College Financial Planning

Achieving your financial goals requires a coordinated, integrated approach. Peace of mind is achieved from knowing that you have planned well. The sooner you start education fund planning the better, since education costs are rising rapidly and aid sources are diminishing.

Plan to Pay for Large Expenses

As the cost of a college education continues to skyrocket – even outpacing the annual inflation rate – planning is critical if you want to have the required funds available.  Whether you use the funds to finance a child’s education or for some other purpose, there are a few ways you can reduce your family’s tax bill.

Shifting income to a child to take advantage of the lower tax rates is one way to build your family’s wealth.  Special income tax rules apply to children under age 14, so you will need to plan carefully.

Watch Out for the “Kiddie” Tax

Children under age 18 pay tax at their parents’ highest bracket on the portion of their unearned income (for example, interest and dividends) that exceeds $1,700 (in 2007).  There are still some effective ways around this potential stumbling block:

  • Take Advantage of Lower Rates
    Even if your child’s income is not earned, the first $850 is tax free, and the tax rate on the next $850 of income is taxed at the child’s rate.
  • Choose Growth Instead of Income
    You can avoid the Kiddie tax if your child invests in growth stocks or growth mutual funds that pay low dividends.  As long as they are held until after the child turns 18, the capital gain is taxed at the child’s rate, not yours.
  • Consider Municipal Bonds
    Interest on these securities is federally tax exempt to owners of any age.  However, they generally do not offer an opportunity for growth with reasonable chance for earning more than the inflation rate.  Ownership of individual bonds may require coupon clipping, and there is the inconvenience of timing sales or redemptions.  Furthermore, bond income is relatively low.

Put Your Child to Work

If you own an unincorporated family business, hire your child.  The salary is a deductible business expense, and if your child is under age 18, you do not have to pay FICA tax on the amount.  The tax rate of the child at 10 or 15% is sure to be less than your own or the business’s.

This concept is called tax leverage – removing income taxed at a higher rate and causing it to be taxed at a low rate.

Use the Gift of Tax Exclusion

You can give up to $12,000 (2007) annually to any number of individuals without creating a gift tax liability.  If the gift is from you and your spouse – regardless of whose funds are used to make the gift – you can give up to $24,000 to each individual.

You should definitely consider a gift program if your children are 18 or older because their unearned income is not subject to the Kiddie tax.  Here are some other ideas about how you can make the most of your gifts:

  • Give your children property that is likely to appreciate in value.  Both the current value and any future appreciation would be removed from your estate.
  • If you plan to sell appreciated property, give it to a child age 18 or older.  The gain on the sale will then be taxed at the child’s lower rate.

Consider a Trust to Hold Gifts

If you are reluctant to make direct gifts to your children, you can still take advantage of the gift tax exclusion.  A qualified minor’s trust provides tax benefits and, at the same time, restricts your children’s access to the funds.

Grandchildren’s Education

If your grandchildren are in college, pay their tuition directly.  You remove the amount of the tuition from your estate, and you still have the flexibility to give each of them an additional $12,000 (2007) per year without gift tax consequences.

Paying for College

Start saving now to ensure that you will be able to pay for all or a share of your children’s education.

Today’s average annual cost for a 4 year, public college exceeds $12,000 while that of a private college averages more than $27,000 (college board average costs for 2007-2008) and those figures will probably grow at a faster rate than inflation.

One of the best calculators can be found on the web at  This calculator lets you choose:  tuition and expenses in today’s dollars; years of college; years until college; savings to date; amount you can save monthly; your savings interest rate; the expected inflation rate; your federal tax rate and your state tax rate.

For example, you’ll find that if your student’s college of choice costs $5,000 per year today, and you plan 4 years of college to start 10 years from now, you have no starting funds but you plan on saving $100 per month and realize 6% interest on the savings, and inflation, federal tax and state tax rates are 3%, 25% and 6% respectively, then:

Given inflation of 3.0%, the yearly cost of college in 10 years will be $6,747, the total cost over the 4 year period will be $28,243, and the total amount you’ll need to have saved when you start is $23,169.

Your current savings plan will provide $14,797. To accumulate $23,169 in 10 years you’ll need to:

  • Increase the amount you invest now to $5,565, or
  • Increase the monthly amount you invest to $146.
  • Earn a rate of return of 15.45%.

Pay Certain Expenses Directly

If you would like to make annual gifts to a child of more than $12,000, you may still be able to do so without negative gift tax consequences.  Tuition payments made directly to an educational institution do not count toward the $12,000 annual limit.

However, this exception does not apply to amounts paid for room and board or books.  Furthermore, if you pay the student instead of the school, none of the amount qualifies under this special rule, even if the money is used for tuition.

The same exclusion applies to payments made directly to providers of medical services – including medical insurance premiums.  If the expense is reimbursed by insurance, it does not qualify.

Withdrawals from Life Insurance

Older life insurance policies required that you surrender a life insurance policy, or make a loan, which would require that you make a non-deductible interest payment.

However, the newer form of life insurance, universal variable life, may contain a withdrawal privilege.  This enables you to make a tax-free withdrawal from the policy.  The amount that is withdrawn will no longer earn interest, but you will not have to pay any.  However, this advance is taken into consideration if the policy is surrendered.

For this reason, many people are now using variable universal life insurance as a funding vehicle for education.

Disqualification for Aid Programs

You should be aware that money in the name of a child, whether it was earned and saved, received from a relative or the result of an investment gain, may reduce aid qualification.  The formula mandated by Congress, and used by most schools (generally referred to as the Congressional Aid Formula) penalizes those students who have money.  This might prompt you to use life insurance or an annuity as the education investment, since these do not count negatively in the congressional formula.

Sources:  Tax Facts 2007, National Underwriter Company
Financial Planning Consultants, Inc.

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