Funding
A Child’s Or Grandchild’s College Education
Win The Game
With the cost of financing a college education rising twice
as fast as inflation, the dream of ending a child or grandchild
to college is becoming more like a nightmare. The increase
in college costs are out-pacing both inflation and the increase
in family income. Within the last decade the median family
income has grown a mere 49 percent while the cost of a public
college education has grown 79 percent and the cost of a private
college education has grown a staggering 102 percent. Moreover,
federal grants and scholarships are becoming more difficult
to obtain.
The key to planning for your child’s or grandchild’s education
is to select a planning strategy.
At first glance, planning for college seems fairly straightforward.
For example, wealthy parents may simply expect to pay for
their child’s college expenses when their child actually attends
college. Such payments do not raise any tax implications (such
as gift taxes). However, this plan may not only be unavailable
for some people, but it also ignores various planning opportunities.
A discussion of some of the more effective planning “vehicles”
follows. These vehicles not only provide the necessary funds
for a child’s or grandchild’s future college expenses, but
also take advantage of various tax planning opportunities.
Scholarships
Many private and government sponsored scholarships and loans
are available to qualified applicants. The federal government
provides almost 70% of all such educational grants.
Planning for a child’s or grandchild’s education does not
necessarily disqualify you from federal aid, since most federal
programs are based on the income rather than the assets
of the applicant. If you are currently applying for
federal aid, try to avoid selling any appreciated assets (e.g.
in order to pay for college expenses) since the capital gain
counts toward your overall income for qualification purposes.
Generally, the proceeds of the scholarship are exempt from
income tax, as long as the scholarship does not represent
compensation for services and is used for tuition, fees, books,
supplies and equipment (and not for room and board).
Who Should Own The Investments Used to Fund the Education?
Long-term investments such as bank deposits or securities
offer growth by paying interest or dividends which are subject
to income taxation upon receipt. A potential method to minimize
federal income taxes on the income earned is to transfer ownership
of the investment to an individual or trust in a lower tax
bracket.
Gift Tax Considerations
Transfers by parents or other persons of money or other property
to children or grandchildren are generally subject to federal
gift taxes unless the transfer qualifies for the annual $10,000
per donee gift tax exclusion. The exclusion is increased to
$20,000 per donee if the donor’s spouse makes no gifts and
consents to “gift-splitting” for that year. The exclusion
is available only for gifts of a “present interest” (as opposed
to gifts of a “future interest”). This requirement is met
by outright gifts as well as by gifts of interests in so-called
Section 2503(b) Trusts, Section 2503(c) Trusts, “Crummey Trusts,”
and transfers under the Uniform Gifts to Minors Act (UGMA)
or the more recent Uniform Transfers to Minors Act (UTMA).
College Expense Payments by Grandparents or Other Relatives
If college expenses are paid by a person or persons other
than the child’s parents (or the persons who claim the child
as a dependent), the payments are treated as gifts to the
child, and are subject to gift taxation. There are two exceptions
which may avoid the application of this gift tax: (1) the
$10,000 annual exclusion; and (2) an exclusion for “qualified
transfers” to educational institutions. Qualified transfers
are payments made directly to educational institutions for
an individual’s tuition. They do not include payments for
room and board, books, supplies, etc. Qualified transfers
are also exempt from the generation-skipping transfer tax.
Custodial Accounts
Income earned on an UTMA or UGMA custodial account or trust
is generally taxed to the minor/beneficiary and should not
be used to discharge parental support obligations which, in
some states, includes providing for a child’s college education.
In order to ensure that the gift is not included in the
donor’s estate, that donor should not act as the custodian
of the donee. A spouse or another related person may act as
a custodian of the donee, however parents cannot make reciprocal
gifts to their children with each parent naming the other
as custodian of the donated property. A parent who is not
a donor may serve as custodian and avoid inclusion of the
donated property in his gross estate for estate tax purposes
as long as the parent cannot discharge his support obligations
from the custodial fund.
Kiddie Taxes
“Unearned income” attributed to children under the age of
14 in excess of a certain amount per year is taxed at the
parents’ marginal income tax rate. Unearned income means all
income except compensation for services, and includes income
from UTMA or UGMA accounts that is taxed to the minor and
not to someone else.
Once a child reaches the age of 14, the kiddie tax is no
longer a concern. At that point, the child receives his or
her own standard deduction. Any “unearned” income attributed
to the child in excess of the standard deduction is taxed
at the individual tax rate starting at 15%. Consequently,
parents could shift income to their child and take advantage
of that child’s lower marginal tax rate.
Planning With Irrevocable Trusts
Transfers to a 2503(c) Trust or Crummey Trust present estate
planning opportunities in addition to planning for college
expenses. In general these types of trusts provide:
(i) Independent management and administration of the trust
assets.
(ii) Flexibility and discretion as to who shall receive income
and principal distributions.
(iii) Asset protection from the claims of creditors (as long
as the donor is not insolvent immediately before or after
the gift) interests in so-called Section 2503(b) Trusts, Section
2503(c) Trusts, “Crummey Trusts,” and transfers under the
Uniform Gifts to Minors Act (UGMA) or the more recent Uniform
Transfers to Minors Act (UTMA).
(iv) Avoidance of probate and the related expenses
(v) Privacy
(vi) A reduction in overall estate tax liability since the
gift is removed from the estate for estate tax purposes.
(vii) Potential avoidance of the gift tax through annual exclusion
gifts.
(viii) Incentive provisions.
Family Income Tax Relief
• Child care credit (1/1/98)
A $400 tax credit ($500 in1999) is available for parents
with qualifying dependents under age 17. The credit is phased
out for taxpayers with modified adjusted gross income (AGI)
exceeding $110,000 for joint filers and 75,000 for single
files.
• HOPE Scholarship credit (1/1/98)
A credit of up to $1,500 per year per student is available
for qualified tuition and related expenses paid during the
first 2 years of a student’s post-secondary education. The
credit applies to expenses paid after 1997 for education furnished
in academic periods beginning after December 31, 1997. The
credit is phased out for joint filers with modified AGI between
$80,000 - $100,000 and single filers with modified AGI between
$40,000 - $50,000.
• Lifetime Learning Credit (7/1/98) A tax credit
is available for 20% of the first $5,000 of qualifying higher
education expenses per family. The credit applies to expenses
paid after June 23, 1998 for education furnished in academic
periods beginning after that date. The credit is phased out
for joint filers with modified AGI between $80,000 - $100,000
and single filers with modified AGI between $40,000 - $50,000.
• Education IRAs (1/1/98)
Beginning in 1998, individuals can make non-deductible contributions
of up to $500 per beneficiary per year to an education IRA.
Distributions from an education IRA are tax free if certain
conditions are met. The maximum contribution is phased our
for joint files with modified AGI between $150,000 - $160,000
and for single filers with modified AGI between $95,000 -
$110,000.
• Student Loan Interest Deduction (1/1/98)
Beginning in 1998, interest paid on a qualified education
loan is partially deductible in computing adjusted gross income
(an “above the line” deduction). The maximum deductible amount
of $1,500 for 1999 and is phased out for joint filers with
modified AGI between $60,000 - $75,000 and single filers with
modified AGI between $40,000 -$50,000.
