Other than their homes, your clients’ largest lifetime expense may be paying for their children’s or grandchildren’s education. Annual tuition at private schools can range from $5,000 to $25,000 for up to 12 years, and college and graduate school can easily be a multiple of this amount. Total expenses to educate one child in this fashion from first grade through college can easily top $250,000. Most individuals and families pay these expenses with after-tax money, meaning that they must earn another 35% or so to gain the necessary funds to pay for school (or incur student loans). However, there are a number of ways to pay for some or all of a child’s educational expenses in a tax-advantaged fashion. Using these techniques can shave your clients’ total tax bill by at least a third in some cases. Moreover, counseling clients to use these techniques also adds some rather visible additional value to your advisory services.
So what are these techniques? You may have your clients consider income shifting and tuition reimbursement accounts as primary methods to lower the cost of education. We’ll also discuss the use of various tax credits when the child reaches college and graduate school age. We will leave it to others, however, to review the methods of using after-tax money for education costs, such as the Coverdell IRA and Section 529 plans.
The concept of income shifting is based on the fact that almost all children have a lower tax bracket than their parents for both earned and unearned income. Most of your clients have income from interest, wages, and some dividends taxed at a 35% rate, and capital gains–and some dividends–taxed as high as 15% to 20%. However, the tax rates of your clients’ children are likely to be between zero and 10% in all categories of earned and unearned income, if they are over age 14.
There are two ways to shift income to children. The first, and the most powerful, can be used primarily by families or individuals who control a business, whether it’s a traditional business or even a home-based “second” job. The second method involves gifting investments that have increased in value. The children may then sell these gifts and pay for the gains at their lower tax rates.
Once a child reaches college age, there are educational tax credits available that can markedly reduce or eliminate any tax burden resulting from income shifting.
Shifting via a Business & Gifting
A child can earn income by working in a business even at a young age. Clear records should be kept of the time worked and the complexity of the work, and the child’s salary should be appropriate to his age and hours worked. All payments for work are tax deductible as ordinary expenses to the business. If the parents’ business is incorporated, then Social Security and Medicare taxes may be due on the amounts paid to the child, though under Federal tax law, if the business is run as a sole proprietorship or spousal partnership, then no such taxes are due.
Any individual of any age may earn up to $4,850 per year without any income tax due to the standard deduction, independent of any unearned income received. Annual income of between $4,850 and $7,300 yearly is currently taxed at 10%, and from $7,300-$29,700 at 15%. All these brackets are significantly lower than the bracket for wage income earned by the parent. If a child receives earned income, then she will need to file her own tax return, rather than being part of her parents’ return. If the child is paid more than the tax-allowable amounts, then it would be prudent to pay estimated taxes as well. State and local income taxes may be due in some locations, and Social Security taxes are due on wages paid by a corporation.
The business owner can pay an older child up to $8,850 per year, with the amount appropriate to the child’s age and job responsibilities. The child can open a traditional IRA and fund it with $4,000 per year. This lowers her earned income back to the untaxed $4,850 level. The money in the IRA can be left to grow tax-free until age 70, or can be withdrawn for educational costs during college and graduate school. If such a withdrawal is made, tax will be due on the entire amount withdrawn, but the young person will probably be in a low tax bracket during those years. Penalties for early withdrawal of IRA savings are waived if the money is used for educational costs. If the child is young and has income of less than $4,850, then a Roth IRA might be appropriate.
An even more aggressive but perfectly legal approach is to pay an older child up to $14,850 (the limit as of 2005) and have the child contribute to a SIMPLE IRA set up by the family business; a tax-deductible $10,000 contribution is allowed. Note that the business is not permitted to run another qualified plan at the same time.
Remember, unearned income up to $1,600 per year for a child under age 14 is taxed at a blended rate of 5% or less; above this amount, the unearned income is taxed at the parent’s bracket. Once the child reaches age 14, unearned income is added to earned funds to determine his taxable income.
When the child reaches college age, tax credits can be used to minimize or eliminate taxation due to the student’s earned income.