Tax Tip for May 2003
Tax planning for college
As a parent with college-bound children, you are or will soon be concerned
with either setting up a financial plan to fund for future college costs, or, if
your children are already college age, with paying for current or imminent
tuition, etc. bills. We'd like to address both of these concerns by suggesting
several 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 (for 2003) 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 (as low as 10% in 2003). 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 that it's 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's 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 don't 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 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 (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 $87,750 for joint return filers
($58,500 for singles) and is gone entirely if your AGI is at $117,750 ($73,500
for singles). (These figures are adjusted annually for inflation.)
Qualified tuition programs. A qualified 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
aren't deductible, and the contributions are treated as taxable gifts to the
child but they are eligible for the annual $11,000 (for 2003) 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 until the college
costs are paid from the funds. And, beginning in 2002, distributions from
qualified tuition programs are tax-free to the extent the funds are used to pay
qualified higher education expenses. States and their agencies or
instrumentalities and private education institutions are all permitted to
establish qualified tuition programs. (Note, however, that distributions from
private education institution programs won't be tax-free until 2004.)
Distributions of earnings that aren't used for qualified higher education
expenses will be subject to income tax plus a 10% penalty tax.
Coverdell education savings accounts. You can establish Coverdell
education savings accounts (formerly called education IRAs) and make
contributions of up to $2,000 for each child under age 18. (This age limitation
does not apply to a beneficiary with special needs, defined as an individual who
because of a physical, mental or emotional condition, including learning
disability, requires additional time to complete his or her education.) The
right to make these contributions begins to phase out once your 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 higher education expenses. (Distributions
are also tax-free if spent on qualified education expenses for elementary and
secondary school education.) If the child doesn't attend college, the money must
be withdrawn when the child turns 30, and any earnings will be subject to tax
and penalty, but unused funds can be transferred tax-free to a Coverdell
education savings account of another member of the child's family who hasn't
reached age 30. (These requirements that the child or member of the child's
family not have reached 30 do not apply to an individual with special needs.)
The above are just some of the tax-favored ways to build up a college fund
for your children. If you wish to discuss any of them, or other alternatives,
please call.
Paying college expenses. You may be able to take a credit
for some of your child's tuition expenses, or write off some of the interest on
education loans. You may also be able to take a deduction for some of those
expenses that you pay in 2002-2005. There are also tax-advantaged ways of
getting your child's college expenses paid by others.
Tuition tax credits. You can take a Hope tax credit of up to $1,500 a
year (for 2003) 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 $2,000 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 2003 for couples with incomes 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. But, beginning in
2002, 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 (both the
principal and the earnings portions) from a Coverdell education savings account
for the same student, as long as the distribution is not used for the same
educational expenses for which a credit was claimed.
Deduction for college costs (available 2002-2005). Starting this year
(and only through 2005), certain taxpayers are permitted to take an
above-the-line deduction for college tuition and related expenses that they pay.
(An above-the-line deduction is more favorable than a below-the-line deduction
because it may be taken regardless of whether the taxpayer elects to take the
standard deduction or to itemize deductions, and it's not subject to the overall
limitation on itemized deductions or to the 2% floor on miscellaneous itemized
deductions.) In 2003, for taxpayers with AGI of up to $65,000 for singles and
$130,000 for joint return filers, the maximum deduction will be $3,000, The
deduction can't be taken in the same year that a Hope or Lifetime Learning
credit is claimed for the same student. However, it can be claimed in the same
year as an exclusion is available for distributions from a Coverdell education
savings account or qualified tuition plan or for interest on education savings
bonds, as long as the deduction and exclusion aren't claimed for the same
expenses.
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.) Note also that, beginning in 2002, in an exception to the rule
that a scholarship must not be compensation for services, a scholarship received
under a health professions scholarship program may be tax-free even if the
recipient is required to provide medical services as a condition for the award.
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.” 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) (for 2003). If the other 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 unlimited gift tax exclusion applies
only to direct tuition costs. There's 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's available even to
taxpayers who don't itemize). The maximum deduction is $2,500. However, the
deduction phases out for taxpayers who are married filing jointly with AGI
between $100,000 and $130,000 (between $50,000 and $65,000 for single filers).
(Some student loans contain a provision that all or part of the loan will be
cancelled 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 won't 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.)
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'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 could be 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.
You 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 591/2 . 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. 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 591/2 . (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. This method doesn't work for 401(k)
type plans. The strategy works because the penalty tax doesn't 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 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.
