As a parent with college-bound children, you are concerned with setting up a financial plan to fund future college costs. We would like to address this concern 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.)
In some cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $28,000 (in 2017) 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, the child's investment income above $2,100 (for 2017) is taxed at your tax rates and not the child's rates. 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 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" 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 2017, the exemption begins to phase out when joint AGI hits $117,250 for joint return filers ($78,150 for all other returns) and is completely phased out if your AGI is at $147,250 ($93,150 for all other returns).
Qualified tuition programs. 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 ($14,000 for 2017). 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. 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. 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 contact us.