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Tax Planning for College

As a parent with college-bound children, you are concerned with setting up a financial plan to fund future college costs. If your children are already college age, your goal is to pay for current or imminent college 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 some cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $30,000 in 2018 and 2019 in cash or assets to each child with no gift tax consequences. And if your child isn't subject to the “kiddie tax,” he or she is taxed on income from assets entirely at his or her lower tax rates—as low as 10% (or 0% for long-term capital gain).

However, where the kiddie tax applies, for 2018 – 2025, the child's investment income above a certain threshold is taxed using the federal income tax rates that apply for estates and trusts (instead of the lower rate that would apply for a single individual). (After 2025, and before 2018, the kiddie tax is computed differently—by applying the parents' rate to the child's investment income above a certain threshold.)

The kiddie tax applies if: (1) the child hasn't reached age 18 before the close of the tax year or (2) the child's earned income doesn't exceed one-half of his or her support and the child is age 18 or is a full-time student age 19 to 23.

A variety of trusts or custodial arrangements can be used to place assets in your children's names. Note, it's not enough just to transfer the income, e.g., dividend checks, to your children. The income would still be taxed to you. You must transfer the asset that generates the income to the children's 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” municipal bonds (munis) provide 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, you must purchase the bonds in your own 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.

If your adjusted gross income (AGI) exceeds certain amounts, the exemption is phased out. For bonds cashed in during 2019, the exemption begins to phase out when joint AGI hits $121,600 for joint return filers ($81,100 for all other returns) and is completely phased out if your AGI is at $151,600 for joint filers ($96,100 for all other returns).

Qualified tuition programs (529 plans). A qualified tuition program (also known as a 529 plan) allows you to buy tuition credits for a child or make contributions to an account set up to meet a child's future higher education expenses. Qualified tuition programs can be established by state governments or by private education institutions.

Contributions to these programs aren't deductible. The contributions are treated as taxable gifts to the child, but they are eligible for the annual gift tax exclusion ($15,000 for 2018 and 2019). A donor who contributes more than the annual exclusion limit for the year can elect to treat the gift as if it 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. Distributions from qualified tuition programs are tax-free to the extent the funds are used to pay “qualified higher education expenses”—which can include up to $10,000 in expenses for tuition for an elementary or secondary public, private, or religious school. 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 ESAs (formerly called education IRAs) and make contributions of up to $2,000 for each child under age 18. This age limitation doesn't 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, income in the account isn't taxed, and distributions are tax-free if spent on qualified education expenses. 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 ESA of another member of the child's family who hasn't reached age 30. The requirement that the child or member of the child's family not have reached 30 doesn't 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. There are also tax-advantaged ways of getting your child's college expenses paid by others.

Tuition tax credits. You can take an American Opportunity tax credit (AOTC) of up to $2,500 per student for the first four years of college—a 100% credit for the first $2,000 in tuition, fees, and books, and a 25% credit for the second $2,000. 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 and fees.

The AOTC is 40% refundable. That means that you can get a refund if the amount of the credit is greater than your tax liability. For example, someone who has at least $4,000 in qualified expenses and who would thus qualify for the maximum credit of $2,500, but who has no tax liability to offset that credit against, would qualify for a $1,000 (40% of $2,500) refund from the government.

Both credits are phased out for higher-income taxpayers. The AOTC is phased out for couples with income between $160,000 and $180,000, and for singles with income between $80,000 and $90,000. The Lifetime Learning credit is phased out (for 2019) for couples with income between $116,000 and $136,000 ($114,000 and $134,000 in 2018), and for singles with income between $58,000 and $68,000 ($57,000 and $67,000 for 2018). The phase-out range for the Lifetime Learning credit is adjusted annually for inflation.

Only one credit can be claimed for the same student in any given year. However, a taxpayer is allowed to claim an AOTC 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 isn't used for the same educational expenses for which a credit was claimed.

Qualified tuition deduction. You're allowed an above-the-line deduction for “qualified tuition and related expenses” for higher education paid during 2017 and earlier. But, absent further legislation, this deduction won't be available for 2018 and later years. These expenses include tuition and fees for the enrollment or attendance of you, your spouse, or any dependent for whom you would be able to claim a personal exemption, for courses of instruction at an eligible institution of higher education.

The maximum deduction is: (1) $4,000 for someone whose AGI, with certain modifications, doesn't exceed $65,000 ($135,000 for a joint return); (2) $2,000 for an individual whose modified AGI exceeds $65,000 ($135,000 for a joint return), but doesn't exceed $80,000 ($165,000 for a joint return); or (3) zero for other taxpayers.

Payee statement (Form 1098-T) from the educational institution required before tuition credits or qualified tuition deduction can be claimed. To claim the tuition tax credits or the qualified tuition deduction, a taxpayer must receive a Form 1098-T payee statement from the educational institution. For purposes of this requirement, if a person the taxpayer claims as a dependent receives the Form 1098-T, the statement is treated as received by the taxpayer.

Scholarships. Scholarships are exempt from income tax, if certain conditions are 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 AOTC and Lifetime Learning credits, above, and may therefore reduce or eliminate those credits.

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 reductions for their employees' 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 $15,000 for 2018 and 2019. Married donors who consent to split gifts may exclude gifts of up to $30,000 for 2018 and 2019.

However, if the other person pays your child's school tuition directly to an educational institution, 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 $140,000 and $170,000 (between $70,000 and $85,000 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 the student performs the required services. There's also no income to report if student loans are repaid or forgiven under certain federal or state programs for health care professionals. Further, for cancellations of student loans after 2017 and before 2026, there's no income to report if a student loan is discharged either under certain federal statutes, or due to the death or total and permanent disability of the student. These are exceptions 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 not deductible unless you qualify for the deduction for education loan interest, described above. The deduction for interest on “home equity loans” (for this purpose, a loan that's (1) secured by the taxpayer's home, and (2) not incurred to acquire, construct, or substantially improve the home) is suspended from 2018 through 2025. After 2025, interest on such “home equity loans” will again be deductible, as it was before 2018; thus, after 2025, taxpayers will be able to deduct the interest on “home equity loans,” the proceeds of which is used to pay college expenses. Interest on a “home equity loan” won't be deductible for purposes of the alternative minimum tax (AMT), a factor which needs to be considered by taxpayers who are subject to the AMT.

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. 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 59½. 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 59½. (Note, however, that you can't 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 annuitizing 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.