type of financial aid available to them. This includes any grants, loans, or scholarships for which they qualify. Of course, all of these recommendations must be considered in light of your particular financial circumstances. Be sure to consult a financial planner to help you choose the best last minute options.