As I am now a parent with three kids in college, this topic has never become more important to me than it is now. Yes!! I have written on this topic for many years, but I certainly want to take it to a whole new level.
Let’s break this down into three distinct groups.
- Those already stressed out and having to deal with paying for a student in college now;
- Those of you who are already paying back student loans and are hoping for a write-off; and
- Those of you that have the luxury of a few years before a child goes to college and don’t realize how fast it is coming.
Each one of these groups has options, but needs to plan carefully and strategically with their CPA and Financial Advisor.
1. Those with Kids in College NOW! You have 4 Options and yes, I feel your urgency and you obviously are the group that needs the most attention. Let’s hit your options first.
- American Opportunity Credit. This credit, originally created under the American Recovery and Reinvestment Act is still available even after the Tax Cuts and Jobs Act. The credit can be up to $2,500 per eligible student and is available for the first four years of post secondary education at an eligible institution. Forty percent of this credit is refundable, which means that you may be able to receive up to $1,000, even if you don’t owe any taxes. Qualified expenses include tuition and fees, course-related books, supplies, and equipment. Bad news: The credit begins to phase out for single taxpayers who have adjusted gross income between $80,000 and $90,000 and for joint tax filers when adjusted gross income is between $160,000 and $180,000. TAKE AWAY- This applies to your new college student while in undergrad, but only if your income is in the right range.
- Lifetime Learning Credit. This credit IS NOT refundable, but it’s a credit of up to $2,000 and there is no limit on the number of years you can claim the Lifetime Learning Credit for an eligible student. More specifically, the amount of the credit is 20 percent of the first $10,000 of qualified education expenses or a maximum of $2,000 per return. Bad news: The credit begins to phase out for single taxpayers who have adjusted gross income between $56,000 and $66,000 and for joint tax filers when adjusted gross income is between $112,000 and $132,000.
- TAKE AWAY – Not as much of a credit compared to the American Opportunity Credit, AND phases out even faster, but it’s great for kids in college after 4 years in undergrad (the “Tommy Boy” plan).
Warning-You can claim only one type of education credit per student in the same tax year. However, if you pay college expenses for more than one student in the same year, you can choose to take credits on a per-student, per-year basis. For example, you can claim the American Opportunity Credit for one student and the Lifetime Learning Credit for the other student.
- Creative Strategy #1 – Make Your Child a Sub-Contractor. If you own a small business, this is one of the best strategies you have at your disposal. Expand your business to the town where your child is going to college, put them on the board of directors, give them specific marketing duties in the business…bottom line…get them legitimately involved in your business. THEN, you can pay them a 1099 (since they are probably over 18, unless you have a child genius) and your child now has their own small business and you get a killer write-off in your business. They can use the funds for college expenses and if they have taxable income they are surely in a lower tax bracket than you. Some interesting side benefits- Your child may learn entrepreneurship, build credit, file a tax return, learn money management and maybe, just maybe realize they aren’t getting a free ride for educational expenses. However, there are still a couple drawbacks. First, the child may now have to pay or deal with SE tax themselves, and again, once their taxable income exceeds $6,300 (in 2015), they are paying income taxes themselves (albeit at probably a lower rate). Is it worth the work and does it pay off? Run the numbers…until you do, you will never know
- Creative Strategy #2 – Put Your Child on Payroll and consider a 127 Plan. nNot as common, as you will see for the reasons set forth below, but it’s a plan where an employee’s gross income and wages do not include amounts paid or incurred under an employer’s qualified educational assistance program (This would be your child’s paycheck for working in your business). More to the point, the first $5,250 of qualified educational assistance provided during the calendar year under a Section 127 plan is exempt compensation for federal income tax, social security and Medicare tax (FICA), and federal unemployment tax (FUTA) purposes. This also includes graduate courses. Sounds great, but there’s one major problem, you can’t hire your kids in a sole-proprietorship, S-Corp or LLC and set up a 127 Plan for them (You have to use a C-Corp). Moreover, the plan must meet an eligibility test, and no more than 5% of the benefits during the year may be provided to more-than-5% owners (or their spouses or dependents). Thus, you end up having to use a C-Corporation, and surprisingly you are good to go with children 21 and older! But, of course the inherit problem with a C-Corp is that we need to make sure we zero out the income so we don’t have the double tax problem. Thus, it requires an “additional entity” for my clients. We still want to run their primary business through an S-Corporation and take care of SE Tax planning strategies, and avoid the dreaded double tax (corporate tax) at the same time. BUT, in some situations, in some states, having a C-Corporation could be a great fit to shelter some additional income for education expenses, and maybe even through in health care for good measure.
2. Those Out of College and Paying Down Debt
- Student loan interest deduction. Not many options here. Generally, personal interest you pay, other than certain mortgage interest, is not deductible. However, you may be able to deduct interest paid on a qualified student loan during the year. Regrettably, you can only deduct up to $2,500 but still allowed even if you itemize deductions. Again, the bad news, it phases out for single individuals with adjusted gross income between $65,000 and $80,000, and for joint tax filers when adjusted gross income is between $130,000 and $160,000. Other than this minor deduction if your income is at the right level, sadly it will probably be with after-tax dollars.
- Make Your Child a Sub-Contractor. If you’re helping your child pay down some student debt, and they are in a lower tax bracket than you…run the numbers. See the details above and take a tax deduction if they are legitimately working in your business and you can shift the income into their tax bracket. The moral of the story- keep your school debt down and settle for a lesser quality university if necessary, maybe even a community college first and then transfer to a major university.
3. Those ‘Thinking about’ Saving for College for their Minor Children
Lots of options here. I suggest you consider implementing 2 or 3 so you are tackling the project from several angles.
- Scholarships and Grants. This method of saving for college is, of course, the most preferential and beneficial for the family. However, this is the most unpredictable and unreliable option. This is an important area for a family to research and understand, but should not be solely relied upon as the primary source of paying for future college expenses.
- Family Investment Account. This is simply a financial account or combination of accounts, such as CDs, Savings account, Stock Brokerage accounts, or Mutual funds maintained for the purpose of paying for the future education of your children. These would be an account(s) owned and maintained by Mom and/or Dad. This is certainly a good first step in saving for the future education expenses, however, is the least tax preferred. The income from the accounts would be taxed to Mom and/or Dad on their personal return, with no deferral of taxes. The benefit is that Mom and/or Dad has complete control of the account, it’s liquid and Mom and/or Dad could use the money at any time without penalty for anything they see fit.
- Real Estate Project. This strategy is fairly straightforward and similar to the Family Investment Account set forth above. It is essentially making the effort to undertake and/or designate a specific real estate project from which the profits will be used for future education expenses. The good thing here is that it forces Mom and/or Dad to commit to a project that is more difficult to exit until the specified time in the future. The con is just that, it is a less liquid investment. Although the gain/appreciation may grow tax-free, it is ultimately not tax preferred for education expenses when its time to exit the project.
- UGMTA Account. (Otherwise referred to as Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA)). In my opinion, this has to be one of the worst methods to save for college education. This is an account that is generally taxed as income to the child, however, because it will create unearned income and would be subject to the onerous “kiddie tax.” Essentially, the Acts allow a person to fund an account for a child but limit that child’s access to the account until the child reaches the age of majority. The age of majority is set by state law and typically ranges from 18 to 21. In general terms, an account established pursuant to UTMA or UGMA is a type of custodial account. The child is the account owner, but the parent (or other adult) is named as custodian. The custodian controls the account until the child is no longer a minor. At that point, the custodial relationship ends and the child controls the account.
- Coverdell Education Savings Account (formerly referred to as an Education IRA). These accounts have several significant benefits and only one major drawback. The beauty of these plans is that they grow tax-free and come out tax-free for qualified education expenses. The can even be “self-directed” similar to that of a retirement plan and invest in real estate or make loans to 3rd parties. The major drawback is that the maximum annual contribution is limited to $2,000 and the income of the parents create a phase-out rule that may even limit the $2,000 even further. Your contribution goes into an account that will eventually be distributed to your child if not used for college. You cannot simply refund the account back to yourself like you can with most 529 plans. This means you lose some degree of control. The ESA is on equal footing with the 529 plan when applying for federal financial aid. The account is considered an asset of the account custodian, typically the parent. Withdrawals are not reported as student or parent income as long as it is tax-free for federal income taxes. Coordinating withdrawals with other tax benefits, especially the Hope or Lifetime Learning credits, can be tricky. The account must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties. Before embarking on an ESA, make sure to consult with your tax professional and understand all of the pros and cons of establishing and maintaining such an account.
- Prepaid Tuition Plans. These are a fairly recent phenomenon and come in two forms. The first are those plans provided directly by a college institution and generally allow a parent to pay for their child to attend the college in the future, but pay for it at today’s tuition costs. The second is more common and is generally referred to as an Independent or Pre-Paid 529 Tuition Plan. It is more of a ‘funding mechanism’ that allows families in any state to pay today’s tuition prices for future tuition bills at more than 250 participating private colleges. Both types of prepaid plans come with some major drawbacks. First, these plans obviously substantially restrict school selection. Although refunds may be available, if your child is attending a school not covered by the plan, there are no guarantees that the amount you have set aside in your prepaid plan will cover the school’s costs. In many cases, it won’t even come close. Another problem with these plans is how they could affect your child’s financial aid. Right now the financial aid treatment is in flux. Currently, distributions from these plans are often treated as an “outside resource” of the child which means the distribution is treated much in the same way a scholarship would be. In effect, your financial-aid need could be reduced dollar-for-dollar.
- 529 College Saving Plans. Of all the plans, this is probably the most powerful. Principally, because families can contribute significant amounts (far more than the Education IRA) and there are no limits imposed based on the income tax bracket of Mom and/or Dad. College savings plans generally permit a college saver (also called the “account holder”) to establish an account for a student (the “beneficiary”) for the purpose of paying the beneficiary’s eligible college expenses. An account holder may typically choose among several investment options for his or her contributions, which the college savings plan invests on behalf of the account holder. Investment options often include stock mutual funds, bond mutual funds, and money market funds, as well as, age-based portfolios that automatically shift toward more conservative investments as the beneficiary gets closer to college age. Withdrawals from college savings plans can generally be used at any college or university, but are now limited to $10,000 per year under the Tax Cuts and Jobs Act. Investments in college savings plans that invest in mutual funds are not guaranteed by state governments and are not federally insured. Many plans have contribution limits in excess of $200,000. No age limits. Open to adults and children. The 529 Plan is generally sold through a financial advisor who can explain more of the details before you embark on this type of plan.
- Educational Trust. This is not a structure that saves taxes but is trust that is designed to hold the tax-preferred investments for the future education expenses of your posterity in perpetuity. This means you can set up an irrevocable trust that generally doesn’t pay taxes (because it holds accounts that grow tax free for education expenses), you can designate back up trustees to manage the trust after your passing, and if your children don’t use the money for education expenses, the monies are held in trust for the next generation’s education expenses. This is a wonderful tool to educate the “family” for many generations to come.
As a fellow parent with college-age children, I certainly understand the pressure and stress college expenses can put on a family. I strongly encourage you to study the options above and see if they could possibly work in your situation. Discuss these options with your tax adviser and stay tuned for additional upcoming articles and radio shows on the topic.
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Mark J. Kohler is a CPA, Attorney, co-host of the Radio Show “Refresh Your Wealth” and author of the new book “The Business Owner’s Guide to Financial Freedom- What Wall Street isn’t Telling You” and, “The Tax and Legal Playbook- Game Changing Solutions For Your Small Business Questions”. He is also a partner at the law firm Kyler Kohler Ostermiller & Sorensen, LLP and the accounting firm K&E CPAs, LLP.