For many parents, anxiety about paying for their children's college educations sets in at about the same time the "+" sign on the pregnancy test comes into view. The cost of college has outpaced the rate of inflation for years, and many experts expect that trend to continue. And while a higher percentage of students today do receive various forms of financial aid, when household income exceeds $80,000, the odds of receiving need-based aid begin to fall dramatically.
There is a big difference, of course, between not qualifying for aid and being comfortably able to write a check for $26,000 (the average cost of a year at a private college in 2005). But there are a number of strategies that families can employ so that Mom and Dad don't have to hitchhike to Parents Weekend.
Rick Jarvis, for example, plans to foot the bill with other people's money. Jarvis does have an advantage: his strategy is built around real estate, and he is a realtor. But his approach could be modeled by almost anyone. Jarvis owns a modest portfolio of residential and commercial buildings in and around Glen Allen, Virginia, and has designated two single-family homes as "College Education I and College Education II." He says the two homes, which are currently worth about $175,000 and $250,000, respectively, are a better place to stash cash for college for his grade-school-aged kids than, say, government-sponsored 529 plans, mutual funds, or savings bonds.
Four years ago, he used 100 percent bank debt to purchase two rental properties, with the assumption that the value of the homes would increase in step with the cost of a college education. Jarvis says that by the time his children, ages eight and six, are ready for college, the debt will be minimal (thanks to the steady stream of rental income) and he will either refinance to free up cash or use what is known as a tax-deferred Internal Revenue Code Section 1031 exchange.
The 1031 exchange allows property owners to enter into a tax-deferred exchange of like kind and reinvest the proceeds without incurring current income tax such as the capital-gains tax. For example, a parent making a 1031 exchange could use the deferred gains reaped as a big down payment on a larger rental property, which would boost cash flow via higher rental income just in time to pay for college.
Another option is to use the 1031 exchange to buy a house or condo for your college student, thus avoiding room and board costs and creating some flexibility. For example, by renting the property to their child, parents can write off ordinary expenses associated with a rental property, such as visiting the site, repairs, and management fees. To make sure the business deductions are legitimate, the student would have to pay rent at fair-market prices. But the Internal Revenue Service allows a parent or any other individual to dole out a tax-free gift of up to $12,000 ($24,000 for couples) annually. Such a gift to a student could then be used to pay the landlord.
"The tax benefits shouldn't wag the dog," when it comes to real estate investments, says Ryan Losi, a tax accountant, CPA, and director at Piascik & Associates who advises Jarvis. Losi, who is also a realtor, contends that buying and selling real estate has to make economic sense before the college-funding strategy pays off. Still, he points out that owning rental properties also gives parents the opportunity to use built-up equity to secure a low-cost line of credit, which in turn can be used to pay for college. The line of credit may have a lower interest rate than an unsecured loan, and like most student loans, many revolving credit lines allow repayment to be stretched out over 10 years.
For parents who own a business, Losi suggests the unorthodox move of opening up Roth IRAs for the kids as a way to save for college. The money in the individual retirement account grows tax-free, and a large portion of it can be distributed without penalty to pay for qualified education expenses. Since IRAs are available only to workers who have "earned income," parents would need to determine a business reason (that is, accounting, administrative, marketing, or the like) to hire their children and provide them with a paycheck. By putting Junior on the payroll and using his income to fund a Roth, parents benefit in two ways: the business receives a payroll-expense deduction and college funds grow tax free (see "Pay the Kids, They're Worth It" at the end of this article).
Pumping Up 529s
For parents who prefer a simpler approach, state-sponsored 529 plans offer some notable advantages, especially if you're aware of some of the fine print that affects how they operate. These plans, which were created in the 1980s and became popular in the 1990s after a key court case assured their tax advantages, allow parents and other relatives to invest aftertax money in a managed fund without incurring taxes on the earnings. The fund can be used to pay for qualified college expenses, including tuition, books, room and board, computers, and school fees. In some cases, state residents receive tax deductions if they open a 529 that is sponsored by their home state; in a few states, 529s are protected from bankruptcy creditors. Anyone can contribute to the accounts, and the funds can be transferred to other family members at any time.
You can pump up 529s if you have extra cash. That is, family members can front-load 529s to get more bang for their compounded buck, says Susan Black, director of financial planning at eMoney Advisor. The government allows an individual to stuff 529 plans with $60,000 in one year (couples can invest $120,000) without paying gift taxes. The catch: the one-time boost uses up five years' worth of gift-tax exclusions. Still, if you have the cash, the power of compounding makes the move worthwhile. Assuming an 8 percent return for 18 years, a 529 frontloaded with $60,000 has an approximate future value of $239,700. If you were to invest the same $60,000 at $3,333 per year for 18 years, the fund would amount to only $124,800.
Another 529 technique that works well in conjunction with estate planning is to have a trust "own" the 529 plan. The advantage is that if the trust owner dies or is disabled, the administration of the plan can continue without interruption. Regardless of ownership, 529 plans allow individuals to pull $60,000 ($120,000 if gift-splitting is used with a spouse) from their estates. If, however, the individual passes away within five years of the gift, a prorated amount is pulled back into his or her estate. The financial-aid advantages of using a trust are generally the same as if a parent or grandparent owned the 529 plan. In general, says Michael Kozak, director of wealth management for Salem, Massachusetts-based Cabot Money Management, schools expect parents to contribute less of their net worth to their children's education than the children themselves.
Establishing an education trust typically costs $8,000 to $10,000, plus annual fees, but the advantages are notable. For example, assets held by the trust may be taxed at the 15 percent capital-gains tax and there are no real funding limits on a trust. Also, careful drafting and funding may avoid gift and estate taxes. Trusts can also be set up to protect the funds from creditors and divorce settlements. The beauty of trusts, says Ralph Wileczek, senior private client adviser for Wilmington Trust, is that "with a properly drafted trust, the grantor (the person funding the trust) avoids gift taxes or pays a very nominal tax and doesn't have to pay any additional transfer taxes, ever."
Marie Leone is senior editor of CFO.com.
Tuition Without Taxation
If you've got an Auntie Mame who has the wherewithal to pay for a child's college education, let her know she can do it tax-free if she pays the school directly. The Internal Revenue Service allows any relative to give the gift of tuition without subjecting the benefactor to any transfer taxes (currently as high as 46 percent). While the IRS limits tax-free gifts to $12,000 annually, gifts of tuition are limitless when prepaid directly to a qualified educational institution — and they don't count toward the annual gifting total. Room and board, books, fees, computers, and other college expenses, however, are not covered under the tax-free status of the rule.
The direct contribution also gives the grantor more breathing room for estate planning, says Ralph Wileczek of Wilmington Trust, since the value of tuition gifts can be omitted from their taxable asset base. Even better, the gifting can all be done without the help of an attorney or complicated paperwork. (There are no tax-reporting requirements for this type of gift.) To let the government know they have made such a gift, grantors need only note it on their annual tax returns. — M.L.
Pay the Kids, They're Worth It
For Owners of Family Businesses, Nepotism can Boost the College Fund
Hiring your kids to work in the family business can do more than build their characters: it can really boost their college funds as well. Consider a scenario in which a mother who owns a small graphic-design studio pays her 11-year-old son $4,000 a year to file and clean up the office. The business's income is reduced by $4,000 for the payroll outlay, which means the business pays $1,400 less in federal income tax ($4,000 x 35 percent federal income tax rate). The son receives his pay as tax-free income based on current limits and restrictions.
For seven years Mom deposits the son's paychecks into a Roth IRA in his name. If the investment grows tax-free at 6.25 percent a year, the IRA will be worth about $34,000. Her son could then begin distributing the funds to pay for qualified education expenses without having to include the distributions as taxable income or incurring an early-withdrawal penalty. The mother can parcel out funds yearly, allowing the balance to grow. She can also keep her son on the payroll to continue funding the Roth IRA. Over 10 years, the mother will have contributed $40,000 to her son's education, while earning $40,000 of income-tax deductions for her business and about $10,000 of tax-free investment income.
At graduation, the son would be left with around $10,000 in the IRA. In most circumstances, the son would be penalized if he invaded that remaining balance before he turned 591/2. But not if he uses the funds to buy his first house, because another key Internal Revenue Service exception applies to first-time homebuyers. So that Roth IRA does double-duty as a college fund and a first-house fund. If that doesn't earn the parents a sweet Silver Anniversary present, then let's hope they have the good sense to cut Junior out of the will. — M.L.
The following article is part of an expanded web version of "Tuition Magicians."
Paying for College, Again and Again
Grandparents hoping to foot college tuition bills for future generations may want to take a second look at generation-skipping taxes.
With the cost of a college education soaring, more grandparents are volunteering to help pay for their grandchildren’s college tuitions. In fact, a widely-referenced survey sponsored by AIG SunAmerica Mutual Funds revealed that, out of 1,000 grandparents polled in 2003, more than 54 percent plan to contribute to their grandchildren's college education. Twenty percent said they intend to pay 75 percent of the cost, while one-quarter expect to chip in between 25 percent and 50 percent.
What's more, grandparents can count on the Internal Revenue Service to help keep the full value of their largesse intact as long as they're alive. The IRS allows any taxpayer to transfer tuition money directly to a school for the benefit of a student without incurring a tax on the transaction. Unfortunately, if a grandparent dies before the payment is made, the rules change. Any assets distributed from a grandparent's estate or trust that are transferred to a grandchild may be subject to estate taxes. The legacy could also be subject to a transfer-tax known as a generation-skipping tax (GST) that can run as high as 45 percent of the transfer amount.
Since the GST doesn't kick in on the first $2 million transferred to grandchildren, however, it usually affects only taxpayers in the higher brackets. But the estates of wealthier grandparents—including funds set aside for educational expenses—could be significantly reduced by the GST. To cope with that situation, they might want to consider installing a health and education exclusion trust (HEET), says Virgilia Bryant of PricewaterhouseCoopers' Private Company Services division.
If structured properly, a HEET takes advantage of the IRS's tuition gift-tax exclusion and, by extension, avoids the GST, says Bryant. However, counsels Bryant, to garner the tax break, grandparents must be willing to give up some money to charity. That means that along with grandchildren and great-grandchildren, the trust must also name a qualified charity as one of its beneficiaries.
By structuring the HEET so a charity is able to receive disbursements, a grandparent can make sure that a grandchild, or "skip person," will never be the only beneficiary of the trust. (A skip person is someone that's two or more generations removed from the original grantor.) That's important, because the IRS won't exempt trusts from the GST if only skip persons are named as beneficiaries. Further, although there's no bright-line tax rule to follow, the charity must have a "meaningful interest" in the income and principle of the trust to avoid being taxed separately, or viewed as a tax dodge.
Any asset can be transferred to a HEET, but all disbursements must be in cash. Also, the initial transfer of cash into a HEET may be taxable. One way around that is if the grantor is living, the transfer could take advantage of each person's $12,000 annual gift tax exclusion—and again, by extension, the GST tax exclusion.
Cash disbursed from a HEET is somewhat restricted, too—it can only be used for tuition. But tax-qualified tuition payments can be for any level of schooling or formal instruction, says Bryant. That includes pre-school, undergraduate and graduate programs, and technical and vocational training. The student can be enrolled part-time or full-time, and can attend programs in the United States or overseas. Qualified medical expenses can also be paid with HEET disbursements made directly to the provider.
Some families use HEETs to supplement state-sponsored 529 Plans, the college- savings vehicles that allow after-tax dollars to accumulate tax-free. While HEETs can only be used for tuition and qualified medical expenses, 529 Plans disbursements can be used to pay for tuition, plus room and board, books, computers, and other qualified college fees and expenses.
Still, HEETs aren't for everybody. Bryant explains that they're complicated structures that require time, money, and expertise to set up. Nevertheless, as an estate-planning tool, they may grandparents help their grandchildren make the grade.— M.L.