Law Office Report - Summer 2008
Tips on Planning and Paying for College Expenses
Attorney Torren K. PiesPlanning and paying for college expenses are daunting tasks. Setting up a financial plan to fund future college costs for children, or paying for such costs for children already in college, requires you to consider various approaches that seek to maximize the advantages of tax benefits to minimize your expenses. The following are common planning techniques:
1. Qualified Tuition Program. A qualified tuition program (“529 Plan”) allows you to make contributions to an account set up to meet a child’s future higher education expenses. Qualified tuition programs can be established by state government or by private education institutions. Contributions to these programs are not deductible, however, the earnings on the contributions accumulate tax free, and distributions used to pay qualified higher education expenses are not subject to tax. Contributions to a 529 Plan are eligible for the annual gift tax exclusion ($12,000 per donee for 2008), and a donor who contributes more than the annual exclusion limit for the year can elect to treat the gifts as if they are spread out over a five-year period. Any distributions of earnings that are not used for qualified higher educational expenses will be subject to income tax plus a 10% penalty.
2. Coverdell Educational Savings Accounts. You can establish a Coverdell ESA and make contributions of up to $2,000 for each child under age 18. The contributions are not deductible. However, funds in the account are not taxed, and distributions are tax free if spent on qualified educational expenses. If the child does not attend college, the money must be withdrawn when a child turns 30, and any earnings will be subject to tax and penalty. Further, unused funds can be transferred tax free to a Coverdell ESA of another member of the child’s family who has not reached age 30. Your adjusted gross income may limit the ability to make these contributions, and in that case, the child could make a contribution to his or her own account.
3. Tuition Tax Credits. You may be able to take a credit for some of your child’s tuition expenses. The Hope Tax Credit provides up to $1,800 for 2008 per student for the first two years of college (a 100% credit for the first $1,200 in tuition and a 50% credit for the second $1,200 in tuition in 2008). There is also a Lifetime Learning Tax Credit 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). Both of these credits are phased out based upon your adjusted gross income. Only one credit can be claimed for the same student in any given year.
4. Gifting Directly to Child, or in Trust, or by Custodial Arrangement. The transferring of ownership of assets to children can be an effective way to reduce the size of your estate and potentially transfer the earnings on the gifted assets to your children at their income tax bracket. Given the annual gift tax exclusion in 2008 of $12,000, a married couple can transfer up to $24,000 in cash or assets to each child with no gift tax consequences. If your child is not subject to the “kiddie tax,” he or she is taxed on income from the assets at his or her lower tax rates. However, where the kiddie tax applies, the child’s investment (unearned) income above $1,800 is taxed at the parents’ tax rates and not at the child’s rates. For 2008, the kiddie tax applies if: (1) the child has not reached age 18 before the close of the tax year, or (2) the child’s earned income does not exceed one-half of his support and the child is 18 or is a full-time student age 19-23.
To the extent you or any other person pays your child’s school tuition directly to an educational institution, there is an unlimited exclusion for gift tax purposes. The unlimited gift tax exclusion applies only to direct tuition costs. There is no exclusion (beyond the normal annual exclusion of $12,000 in 2008) for dorm fees, books, and other college living expenses.
Gifts can be made in trust or under a custodial arrangement under the Wisconsin Uniform Transfers to Minors Act. If the kiddie tax is an issue, consideration should be made to invest in growth funds which reduces the ordinary income or capital gain distributions, or in tax-exempt investments.
The above are just some of the tax-favored ways to build up a college fund and some of the tax-favored ways to pay for college expenses. Not all of the strategies may be used in the same year, and use of some of the strategies may reduce the amounts that qualify for the other strategies. Speak with your attorney to determine what strategy, or combination of strategies, should be used in your situation.