Few college savers think about taxes when they start socking away dollars for the cap-and-gown days. Even though tax season is over, integrating...
Few college savers think about taxes when they start socking away dollars for the cap-and-gown days.
Even though tax season is over, integrating college financing with taxes should be a year-round activity.
You could pay for college with more pre-tax dollars, which frees up additional funds for tuition bills. In the process, you would also engage your children in financing their education.
Steve Podnos, a Cocoa Beach, Fla.-based financial planner and physician, is following a tax-advantaged strategy with his two children that employs them directly and sets aside college funds from their earnings.
“You can pay for entire educations with money that’s taxed no higher than 15 percent [marginal rate],” Podnos says of his children’s income. “If you’re in any bracket above 15 percent, this makes sense.”
The core of Podnos’ plan is to invest a child’s earnings at an early age while they are working for you.
This strategy is ideal for the self-employed, sole proprietors and professionals, and it can work for any person who sets up a new business that’s unincorporated.
Podnos has seeded college funds for each of his three children, ranging in age from 15 to 18. His oldest, Rachel, has more than $30,000 in her conventional, Roth and Coverdell IRAs, which she saved while working for her parents. Podnos also invested additional funds in a college trust account.
Here’s how employing your child works. Say you have a 10-year-old who can do some light office work, which could include anything from computer maintenance to filing. You pay your child up to $4,850 per year for “jobs related to their age or abilities,” Podnos says.
A child in your employment can also contribute $4,000 annually to his own individual retirement account (IRA) — and use it for college funds.
“The first $4,850 the child earns is tax free to them [the standard deduction for singles]. This money can be used to fund a trust account, Coverdell or 529 plan,” Podnos says.
Wages can go into any college-investment vehicle, although trust funds like Uniform Gift to Minor Act accounts may jeopardize financial assistance if your family is likely to qualify for aid.
When your child works for you, though, one of the initial assumptions may be they won’t qualify for aid. Then the trust route isn’t a problem.
Funding vehiclesState-sponsored 529 plans are also a worthy receptacle for college funds, just be careful when selecting them. They tend to be expensive; most are sold through commissioned brokers and limited in fund choices.
There are more than 100 such plans, with each state varying in expenses and available tax breaks.
If you don’t own a business or intend to start one, you can still gift up to $2,000 annually per child in a Coverdell Educational Savings Account (for joint filers with adjusted income under $220,000) and fund your own Roth IRA — up to $4,500 per year if you are over 50 and your adjusted joint income is under $160,000 annually.
Since your child is likely to be in the lowest tax brackets when in college, they can benefit from the four major tax breaks.
The only way these write-offs benefit your child, though, is if he is what Podnos calls “emancipated,” — that is, he isn’t declared a dependent on your tax return the years in which he takes the breaks.
Podnos says the benefits of this plan more than offset the loss of the child exemption.
Other tax breaksThe Hope credit can offset up to $1,500 in tuition expenses for the first two years of college. In the next two years, your child can take up to $2,000 in total tuition write-offs with the Lifetime Learning Credit. Either credit can be taken, but not both.
Moreover, if a student’s adjusted income is under $65,000 ($130,000 if filing a joint return), he can deduct up to $2,500 in college loan interest.
An even juicer write-off is the $4,000 tuition and fees deduction — doubled from $2,000 the previous tax year.
Adjusted gross income for singles also must be under $65,000 to qualify for the maximum deduction.
Podnos’ strategy comes up short if you are strictly a salaried employee with no other business on the side. Your child will need earned income to fund their Roth or other IRAs; you just can’t give them the money. They must be doing legitimate work.
Payroll taxes• You need to fund payroll taxes of 15.3 percent for your child employee if your business is incorporated.
• The payroll-tax exclusion for a child working for an unincorporated family business only applies if he is under 18.
There’s no reason you can’t employ this strategy when you start, for example, a consulting business, or if your spouse has a small business.
If you employ your child — and your business is unincorporated — you also get a tax break because you can totally deduct his wages as an ordinary business expense.
And your child doesn’t have to work for your business to earn income, either. He can work for an aunt, uncle or grandparent in their unincorporated businesses.
Want to take your business-education program one step further?
Your small business can offer a Section 127 benefit, which provides up to $5,250 per year to employees for tuition reimbursement. This program is totally deductible as a business expense and a tax-free perk for your child, if you choose to employ him.
127 programsThe rules for a 127 program are restrictive. Your child employee must not be a dependent, and you have to offer the same benefit to all of your employees.
The benefit can only be used for tuition, not room and board. The child must be 21 or older and own less than 5 percent of your business.
There are also some extensive paperwork requirements, such as having a written plan, filing a Form 5500 and nondiscrimination rules. See your accountant for details.
If you do it correctly, you will be paying for college with more pre-tax dollars. That means your child can put more money to work on campus and send less to the IRS.