The best way to ensure that your children have a college education is to begin making financial plans while they are young. Unfortunately, the annual cost of sending a child to a state university typically ranges from $7,000 to $12,000, and the cost of a private colleges is at least double that.
Following are the tax consequences of three popular alternatives for financing these costs:
* Gifts to children: Parents often transfer income-producing or appreciated property to their children. With careful tax planning, the income produced by such property or the gain realized from a subsequent sale will be taxed at the child's low tax bracket rather than at the parent's higher rate.
For example: Over the years, Gordon and Della Johnson, a married couple, give their daughter, Stacy, 1,000 shares of XYZ stock. The stock, which originally cost the Johnsons $30,000, has an appreciated, fair-market value of $80,000. As Stacy sells the stock (during her four years of college), the $50,000 gain will be taxed in her 15 percent tax bracket, generating about $7,500 of tax liability. Thus, Stacy will retain $72,500 of the sales proceeds to help finance her college costs (the selling price of $80,000 less $7,500 tax).
In contrast, if the Johnsons retained ownership of the XYZ stock in their own name, the $50,000 gain would probably be taxed in the 28 percent capital gain bracket (tax: $14,000).
In this situation, only $66,000 would remain, after taxes, to help finance Stacy's college costs.
A taxpayer may give as much as $10,000 a year to each child without incurring any gift tax. Better yet, if a husband and wife make a "joint gift," the tax-free exclusion is doubled to $20,00 a year.
But a word of caution: Under most circumstances, investment or passive income earned by a child under the age of 14 will be taxed at the parent's rate, regardless of the child's tax bracket. Thus, in the above example, Stacy should wait until she is age 14 (or older) to begin selling the XYZ stock; otherwise, the tax advantage will be lost.
* Qualified minor's trust: In case you are somewhat apprehensive about making direct gifts to your children, here's an attractive alternative. During the life of a QMT, the trustee (typically the parent) may make distributions for the minor's welfare or may allow the trust to accumulate income and principal. However, when the beneficiary reaches the age of 21, the trust is terminated and any remaining principal (plus accumulated income) must be distributed.
A QMT must file a fiduciary tax return, and the first $3,450 of trust taxable income is taxed at a 15 percent rate, even if the beneficiary is under age 14.
In contrast, passive or investment income of a child under the age of 14 is normally taxed at the parent's higher bracket (in 1991 the highest marginal tax bracket is 31 percent). Accordingly, the QMT provides two excellent advantages over direct gifts to children:
(1) The opportunity to retain control over the principal and income (until the child is 21).
(2) The ability to take advantage of lower tax rates, even if the child is under the age of 14.
Various states place different restrictions on QMT use.
* Educational savings bonds: Interest income of Series EE bonds used to pay for college costs is excluded from taxable income. Here are the restrictions and limitations related to this provision:
(1) The owner of the bond must be at least 24 years old, and the bond must have been purchased after Dec. 31, 1989.
(2) To make all interest tax-free, the aggregate redemption amount (principal and interest) may not exceed the qualified educational expenses of the student.
(3) Qualified higher education expenses are limited to the cost of tuition and required university fees, less scholarships, grants and other tuition reduction amounts. Costs such as dormitories, board, transportation, books and non-required fees do not fall within the scope of this provision.
(4) If the redemption amount of the bonds (principal and interest) exceeds the qualified education expenses, the amount of excludable in terest is reduced on a proportional basis.
The exclusion is phased out for taxpayers with modified adjusted gross income (MAGI) falling within the following levels: Married-joint filing status, from $60,000 to $90,000; all other taxpayers, from $40,000 to $55,000. Above these levels, the income exclusion is eliminated.
One final thought. You don't have to put all your eggs in one planning basket. If you're starting to set up a funding program for a child under the age of 14, you might want to move simultaneously in three directions:
(1) Transfer income-producing property into a qualified minor's trust (to take advantage of the lower tax rate).
(2) Make direct gifts to your child of appreciated property or property with appreciation potential (but defer selling these assets until the child is 14).
(3) If your income falls below the MAGI phaseout levels, invest in Series EE Education Savings Bonds.
Myron Lubell is a certified public accountant and associate professor of accounting and taxation at Florida International University.