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Caveats For College Funding Breaks

           Don’t get too excited about the new tax breaks aiming to make it easier to pay for college.  Some of the breaks exclude high-income earners, and breaks geared to families with up to $160,000 of income can knock you out of contention for financial aid.  Here’s the scoop.

            The Hope Scholarship Credit and Lifetime Learning Credit won’t help high-income individuals.  A joint filer with less than $80,000 of income ($40,000 for single filers) qualifies for a full credit.  The credits decrease if you have more than $80,000 of income, and there’s no credit if you have more than $100,000 of income ($50,000 if single).  The Hope provides up to $1,500 per student annually for two years, while the Lifetime Learning Credit offers up to 20% of the first $5,000 of tuition and fees paid in any year from 1998 to 2002 and up to 20% of the first $10,000 after 2002.

            Penalty-Free Withdrawals are permitted from your IRA to pay for college expenses.  But it’s usually better to preserve your tax-deferral for retirement – even if you must borrow the funds by taking a tax-deductible home equity loan.  Also, the withdrawals will hurt your financial aid possibilities.

            Education IRAs may appeal to families with higher income or grandparents.  You can put away up to $500 annually for a child and get the benefit of tax-free compounding.  Contributions are not tax-deductible, but you won’t pay income tax on withdrawals.

            You can make the full $500 annual contribution if you have less than $150,000 of income ($95,000 if single).  A contribution is reduced if you have income above $150,000, and you can’t contribute to an Education IRA if you have more than $160,000 of income ($110,000 if single).  But even if you qualify, look before you leap.

            Every dollar in these accounts when you apply for aid will reduce your eligibility by 35 cents.  In addition, each dollar of investment income earned on the Education IRA can reduce aid by as much as 50 cents.  Well-intentioned parents or grandparents who set up an Education IRA could ultimately knock a student out of contention for aid.  If you’re sure your child won’t qualify for aid, however, the Education IRA may be okay.

            Kalman A. Chany, author of Paying For College Without Going Broke (Princeton Review/Random House), warns that the aid formulae are riddled with quirks and sometimes aid is given to families who don’t expect it.  A child of divorced parents often qualifies for aid, for instance.  A family with income of $150,000 could qualify if they have two kids in college at the same time, or if one child goes to an expensive university and the family has high medical bills.

            Education Loan Interest Is Deductible this year thanks to a new tax break.  Up to $1,000 of interest is deductible this year, and that increases by $500 annually through 2001 when you can take a $2,500 interest deduction.  But you only get the full deduction if you have less than $60,000 of income ($40,000 if single), so consider first having the student borrow through the Stafford or Perkins loan programs.  If more funds are needed, parents can take an education loan, but should consider making it deductible by borrowing against home equity.

            Parents with kids under 14 are often wise to keep college savings in growth-oriented investments and in their name – not the child’s.  When the child reaches 14, calculate whether you’ll qualify for aid and plan college funding around that.  Once you’re sure you won’t qualify, a trust, a family limited partnership or UGMA may be a solution, along with an Education IRA.

Seven Ways To Help Your Children

            What parent does not want to help a child?  But what’s the best way to help?  Here are several ideas about sensible steps and techniques for aiding your offspring.

            Teach Money Skills.  For a teenager or child in his 20s, consider gifting some cash and letting the child invest it.  You and your spouse each can gift up to $10,000 a year per child without triggering gift taxes.  But if you do this, don’t cheat.  While it’s sometimes hard for successful parents to allow a child to stumble or fail, letting your son or daughter make all the decisions will provide invaluable lessons in money management.

            Include Your Child.  When your children are mature enough, bring them to a meeting with your financial advisor and let them have some input.  If you’re establishing a trust or a partnership for estate planning, bring the children into the process.  Just listening to the discussions will give them important information.

            Gift Appreciated Assets.  If you give your child an appreciated asset, such as a stock or mutual fund shares, then your child can sell it and pay the capital gains tax at his or her rate.  Chances are, you’d pay a capital gains tax rate of 20%.  But your child is probably in the 15% income tax bracket, and will only pay 10% on capital gains.  The child can use the money to pay tuition for a private school or college, a summer vacation, or a new car.  If your children need a new computer, for instance, and you plan to sell stock to pay for it anyway, then using this gifting strategy makes a lot of sense.

            Set Up A Roth IRA.  As long as your child has earned income – even just from doing household chores for you – he or she can contribute to a Roth IRA.  If your children are in their 20s or 30s and working, consider gifting them the $2,000 they can contribute annually to a Roth IRA.

            A Grand Idea.  Consider paying for a grandchild’s college or private school tuition.  This is an especially good idea for grandparents who have already used up their lifetime estate tax exemption of $650,000 and want to make gifts in excess of the $10,000 annual cap without incurring gift tax.  You can give more than $10,000 as long as the additional amount is used for educational purposes.  You must, however, pay the educational expenses directly to the school and not to the child.

            FLP for Your Kids.  For parents with a multimillion dollar net worth, setting up a family limited partnership or limited liability company often makes sense.  You can place securities or a business interest in one of these pass-through vehicles.  Each parent can take a 1% general partner interest and split the 98% limited partner interest among children.  The parents remain in control of this family vehicle, but because of the split ownership, the interests are deemed to be illiquid.  As a result, the IRS lets you discount the value of the securities, business interest, or other assets in the FLP or LLC.  That means an annual gift of, say, $12,500 of securities, after taking a 25% discount for illiquidity, falls below the maximum $10,000 that you can give without incurring gift tax.  And remember, each parent can give each child $10,000 a year.  With this strategy, you retain control of the LLC or FLP until your children are ready to handle the accumulated wealth, and you’ve taken assets out of your taxable estate.

            Buy a Business.  Parents with taxable estates who are planning a new business venture should consider making children the equity owners.  Say you’re buying a building, restaurant, or other venture for $500,000.  You can give a $400,000 loan to the new company secured by the company’s assets and your child can invest $100,000 in the business and get non-voting shares.  If the building or business turns a profit and you sell for , say $1.5 million, the parents might receive their $400,000 plus $200,000 of loan interest and the child might receive the remaining $900,000.  For someone in a high estate-tax bracket, keeping gains on the business venture out of an estate would be a winning strategy.