TAX PLANNING OPTIONS FOR COLLEGE EXPENSES

By Benjamin T. Branche, Esq.

College costs continue to skyrocket and show no sign of leveling out. State and county colleges, as well as private colleges and universities, continue to raise tuition, and charges for room and board. While children look forward to the college experience, parents wonder how they are ever going to be able to pay for it!

It's never too soon to start planning for your children's college education, and if they are already headed to college, there are still ways to reduce the cost of a college education. General information about tax planning options is provided below.

TRANSFER ASSETS TO CHILDREN
As every taxpayer knows, the less income you have the less tax you have to pay. Therefore, one option may be to transfer assets to children with lower tax rates; thus, saving on taxes. This year, 2009, each parent can contribute $13,000 to each child (totaling $26,000 for married couples per child) without gift tax consequences. If your child is not subject to the "kiddie tax," then he or she would be taxed at his or her lower rate, which could be as low as 10% (0% for long-term capital gains). However, if the kiddie tax applies, your child's investment income above $1,900 for 2009 is taxed at the your rate, not the child's rate. The kiddie tax applies if the child has not yet reached 18 before the close of the tax year, or the child's earned income does not exceed one-half of his or her support and the child is age 18 or is a full-time student age 19-23. In order to protect the asset once transferred to the child, trust or custodial agreements could be established. This would prevent the child from wasting or otherwise disposing of the assets.

QUALIFIED TUITION PROGRAMS
Qualified tuition programs, such as 529 plans, are a relatively new way to allow you to buy tuition credits for a child or make contributions to an account set up to pay for a child's future higher education expenses. Such programs may be set up with the state or by private education institutions. The contributions to these programs are not deductible and the transfers are treated as taxable gifts, although if the amount transferred is less than $13,000 (the annual gift exemption for 2009) there is no gift tax. An additional benefit of the plan is that a donor may contribute 5 years worth of gifts ($65,000) at one time, which gifts will be spread out over five years, resulting in no gift tax issues. However, if the donor does not survive the five years, the gifts for the remaining years are included in the decedent's estate. The benefit of such plans is that the earnings on the contributions accumulate tax-free until the college costs are paid from the funds. Distributions made from such qualified tuition programs remain tax-free to the extent the funds are used to pay for qualified higher education expenses. The drawback to such plans is that if the earnings are not used for qualified higher education expenses they will be subject to a 10% penalty.

EDUCATION SAVINGS ACCOUNTS
Coverdell education savings accounts (formerly education IRAs) also provide an opportunity to transfer wealth to your children to benefit their education. Under the Coverdell ESA, a contribution may be made of up to $2,000 for each child under age 18. However, if the child is disabled or has special needs as defined for the program, the age limitation does not apply. The right to make such contributions phases out if the parents' Adjusted Gross Income exceeds $190,000 for joint filers ($95,000 for single filers). Under this program, children may make contributions to their own account; therefore, this account may still be funded if their parents do have income beyond the limits set forth. The contributions to a Coverdell ESA are not deductible; however, funds in the account are not taxed, and distributions are tax-free if spent on qualified education expenses. If the child chooses not to go to college, the money must be withdrawn when he or she turns 30, and the earnings will be subject to income tax and a penalty. Alternatively, unused funds can be transferred tax-free to a Coverdell ESA of another member of the child's family who has not yet reached the age of 30. As with the limitation on contributions, the age limitation does not apply if the child has special needs as defined under the plan.

TAX EXEMPT BONDS
Another simplified way to achieve economic growth, which is especially applicable in today's economy, is tax-exempt bonds. The interest rates and risk of the bonds vary greatly; however, with a good advisor the rates may be maximized and risk minimized. College savings bonds are an example. An investment in such zero coupon bonds can grow into a sizeable fund by the time your child reaches college age.

Series EE U.S. Savings bonds offer additional tax savings options. First, you don't have to report the interest for tax purposes until the bonds are cashed in, and second, interest on Qualified Series EE bonds may be exempt from federal tax if cashed in and the proceeds are sued for qualified college expenses. To qualify for the exemption, the parent must purchase the bonds in their name or jointly with a spouse. The proceeds must be used only for tuition and fees. It may not be used for books or room and board. If only a portion is used for qualified expenses, the remainder would be subject to income tax. You should note that this benefit is phased out when adjusted gross income ("AGI") exceeds $104,900 for joint return filers ($69,950 for single filers) and completed phased out if joint AGI is $134,900 or more ($84,950 for single filers).

TAX CREDITS
As a parent paying for your child's education, you may also be able to take a tax credit for some of your child's tuition expenses. The American Opportunity Tax Credit (also known as the Hope Credit) provides for a credit up to $2,500 (2009 and 2010), per student for the first four years of college. The American Opportunity Tax Credit is broken down into two parts. The first part provides a 100% credit for the first $2,000 in tuition, fees and books, and a 25% credit is available for the second $2,000. The American Opportunity Tax Credit is 40% refundable, which means you can get a refund if the amount of the credit is greater than your tax liability. For 2009, the American Opportunity Tax Credit is phased out for joint filers with income between $160,000 and $180,000 ($80,000 and $90,000 for single filers). To claim the credit, you should file Form 8863 and attach it to your Form 1040 or 1040A.

The Lifetime Learning Credit is available for 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). For 2009, this credit is phased out for joint filers with income between $100,000 and $120,000 ($50,000 and $60,000 for single filers). Only one of the two credits can be claimed for the same student each year.

STUDENT LOANS
Although interest on student loans is personal interest and generally not deductible, you can deduct interest on loans used to pay for your child's education at a post secondary school. The deduction for interest is an above-the-line deduction, meaning that you don't have to itemize. The maximum deduction is $2,500; however, as with other programs, the deduction is phased out for higher income taxpayers. The deduction phase-out for taxpayers filing jointly is $120,000 and $150,000 ($60,000 to $75,000 for single filers).

Student loans may also be forgiven if the student works in certain professions for certain employers. Examples may include programs with the military and public hospitals that meet certain requirements. If the loan is cancelled, the student will not have to report any income if he or she performs the services as required. This is an exception to the general rule that cancelled debt is considered income.

SCHOLARSHIPS
Scholarships, which are well known to all students, are exempt from income tax. However, to be exempt certain conditions must be satisfied. The scholarship cannot be compensation for services, and it must be used for tuition, fees, books, and supplies. It may not be used for room and board. This benefit will also reduce the amount of expenses that may be taken into account in computing the American Opportunity Tax Credit and Lifetime Learning Credit.

Finding an employer that will pay your child's education expenses is difficult; however, sometimes the benefit of the paid for education is worth lower pay. If an employer does pay for your child's education, the cost of the education is usually taxable as compensation to the parent. However, if payment is part of a scholarship program that meets scholarship requirements, it would be treated as a scholarship. Working for a college or education institution is another option. Most schools have programs through which children of employees are offered free or reduced tuition. As long as certain requirements are met, these tuition reductions are exempt from income tax.

GIFTS FROM GRANDPARENTS
Gifts from family members (usually grandparents) are among one of the common ways that children receive assistance. If such is the case, the person making the gift may be subject to gift tax, to the extent the payments and other gifts exceed the annual gift exemption of $13,000 or $26,000 for married couples. This issue can be avoided if the donor makes the payment of tuition or other qualified expenses directly to the institution. If paid directly to the institution, there is no limit on the amount that may be transferred. For purposes of the transfer it is important to note that the exclusion only applies to tuition; it does not apply to room and board, books, supplies, etc...

LOANS
Bank loans, especially on home equity, are another option for financing. As discussed above, interest on loans used to pay education expenses is personal interest and generally not deductible. However, if the student or parent takes out a home equity loan and the interest on the loan is qualified residence interest, the interest is deductible for regular income tax purposes (the deduction would not qualify for alternative minimum tax purposes). The interest would then be deductible as qualified residence interest and not educational loan interest.

One option, although not usually recommended, is to borrow against retirement plan accounts. Most plans authorize the participant to borrow cash; however, the loan must carry an interest rate equal to the prevailing commercial rate for similar loans. Unless the borrow qualifies for the deduction for education loan interest, there is no deduction for the personal interest paid. This option is less attractive because there are strict requirements to satisfy, and the loan may be treated as a premature distribution that is subject to regular income tax and additional penalty tax.

IRA WITHDRAWALS
Another less recommended option is to withdraw money from IRAs. These assets represent the largest cash resource for many taxpayers; however, pulling money out can significantly impact the amount available at the time of retirement. Typically there is a 10% penalty for early withdraw from qualified plans. However, there are some exceptions. One exception is that you can pull money at any time prior to age 59 ½ to pay college costs without the 10% penalty. However, these withdrawals would be subject to your regular income tax.

Some qualified plans, such as 401ks, don't permit withdrawals, or restrict them. One restriction is that a person may only withdraw from such a plan if there is an immediate and heavy financial need and the participant lacks other resources. College education does apply as one of these needs. However, in a 401k, to the extent that such withdrawal is premature, then it would be subject to regular income tax and a 10% penalty if made before the age of 59 ½.

The above options are not exclusive. There are many other ways to plan for the expenses associated with college. The list of options is numerous; however, it should be noted that not all strategies may be used in the same year. It takes planning to determine which should be used in which situation, and it helps to have good advisors to assist in those decisions. Such advisors may include attorneys, financial advisors, accountants and college planning consultants.

As a tax, trusts & estates attorney, I am available to work with you to develop a college funding plan that will optimize your savings and minimize your college expenses. I can be reached at 609 275-0400 or by email.