Tax Tips
College Expenses - Planning - September 2002
Richard Scrivanich - Partner
If you are a parent with college-bound children, you are or will soon be concerned with either setting up a financial plan to fund for future college costs, or, if your children are already college age, with paying for current or imminent tuition, etc. bills. I'd like to address both of these concerns by suggesting several approaches that seek to take maximum advantage of tax benefits to minimize your expenses. However, this month I'll only deal with the "planning," while next month we'll look at "paying" for these 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.)
Planning for college expenses.
In many cases, transferring ownership of assets to children can save taxes. You and your spouse can transfer up to $22,000 a year (for 2002) in cash or assets to each child with no gift tax consequences. For children over 13, the income from the assets is taxed entirely to them at their lower tax rates (as low as 10% in 2002). For children under 14, however, income above $1,500 (in 2002) is taxed (under the "kiddie tax" rules) at your rates.
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 to them, e.g., dividend checks. The income would still be taxed to you. You must transfer the asset that's generating the income into 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" munis carry 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, the bonds must be purchased by you in your 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. But if your adjusted gross income (AGI) is too high, the exemption is phased out. For bonds cashed in during 2002, the exemption starts to "disappear" when your (joint) AGI hits $86,400 for joint return filers ($57,600 for singles) and is gone entirely if your AGI is at $116,400 ($72,600 for singles). (These figures are adjusted annually for inflation.)
Qualified tuition programs.
A qualified tuition program allows you to buy tuition credits for a child or to make contributions to an account set up to meet a child's future higher education expenses. Contributions to these programs aren't deductible, and the contributions are treated as taxable gifts to the child but they are eligible for the annual $11,000 (for 2002) gift tax exclusion, and a donor who contributes more than the annual exclusion limit for the year can elect to treat the gifts as if they were spread out over a 5-year period. The earnings on the contributions accumulate tax-free until the college costs are paid from the funds. And, beginning in 2002, distributions from qualified tuition programs are tax-free to the extent the funds are used to pay qualified higher education expenses. States and their agencies or instrumentalities and private education institutions are all permitted to establish qualified tuition programs. (Note, however, that distributions from private education institution programs won't be tax-free until 2004.) 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 education savings accounts (formerly called education IRAs) and make contributions of up to $2,000 for each child under age 18. (This age limitation does not 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, funds in the account aren't taxed, and distributions are tax-free if spent on higher 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 education savings account 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 give me a call at (562) 698-9891.
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acting on any of the information provided. If you have any questions,
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