Over the years, as our clients’ children reach the age of maturity, our clients are constantly asking how to efficiently help their children with college education funding. Keep in mind that college education is extremely expensive, and if you “overspend” helping your children with education costs, this could damage your ability to retire comfortably, or at a reasonable age. Therefore, you must achieve a reasonable balance to financial assistance you give to your children and planning for your own retirement.
Because of this “balancing act” most parents must face, we developed a summary of college funding strategies. This includes not only the traditional college funding strategies, but also ideas we have which will help you “spend less” for these costs, either through tax savings or other strategies.
Please note that the purpose of this blog is not to answer questions, but to open your mind as to new possibilities you may not have considered. Remember, our goal is to help you reduce the amount you help pay for your children's education costs, while at the same time keeping as much of your money as possible for your retirement goals. If you have any questions after reading this, please do not hesitate to call or email:
► College education savings plans such as 529 Plans, MESP Plans, Education IRA accounts.
- There may be a State of Michigan tax credit, however it may be limited.
- The account grows tax-deferred until withdrawn.
- Withdrawals of earnings may be tax-free if the withdrawals are used for valid education expenses.
- The funds are designated for specific persons.
- The grantor may change the beneficiary if they wish.
- If funds are not used for valid education expenses, there is tax and penalty on the earnings portion of the withdrawal. The IRS penalty is 10%. Taxes are paid at your normal income tax bracket, based upon your Adjusted Gross Income.
- The assets of these designated accounts are held apart from your own portfolio. In other words, the rate of return may be limited to the investments offered in each specific plan.
- There are limited investment options for these plans. In some plans, such as MESP Plans, you may not have control over the investment options. The investment options may be chosen for you, based upon the current age of your child. In other words, if your child is younger, the investment options may be very aggressive. If your child is older, the investment options may be too conservative.
- All deposits made to these types of savings plans are after-tax deposits, not pre-tax deposits, other than the potential State tax credit.
- When you withdraw from college savings plans, principal and interest withdrawals reduce potential education tax credits, dollar for dollar. Education tax credits may be up to 2,500.00 per child per year, sometimes for the full four years of undergraduate school, and a number of years for graduate college.
- Withdrawals from these plans also limit the ability for a Tuition and Fees deduction on your Form 1040.
► Utilize Student Loans
Some do not require payments of interest or principal until college is completed (subsidized loans), and some require only interest payments until college is completed (unsubsidized loans). Generally, interest on student loans may be tax deductible to the parent or the student.
► IRA, 401(k), or 403(b) Retirement Accounts
● You may withdraw from IRA or other qualified accounts, IRS penalty-free, when using the withdrawals for higher education expenses.
● The college education credit is not necessarily offset by withdrawals from retirement plans, unless it causes Adjusted Gross Income to be too high for the credit (please see your tax advisor to determine if this is true for you).
● There is no limit for the Tuition and Fees Deduction when withdrawing from retirement plans, unless they affect your Adjusted Gross Income (please see your tax advisor to determine if this is true for you).
Summary: The benefit of using tax-qualified retirement plans to fund college education costs is that your deposits may be tax-deferred, your withdrawals could be IRS penalty free, and you may be able to use Tuition and Fees deduction or education tax credits to offset the tax liability on withdrawals (please see your tax advisor to determine if this is true for you).
► Income Shifting Strategies
● Example: Tammy owns publicly traded stock which she purchased through her employer’s stock purchase plan. The stock is worth two times the price she paid. When her child reaches age 18, or before, Tammy may establish a joint brokerage account for her child with their Social Security number, and transfer the appreciated stock into the brokerage account. The child may then sell the stock and report the gain under their tax identification number. If the child's Adjusted Gross Income is not too high compared to the parents, the child may utilize their standard deduction, possibly their exemption allowance, possibly education tax credits, or the Tuition and Fees Deduction, to offset all or a major portion of the taxable gain on the sale of the stock.
Summary: Instead of the parent having to sell the stock in their high income tax bracket and possibly pay an Alternative Minimum Tax, this allows the parent to avoid the gain on the sale and shift the majority of the gain to their child, virtually tax-free.
● Example: Dr. Bill owns a medical building for his practice. Dr. Bill is currently receiving rental income from his building, because his mortgage payment is very low versus the rent payment, or his building is paid off. He is paying income tax on the rental income in his ordinary income tax bracket with no deductions to offset this. (Please see your tax advisor to determine if this is true for you.)
Dr. Bill may shift the income to his child, after making some adjustments on the ownership of the building. The child may then use the income to pay for college education expenses. The college student pays income tax in their income tax bracket and may utilize their standard deduction, possibly their exemption allowance, possibly their college education credits, or the Tuition and Fees deduction to offset the taxable income of the building rent.
Summary: The benefit is that Dr. Bill does not have to receive the income, pay income tax at his highest bracket, and then pay for college education costs with after-tax dollars. This is a strategy wherein Dr. Bill is actually helping the college student pay for costs, virtually with before tax dollars. (Please see your tax advisor to determine if this is true for you.)
● Advantages to Income Shifting:
- You always control your portfolio and the income from the portfolio. In other words, assets are not placed into the college student’s name until they are ready to spend for college costs.
- You choose what income sources are shifted to the college student at the time college costs must be paid. In other words if you have multiple sources, you can choose from any variety of sources, from year-to-year.
- You’ll fully utilize their income tax advantages, such as their standard deduction, possibly their exemption allowance, their ability to maximize their education tax credits, and possibly their ability to maximize the use of the Tuition and Fees deduction to offset taxable gain on investments or income received.
Summary: You are minimizing tax on the income shifted, as you're not claiming this income as part of your Adjusted Gross Income. At the same time, the college student is utilizing tax advantages already available. You may fund college costs primarily with before-tax dollars, rather than after-tax dollars.
For example, using the first strategy discussed, if Tammy would normally have paid State income tax, a 20% capital gains tax, and a 5% alternative minimum tax in her Federal tax bracket, to sell 40,000.00 of stock for which 20,000.00 was capital gain, Tammy would have paid a total of 6,000.00 tax on the 40,000.00 of stocks sold. By shifting the 40,000.00 of stock to the college student’s tax return, 6,000.00 of tax is avoided. Ultimately, if Tammy sold the stock, she would've had to have owned 47,500.00 of before-tax funds to pay 40,000.00 of college costs. Under the income shifting strategy, Tammy needed 40,000.00 of total income, of which 20,000.00 was not taxed to her.
► If you have existing college savings accounts, how are they most effectively used?
● If you are utilizing student loans to pay for some of the college costs, whether the student loans are subsidized or unsubsidized, liquidate the MESP, Education IRA, or 529 Plans after the first four years of college are complete, to pay off student loans. If the student has gone on to a graduate or post-graduate degree, the withdrawals from the formal college savings plans for these costs may be penalty free.
● The formal college savings plan withdrawals may take place the third or fourth year of college, depending on how much is accumulated. During the first few years of college, maximize the education credits or Tuition and Fees deduction. You may forego these credits and deduction the third or fourth year of college education, if you withdraw the formal college savings plan funds during that time.