Ready for School

If a child’s parents have investments that have appreciated and subsequently sell them, they will pay ordinary income tax–35% in most cases–on those investments if they have been held for less than one year. Longer-term investments will be taxed at lower rates–as low as 15% in certain cases. If parents instead gift appreciated investments to a child, then the child can sell the asset and pay tax in a lower bracket. Income shifting by gifting may also lower the parents’ adjusted gross income (AGI), which may allow more eligibility for otherwise-phased-out tax breaks. A parental asset held more than one year can be gifted to the child and immediately sold without losing the long-term status, as gifted assets retain the donor’s basis and holding period. Each parent may gift each child up to $11,000 of assets or cash per year without any gift tax consequences.

For a child under age 14, the first $800 in unearned income goes untaxed, and the next $800 is taxed at 10%. After $1,600, the tax is imputed at the parents’ rate. However, once the child reaches age 14, the tax is imputed at the child’s own rate as noted above, which is almost always significantly less than the rate of the parent. It therefore pays to have a child receive unearned income of up to $1,600 per year under age 14, and higher amounts at later ages. The income can come from the sale of gifted assets or from income generated by funds held in a custodial (UTMA) account. If a child’s total income is less than $30,000, placing him in the 10% or 15% income tax bracket, then long-term capital gains taxes on the child’s sale of investments is in the 5% bracket.

In certain cases, a family limited partnership or a limited liability company can be used to shift income to children, without the parents losing control of the underlying assets. This method of transferring income may be preferable to the irrevocable gifting when making contributions to a UTMA account. Other methods that give parents some continued control of gifted assets include a minor’s trust, an irrevocable trust with Crummey powers, and a 529 plan.

I encourage clients to fund custodial accounts as early as possible in their child’s life to take advantage of these facts. A significant amount of gifted assets, such as growth stocks, may not produce much unearned income. These investments can be shifted to those that produce more income, or sold when the child is over age 14. Parents should also gift income-producing assets to a child over 14 in order to take advantage of the child’s lower tax bracket. Remember that funds transferred into a UTMA account are legally owned by the child.

Tuition Reimbursement

A Section 127 tuition reimbursement plan may be offered by your business to benefit a child who is attending either college or graduate school. Under such a plan, your business may reimburse tuition and book expenses up to $5,250 per year and deduct it as a cost of business. It is not reported as income to the student, although the student cannot be a dependent on your tax return. This is yet another reason for children to declare themselves financially independent as they enter college. The Section 127 plan–which must not discriminate toward highly compensated employees–can be an excellent idea for a small family business.

When children reach their college years, it is usually advantageous to have them declare themselves independent in terms of financial support. The parents do lose the ability to use the child’s personal exemption of $3,100, but this benefit has usually been phased out already if the parents have substantial income. Even if the personal exemption has not been phased out, it often pays for the child to be independent for three reasons: The Hope Learning Credit, the Lifetime Learning Credit, and the aforementioned Section 127 plans.

The rule for being independent of the parents is that the child must have more than 50% of her yearly expenses paid from her own assets. This money can come from custodial accounts, earned income, withdrawal of IRA money, or even from money gifted to the child by parents or grandparents each year in school. Once the child is independent, he or she may file for the Hope Learning Tax Credit of $1,500 per year for the first two years of college. Note that this is a tax credit, not a deduction, and can be used as long as the child’s income is less than $41,000. Using this credit usually results in the child having little or no tax liability.

For instance, a child with $20,000 per year in income during the first two years of college could use her personal exemption ($3,100) and standard deduction ($4,850) to lower her estimated taxes due to about $1,800. The Hope credit could be applied, and the young adult would pay $300 in tax on $20,000 in income.

An alternative to the Hope for students with high tuitions is the Lifetime Learning Credit, which can be used throughout college and graduate school, and is equal to 20% of the first $10,000 in tuition paid each year. Therefore, a credit of up to $2,000 per year can be applied against any income tax due. This credit is better than the Hope for the first two years of school if tuition is over $7,500 per year, and is the only credit available after the first two years of college. The student cannot be a dependent of her parents, and only one Lifetime Learning Credit can be used per year per family.

To conclude, these methods are meant to suggest areas for an advisor to explore with the client’s tax professionals, and not as specific advice for an individual client. Using pre-tax and low-tax-bracket funds not only will help pay for a child’s education costs, but will also add value to your relationship with clients.

Steven Podnos, MD, MBA, CFP, is a principal with Wealth Care LLC, based in Merritt Island, Florida, and author of Building and Preserving Your Wealth (Oakhill Press, 2005). He can be reached through www.wealthcarellc.com.