Before College – Planning
Generally, consider gifting your income generating assets to your child. The income earned by these assets would be subject to a lower tax rate than yours. However, with the enactment of kiddie tax, the unearned income of your child over $2,100 is taxed in the parent’s marginal bracket.
Investing in bonds may be one way to plan for your child’s future. There are several types of bond investments available in the market today. Tax-exempt bonds or tax-exempt bond mutual funds pay interest that is tax-free.
Another type of bond to consider is Series EE bonds. This type of bond has two interesting characteristics. Interest is only taxed when the bond is exchanged for cash. Additionally, interest earned can be exempt from tax if the bond is issued in the parent’s name and the proceeds are used for qualified college expenses such as tuition, fees, etc. The exemption from tax for Series EE bonds is decreased when the parent’s income exceeds certain levels.
An additional option is to invest in a 529 Plan (Qualified Tuition Program). Parents have two options with a 529 Plan. They can prepay their child’s tuition by buying tuition credits at today’s cost for future use or they can contribute to an investment account that is specifically set up for higher education. The contributions are not tax-deductible however they qualify for the annual gift tax exclusion of $14,000. In case your contribution is higher than the $14,000, parents may elect to treat the contribution as it was made over 5 years. Accumulated income grows tax-free until it is distributed from the account. Distribution proceeds used for qualified college expenses are exempt from tax, but if the distribution proceeds are used for other purposes, the withdrawal becomes taxable plus a 10% tax penalty on the amount of the withdrawal.
Lastly, Coverdell education savings accounts (Coverdell ESAs) may be the option you are looking for. Set up this account and have the ability to contribute up to $2,000 a year for your child under age 18 (age limitation is different children with disabilities). The contribution is not tax-deductible; the income earned by the account is not taxed and will be tax-free if used for qualified college expenses. If your child decides not to pursue a college education, the child has to claim the money by age 30, the earnings are taxable, and the earnings are subject to a federal tax penalty of 10%. The unused funds of an account owner who is over 30 can be transferred tax-free to a sibling’s Coverdell ESA account who is under the age of 30.
While in College – Paying
Thinking, “I am too late. My child is about to enroll in college and there are no funds set aside?” There are also ways to get tax savings from paying college expenses.
American Opportunity tax credit is a $2,500 tax credit per child for the first 4 years of their education. Qualified expenses include tuition, fees and books. 40% or $1,000 of this credit may be refundable.
For students that go on for secondary and graduate degrees the lifetime learning credit maybe available. The amount of this credit is limited to $2,000 per family and is calculated at the rate of 20% of expenses up to $10,000 in qualifying expenses.
These tax credits are designed to progressively decrease or even become wiped out when income exceeds certain levels. This may actually result in the credit not being available.
Scholarships should be the first choice to pay for a student’s education. This will reduce education costs since they are generally tax-free. The scholarship is taxable when it is considered compensation.
When employers pay an employee’s child’s tuition, the employee is usually taxed on the value of the payments. There is an exception to this rule, when focus of the education is different from the work of the employer, for tax purposes it is a scholarship and tax-free.
Gifting is an option before and after the student starts college. For example the student’s grandparents want to gift money to pay for their grandchild’s college costs. A single grandparent may give the student up to $14,000 without paying gift tax. Married grandparents may give the student up to $28,000 without paying gift tax. It must be noted that tuition directly paid to the educational institution falls under an unlimited gift tax exclusion.
Some parents consider having the student get a loan instead. As a general rule, interest from student loan is not deductible, however up to $2,500 in interest is deductible when the loan proceeds pay for higher education.
Parents and students can also opt to withdraw money from their retirement plans. Recipients of retirement plan funds are exempted from 10% penalty for premature distribution when the withdrawals pay for college costs. The withdrawal may be taxable depending on the type of retirement plan..
There are various ways to plan your child’s educational cost, but not all of the items discussed applies to all individuals and can be used at the same time. Uncertain as to what is the best option for you or you would like to know more of tax planning for your child’s future? This article is an example for purposes of illustration only and is intended as a general resource, not a recommendation.