This section provides an overview of earned and unearned income, how those types of income are taxed and how the various tax deductions, exemptions and education tax credits can be used to reduce federal income tax.

You see, when you have income you have to pay tax on that income to the IRS. What is left after taxes, you get to keep. Therefore, the cost of education isn't the net cost of the education after aid is considered, it is what you have to gross in income in order to end up with enough after taxes to pay that net (after aid) cost of college.

Most financial advisors, college counselors and parents fail to recognize that reducing the tax cost associated with education funding is similar to receiving a "scholarship" or "grant" from the IRS. That's why we refer to any tax-saving tactic or tax benefit that reduces the overall cost of college as "tax aid." Your child may not qualify for need-based aid or be talented enough to receive a merit scholarship, but you still may be able to get some "tax aid."

The primary tax-saving tactic is income-shifting. We are going to discuss how to "shift" earned and unearned income to your child with the goal of paying less income tax on the child's tax return than you would on your own. Then you simply use the income and assets that you shifted to the child to pay education costs.

How to "Shift" Unearned Income to Your Child

Parents who do not own a business cannot shift earned income to their children, but they can gift appreciated assets that they own outright to their children, and most often those assets will be stock, mutual funds, exchange traded funds and stock acquired through options and grants.

For our purposes we will use stock as the primary asset in this discussion, whether it was acquired through a broker on the open market or obtained through a grant or option as part of an employer's equity compensation plan.

Gifting Appreciated Assets

As mentioned above, the goal of gifting assets is to shift any capital gains tax liability to your child so that she can pay the tax at her typically lower tax rate.

 

Gift Tax Basics

When you own outright stock that you bought through a broker or you acquired from a stock grant, whether through exercise, purchase, or vesting, you can then make individual gifts to your child (including transfers to UGMA or UTMA accounts) of up to $13,000 yearly, or joint gifts with your spouse of up to $26,000 yearly, without any gift tax consequences. When your children are minors, the only way they can own such assets is through custodial accounts (UGMA and UTMA) or trusts. Gifts to individuals under the age of 18 are held in UGMA (Uniform Gifts to Minors Act) or UTMA (Uniform Transfers to Minors Act) accounts on behalf of the minor, and a custodian maintains legal control of the account until the minor reaches age 18 (age 21 in some states if elected when the account is established). Gifts to individuals 18 years of age and older can be made outright to the individual.

With the national average price of a four-year private college education exceeding $38,500 per year, an annual gift of $26,000 will fall well short of funding the entire cost. So many parents choose to begin gifting the maximum of $26,000 (jointly) per person to their children while the children are still under the age of 18 in order to accumulate enough money in the child's account to pay for college. Money paid directly to the college does not count towards the yearly gift amount totals.

Gifts of stock are based on the stocks' value at the time of the gift and not on your tax basis. The basis and holding period of property acquired by gift are carried forward to your child. The kiddie tax determines the tax rate that applies to your child when the stock is sold.

Purchasing stock, in the open market through a broker and owning it outright, makes it easy to gift the stock later on, but it is not as simple or effective with certain types of company stock grants.

Type of Company Stock Grant Affects Tax Strategies

The tax status of the underlying shares of company stock after grant, vesting, purchase, and/or exercise is the most important factor in determining whether the shares can be used efficiently to pay for college. Ideally you want appreciated stock which you can gift to a child in a qualifying disposition (described below) that will effectively transfer a large portion of the capital gain at sale to the child. Even with the changes in the kiddie tax, this can be an effective strategy when combined with other approaches. The purpose behind gifting appreciated stock to a child is to take advantage of the child's typically lower tax bracket by having the child sell the stock and pay the tax at the child's tax rate instead of yours. This is called income-shifting.

The disadvantage of using nonqualified stock options (NQSOs), stock appreciation rights (SARs) and restricted stock or restricted stock units (RSUs) to fund college costs is that you have to pay ordinary income tax on the spread at exercise (or with restricted stock and RSUs at vesting) before you can gift the stock to your child. The amount of taxable income realized, plus the exercise cost with stock options, is the tax basis carried over to your child. These forms of equity compensation can be a good source of college funds, particularly if you have not allocated the gains from your stock grants to other financial goals, but generally they are not the most tax-efficient types of grants to use.

Incentive Stock Options (ISOs)

ISOs, on the other hand, are not considered compensation income for regular tax purposes upon exercise when you hold the shares. At sale, you can receive favorable long-term capital gains treatment for the full amount of the sales price over the exercise price if you comply with the holding requirements of two years from grant and one year from exercise. You want to avoid gifting the ISO stock too soon, as this has unusual tax consequences similar to those of a wash sale. When your gift is a qualifying disposition (i.e., it meets these holding periods), the ISO stock can then be sold at lower capital gains rates.

At first, ISOs always seem an effective way to gift appreciated stock through a qualifying disposition, while having the child pay the tax on the gain at sale. However, when you exercise and hold ISOs, you may trigger the alternative minimum tax (AMT). When you sell ISO stock, you have an AMT adjustment that helps you use up the credit generated at exercise. You do not have the same AMT income adjustment for gifting ISO stock. However, new rules for the Hope Tax Credit permit the credit to be used against the AMT, thereby reducing the amount of the AMT dollar-for-dollar.

Employee Stock Purchase Plans

Tax-qualified Section 423 ESPPs let employees purchase shares of company stock at regular intervals using after-tax dollars. These plans commonly are administered through payroll deductions and can allow employees to buy shares at a discount to the market price on either the offering date or the purchase date. Shares purchased through a Section 423 ESPP can receive favorable tax treatment if you meet holding requirements of one year from the purchase date and two years from the offering date.

Assuming you sell the stock at a profit, most of the spread between the discounted purchase price and sale price is capital gain, with no tax on the discount at the time of purchase. You do owe some ordinary income at sale for the discount at purchase, usually calculated from the stock price at the start of the offering period. If your ESPP is not a Section 423 plan (nonstatutory), the difference between the purchase price and the market value of the stock on the purchase date will be treated as ordinary income in the year of purchase and subject to income tax withholding at that time (i.e., the tax treatment is similar to that of NQSOs).

As with ISO stock, you do not want to gift ESPP stock that has not met the holding period requirements. Otherwise, it will be taxed as a wash sale. After holding the ESPP stock long enough, when you gift the shares, you still pay ordinary income tax on the discount from the offering price as with any sale of ESPP stock held for the required period (assuming the stock appreciated above the purchase price). From a tax standpoint, at worst, if you purchase shares through a Section 423 ESPP with a 15% purchase price discount and the market value at the time of a qualifying disposition shows a gain of 20%, you will have to pay only ordinary income tax on the 15% purchase price discount from the stock price at the start of the offering. If you dispose of the shares by gift to your child, his or her tax basis will be the purchase price plus the 15% that you paid the ordinary income tax on. The additional 20% of capital gain from market appreciation is effectively shifted through the gift. When the child sells those shares, the gain will be taxed to the child.

Restricted Stock

Similarly, restricted stock can be gifted, effectively shifting embedded capital gains to the recipient, but the overall tax efficiency of this strategy depends on whether you choose to make an 83(b) election (not available for RSUs) at the time of grant.

With grants of restricted stock, the entire amount is taxed as ordinary income to you, unless you choose to make an 83 (b) election or unless you have an RSU grant with a deferral election. By making an 83(b) election at the time of grant, you choose to pay ordinary income tax on the market value on the date of grant. Any future appreciation is taxed as capital gain. Upon vesting, however, if you chose an 83(b) election and it paid off for you because the stock price went up in value, you could gift those shares to your son or daughter, effectively shifting that capital gain to the child.

Example of Paying Capital Gains under the Kiddie Tax

As you may recall, the unearned income of children under the age of 19 and full-time college students under the age of 24, is subject to the kiddie tax. Under the kiddie tax in 2009, the first $950 of a dependent child's unearned income (dividends, interest and capital gains) is tax-free (i.e., offset by the child's standard deduction), the second $950 of unearned income is taxed at the child's tax rate, and any amount over $1,900 is taxed at the parents' typically higher tax rate.

So if your child realizes $10,000 in long-term capital gains in 2009 from the sale of stock that was gifted to her, there would be no tax on the first $950 in gains and she would pay the lower capital gains tax rate of 5% ($47.50) on the next $950 in gains. The remaining $8,100 in capital gains would be taxed at your capital gains tax rate of 15% (assumed). Hence, your tax would be $1,215.

Due to the new kiddie tax rules, gifting appreciated assets to your child is not as attractive as it once was; however, if your child holds the assets that are gifted to her, there will be no capital gains tax due until she sells them and realizes the profit. Stockpiling gifted assets until the college years and then selling them and realizing the gains can be a good tax-saving tactic and will be addressed later in this chapter.

Now that we have covered ways to shift to your children through gifting the capital gain from stock, mutual funds, ETF's and company stock you acquired through various types of stock grants, let's look at how business owners can shift earned income to a child.

Shifting Earned Income to Your Child

"Shifting" in this case means paying your child instead of yourself. If you work for somebody else, you cannot "shift" part of your income to your child. You can't call up human resources where you work and tell them you'd like to hire your child for the summer and request that they pay $5,000 of your salary to your child instead of you. But if you own a business, you can hire your child to do a legitimate job for a reasonable wage. The child will have to pay FICA and Medicare withholding taxes on her earned income (there are exceptions), but our discussion will focus on federal tax.

The amount of money that you can reasonably pay a child for performing legitimate jobs depends on the age of the child, the nature of the work and what you and your tax advisor feel comfortable paying her without challenging what the IRS would consider reasonable.

The standard deduction for 2009 for a dependent child is the child's earned income +$300 up to the maximum of $5,700. If you hired your 14 year old child and paid her $5,700 per year, she could use the standard deduction of $5,700 to eliminate her taxable income, and her federal tax would be zero. Conversely, if you had taken another $5,700 in income out of the business in the highest tax bracket of 35%, you would have paid $1,995 in federal tax. By shifting this income to your daughter, you save $1,995 and the $5,700 of salary that she received can go toward paying private school costs.

 

If you pay her $7,000 per year, $1,300 more than the $5,700 she has in the standard deduction, then she would have to pay tax on the $1,300 at a rate of 10%, resulting in a federal tax of $130. She could also make a $1,300 contribution to an IRA which would then reduce her taxable income back down to $5,700, and she would have a federal tax of zero. She could use the money in her IRA later on down the road to pay for college costs. She wouldn't have to pay the typical 10% excise tax (penalty) on the withdrawal of the IRA money if it is used to pay for qualified higher education expenses, but she would have to pay ordinary income tax on the amount that she withdraws at that time.

During the college years, if your daughter uses her income and assets to provide more than half of her own support, then she can claim the standard deduction, the personal exemption and one of the education tax credits on her tax return. These techniques give her greater ability to minimize or eliminate the tax due on earned and unearned income that she receives. This is the biggest reason why stockpiling appreciated assets and then selling them during the college years can be an effective tactic, simply because there is a greater ability to the tax on the realized capital gains.

Combining Strategies to Fund College

Example: Capital Gains and the Kiddie Tax
The Hope Credit, the standard deduction and the personal exemption provide a useful combination to minimize or eliminate the tax on capital gains, even when your child is still within the grasp of the kiddie tax.

2009 Example: Selling Stock
You have a daughter in college full-time between the ages of 18 and 23. If she is paying college tuition, she can use her standard deduction, personal exemption and the Hope Credit to eliminate the federal tax on about $26,000 of long-term capital gains in 2009. For example, if she has accumulated $100,000 in an UGMA/UTMA account with $26,000 of embedded long-term capital gains, she will have to pay tax on the $26,000 when she sells the investments in her account. She needs to sell to have money to pay for college. The key steps in eliminating the capital gains tax are claiming the Hope Credit, personal exemption and standard deduction.

As long as you (the parents) do not take the Hope Credit on your tax return, and do not claim her as a personal exemption, she can claim the Hope Credit on her tax return. In this example, she would be using her own resources, specifically her UGMA/UTMA assets, to provide over half of her support which includes the cost of college. Therefore, she would be able to pass the support test and claim the $3,650 personal exemption as well as the Hope Credit. IRS Publication 501 states that, in general, if a person uses income and assets to provide over 50% of his or her own support (such as housing, food, education and clothing), that person can claim himself or herself as a personal exemption on a tax return. Since in this example your daughter is able to claim herself as a personal exemption, she is also able to take the full standard deduction of $5,700 for herself.

In this scenario, your daughter would simply sell about half of her $100,000 of appreciated stock, generating capital gains of up to $26,000. The $26,000 of taxable income from the long-term capital gains would be reduced by your daughter's standard deduction of $5,700 and her personal exemption of $3,650, bringing her taxable income down to $16,650. It would be assessed at your tax rate of 15%, resulting in a federal tax of $2,498. The Hope Credit (worth up to $2,500) would then eliminate the $2,498 tax.

In 2009, the only way that college students under age 24 will be able to avoid the kiddie tax is if they provide over half of their own support from their earned income (i.e., wages and salaries, not income from selling stocks). This means that, in the example above in 2009, your daughter would be subject to the kiddie tax and would therefore be taxed at your rate (15%) on her $26,000 of capital gains instead of at her lower tax rate of 0%.

Because the support test for the personal exemption is based on both income and assets, your daughter would pass the support test and be able to claim the personal exemption for herself, but she would still be subject to the kiddie tax because she isn't providing more than half of her own support exclusively from earned income. Oddly enough, she would qualify for the full standard deduction, the personal exemption and the Hope Credit, but would still be subject to paying tax on her capital gains at your tax rate due to the kiddie tax.

Long-term capital gains	$26,000
Student's personal exemption (support test)	- $3,650
Student's standard deduction (single filers)	- $5,700
Net Taxable Income	= $16,650
Capital gains rate (parent's rate of 15%)	x 0.15
Gross Federal Tax	= $2,498
Hope Credit	($2,500)
Federal Tax Due	$0

This overall strategy has not changed much over the years, but the effectiveness of the strategy is diminished somewhat in 2009 due to the new kiddie tax rules that went into effect and the capital gains are taxed at the parent's higher tax rate. The outcome is that your child can eliminate the capital gains tax on only $26,000 in one tax year instead of over $40,000 that could be eliminated if the 0% rate applied. Yet she can repeat the strategy over several consecutive years while in college.

Regardless of the new rules for the kiddie tax, this strategy is still a highly effective way to fund college expenses in a tax-efficient manner using company stock that was acquired through NQSOs, ISOs, ESPPs and restricted stock, as well as traditional stock, mutual funds and exchange traded funds. Furthermore, earnings in 529 College Savings Plans and 529 Pre-Paid Tuition Plans grow tax-deferred and are tax-free if used for qualified higher education. These can be good accounts to use for minimizing future taxes on reinvested proceeds from the sale of appreciated assets. These proceeds, if reinvested in bonds and/or Certificates of Deposit outside a 529 plan, will generate interest income on the student's tax return. Alarmingly, if this interest income is over approximately $10,000 a year, the student may be subject to the alternative minimum tax (AMT)—ultimately raising the student's federal tax bill.

If you had not gifted these appreciated assets to your daughter, but had instead kept them yourself and then sold them to pay for college, you would have paid long-term capital gains tax on the entire $26,000 of realized gains at your (assumed) rate of 15%. So the income-shifting tactic saved you $3,900 ($26,000 x .15).

Anyone can gift appreciated assets, and the great thing is that in addition to buying stock, mutual funds and exchange traded funds through a broker, millions of parents can also use stock acquired through their employer, whether through exercise, purchase, grant or vesting.

For parents who do not own a business, shifting unearned income like capital gains is really the only form of income-shifting they can use. Business owners on the other hand, as we have already discussed, can not only shift unearned income but earned income as well. Let's take a look at an example of using both income-shifting methods during the college years, but without the kiddie tax.

Example: Earned Income and Capital Gains - with no Kiddie Tax

In this example, we will assume that you hired your daughter through your family business to set up a new computer network and you paid her $14,000. In addition, we will assume that your daughter sells some of her appreciated stock and realizes $26,000 in long-term capital gains, the same as our previous example.

Furthermore, we will assume that she is attending a 4 - year public college with a cost of attendance of $18,500, the national average. Since support is calculated on an annual basis and she is only in college for nine months during the year, we need to divide the cost of attendance by nine to determine her monthly support amount ($18,500 / 9 = $2,056). To convert the monthly support to an annual support amount, we simply multiply $2,056 by 12, and her total support for the year (including all of her college costs) is $24,672 rounded off.

Due to the fact that your daughter is able to pay more than half of her own support ($12,336) using her earned income ($14,000), she will not be subject to the kiddie tax even though she is a full-time college student under the age of 24.

As in the previous example, your daughter will be able to take advantage of the standard deduction, personal exemption and the Hope Credit to offset her earned and unearned income, but since she now has earned income, the tax is calculated differently.

The standard deduction and personal exemption get applied against her earned income of $14,000 first ($14,000 - $3,650 - $5,700 = $4,650), leaving a remaining earned income of $4,650 which is taxed at 10%. The tax from the earned income is $465.

Now comes the best part. Because your daughter was able to provide more than half of her support from her earned income, she avoids the kiddie tax which means that her long-term capital gains will be taxed at the regular capital gains tax rates. The current long-term (stock held over one year) capital gains tax rate is 15% for taxpayers in the 25% tax bracket and above, but the rate is 0% for taxpayers in the lower (10% and 15%) brackets for regular tax purposes. Your daughter's net taxable income of $30,650 ($40,000 - $3,650 - $5,700 = $30,650) falls in the 15% tax bracket for single taxpayers (less than $33,950) which means that her capital gains tax rate is zero from now through the 2010 tax year. Thus, the long-term capital gains tax will be $0.

Earned Income	$14,000
Student's personal exemption (support test)	- $3,650
Student's standard deduction (single filers)	- $5,700
Net Taxable Income	= $4,650
10% Tax Rate	x 0.10
Tax on Earned Income	= $465
Long Term Capital Gains	$26,000
Capital gains rate 0% (through 2010)	x 0
Tax on Unearned Income	$0
Gross Federal Tax	= $465
Hope Credit	($2,500)
Federal Tax Due	$0

If you are in the 35% tax bracket and did not implement this tax-saving technique, you would have paid $8,200 in taxes on the combined capital gain and earned income.

Earned Income of	$14,000 x .35 = $4,900
Capital Gains of	$26,000 x .15 = $3,900
Tax Savings	$8,800

In summary, instead of selling appreciated assets in your tax bracket and/or paying yourself more money out of your business, you can shift earned and unearned income to your child and use her standard deduction, personal exemption and one of the education tax credits to minimize or eliminate the federal tax on the child's tax return, potentially saving yourself thousands of dollars in taxes each year.

Recovering the Cost of Education

What? Recovering what? As you know, college is downright expensive. But implementing the tax-saving tactics that we have just covered may save you enough money that over time, the accumulated savings could add up to what you would spend in total on the cost of education. Let's do the math.

In our example of shifting earned income to your child during the K-12 years, we said that your child's standard deduction of $5,700 would eliminate her taxable income of $5,700 per year from working in your business. The tax savings to you was $1,995 per year - what you would have paid in tax on that $5,700 in your tax bracket had you taken the income yourself to help pay for private school.

If you begin to accumulate this tax savings each year and earn a hypothetical rate of return of *8% annually on it, in time you may be surprised. After saving $1,995 each year during four years of private high school, your tax savings account will grow to $8,990 with the *8% return. This $8,990 will continue to grow at *8% each year during the next four years of college at which time it will be worth $12,231.

If your child uses an admissions tip and chooses to attend a satellite campus of a large well-known state university instead of attending the university's main campus, you may save an additional $1,500 per year during each of her four years of college. The savings from this tip alone would be worth $6,759 at the end of paying for college.

Finally, by using the income shifting tactic for both earned and unearned income during the college years, you achieved a tax savings of $8,800 per year by not having to pay tax on $26,000 of capital gains and $14,000 of wages. The result is that you will have an additional $39,654 in tax savings at the end of college as a result of this strategy alone.

The total savings at the end of college equals $58,644 ($39,654 + $13,231 + $6,759). Most parents have about 15 years until retirement after they are finished paying for college which means that your $58,644 growing at *8% per year will be worth $185,000 when you are ready to retire.

In short, you will have more than recovered the average cost of a four-year private high school (9th -12th grades) education and a four-year degree at a state university; a total cost of around $168,000.

More often than not, the financial services industry gets it wrong when it comes to college and retirement. College and retirement are not separate roads, rather, college is a tollbooth on the road to retirement and the less you pay in tolls the more money you will have at retirement.

The question is - what is Your Best Strategy® to pay for college and have the most money for retirement?

 

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* The rate of return is hypothetical only, and does not represent any particular investment.  Actual results will vary.
All investments entail risk, including the risk of some or all of an investment.  Investments do not provide a guarantee against loss.  INDY College Funding does not offer investment products or advice.  Before choosing any investment, seek the advice of a financial adviser.