Junior Goes to College! Innovative Strategies to Save for Your Children's College Education with Pre-Tax Dollars

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Overview

The cost of college tuition has gone through the roof. The average cost of a private university can range from $40,000-60,000 per year. The cost of a public university is a lot less in most cases except that the competition is pretty stiff to gain admission to a top public university.  Getting into schools such as UNC-Chapel Hill and UVA can be like getting Harvard. The student loan dilemma adds another layer of complexity in terms of availability and qualification and how to pay for college.

 A wise friend of mine who is a Rabbi told me recently  that sometimes the best way to pay for something is with money!  It's just that we need a lot more of it when it comes time to pay for Junior's college education. It seems obvious but the point is this - plan and save early for these costs if you can. With higher tax rates, you can have Uncle Sam subsidize the college savings plan by using pre-tax dollars.  

This article is designed to outline the tax considerations of adding Junior, a minor,  to the payroll in the family business and making contributions of his earned income into a traditional or Roth IRA or a 401(k) or Roth 401(k) as a college savings plan.

If you don't have a business, you need to start one. I have frequently discussed the creation of a Family LLC for investment management purposes as a valid business for tax purposes. Many taxpayers have part-time or sideline income. Turn this hobby or part-time income into a business.

What is Available Now for College Savings?

Saving for college can be harder than saving for retirement. The clock starts ticking the day your child is born - and the closer college draws, the less investment risk you can take. What are the current and perhaps tax-advantaged plans for college savings?

A. Coverdell Education Savings Accounts (“ESAs”) let you save up to $2,000 per year per student. Earnings grow tax-deferred, and withdrawals are tax free for education costs.

B. Section 529 Plans are state-sponsored college savings plans. Each state sets its own lifetime contribution limit, which ranges between $100,000 and $300,000+. Traditional “prepaid tuition” plans cover specific units of tuition such as a credit hour or course.

Newer “college savings” plans invest contributions in mutual funds for potentially higher growth, generally adjusting portfolios from stocks to bonds and cash as your child ages. You can choose any state’s plan; however, some states offer deductions for contributions to their own plans.

C. U.S. Savings Bonds let you defer tax on gains until you redeem the bond. Interest on Series EE Savings Bonds issued after 1989 to individuals age 24 or above may be tax-free if you use it the year you redeem the bond for “qualified educational costs” (tuition and fees minus tax-free scholarships, qualified state tuition plan benefits, and costs for which you claim the American Opportunity or Lifetime Learning credit).

For 2013, the exclusion phases out for households with “modified AGI” from $74,700-89,700 (singles and heads of households) or $112,050-142,050 (joint filers) and isn’t available for married couples filing separately.

Plan

Coverdell ESA

Section 529 Plan

Donor AGI Limit

$110,000 ($160,000 joint)

None

Contribution Limit

$2,000 per year

$115,000-315,000 lifetime
(varies by state)

Federal Deduction

None

None

State Deduction

None

Some

Withdrawals

Tax-free for elementary, secondary, and college costs, including reasonable room and board. Expenses paid out of ESA accounts do not qualify for American Opportunity or Lifetime Learning credits. Withdrawals not used for education are taxed as ordinary income.

Tax-free for “qualified higher education expenses.” Withdrawals not used for college are taxable only if they exceed contributions.

Age Limit

Use by age 30. Otherwise, pay tax on gains or roll into a family member’s ESA.

Designate new beneficiary if child chooses not to attend college.

Surprisingly, this does not seem to get discussed much in comparison to existing programs such as 529 Plans.

The concept of adding Junior to the payroll does not suffer from phase outs based upon AGI and will in many cases not be subject to any federal, state or employment withholding taxation. Additionally, the funds will grow on a tax-deferred basis.

Employment Taxation Considerations for Children Working in a Family Business

Payments for the services of a child under age 18 who works for his or her parent in a trade or business are not subject to social security and Medicare taxes if the trade or business is a sole proprietorship or a partnership in which each partner is a parent of the child. A LLC is taxed as a partnership for federal tax purposes.

Payments for the services of a child under age 21 who works for his or her parent in a trade or business are not subject to Federal Unemployment Tax Act (FUTA) tax. Payment for the services of a child are subject to income tax withholding, regardless of age.

The wages for the services of a child are subject to income tax withholding as well as social security, Medicare, and FUTA taxes if he or she works for:

(1) A corporation, even if it is controlled by the child's parent,

(2) A partnership, even if the child's parent is a partner, unless each partner is a parent of the child, or

(3) An estate, even if it is the estate of a deceased parent.

The Family Investment LLC

In case you don't already have a family business in operation, not to worry! Create a Family Investment LLC.  The proposed solution envisions the creation of a family limited liability company (LLC) by the taxpayer. The Family LLC can be the operating vehicle for all of your "Moonlighting" and consulting income or how about that part-time income your wife makes as a realtor.

The non-tax business purpose for the creation of the LLC is to facilitate the consolidation of investment assets and management for the family. This business is valid for tax purposes according to IRS guidelines and case law. The LLC may be a single member LLC that is member managed or alternatively may be a LLC that is managed by a Manager.

Following the creation of the family LLC, the taxpayer may transfer title to investment accounts and holdings to the LLC. Investment income flows in the Family LLC. The Client who serves as manager of the Family LLC is entitled to pay himself a management fee structured as a guaranteed payment or salary from the LLC.

The Client may in the absence of a transfer of assets to the LLC may create an arms-length management agreement between the LLC and the Client to provide investment management services.

Traditional IRA and Roth IRA Basics

The 401(k) allows a participant to defer up to $17,500 of earnings on a pre-tax basis in 2013. A participant that is older than age 50 may contribute an additional $5,500 per year. The Roth version of the 401(k) allows for after-tax contribution of $17,500 into the plan. the investment earnings within the plan are tax-deferred and distributions are tax-free.

IRA contributions are the same for traditional and Roth IRAs. The amount of IRA contribution is reduced by the amount of contribution made to a Roth IRA. The IRA allows a taxpayer to contribute $5,500 in 2013 ($6,500 if the taxpayer is age 50 or older) if the taxpayer is a participant in a company sponsored pension plan.

IRA distributions are taxed as ordinary income rates. Distributions before age 59 ½ are subject to a 10 percent early withdrawal penalty. The account balance is included in the taxpayer’s taxable estate. However, IRC Sec 72(t)(2)(E) provides an exemption from the ten percent penalty for higher education expenses. The same exemption provisions allow for an early withdrawal for the purchase of Junior's first home.

The primary difference between the Roth IRA and IRA or qualified plan is that the Roth IRA does not have required minimum distributions. Distributions from the Roth IRA are not subject to income taxation. However, the distribution must be a “qualified” distribution. Qualified distributions require five years of “seasoning” within the plan unless the taxpayer is at least age 59 ½.

The investment guidelines for a Roth IRA are similar to the restrictions for a traditional IRA. The policyholder can expand the investment guidelines through the use of a self-directed arrangement. The prohibited transaction guidelines applicable to the traditional IRA apply to the Roth IRA as well as the tax rules on unrelated business taxable income (UBTI).

Kiddie Tax Considerations

The “Kiddie tax” is a special tax intended to stop parents from shifting investment income to children, who are presumably taxed at lower rates than the parent(s). For 2013, the tax applies to dependent children under age 19 and dependent full-time students under age 24 who report unearned income over $2,000.

Here are the rules:

(1) If your dependent child’s unearned (investment) income is under $950, no return is needed.

(2) If your child’s unearned income is more than $1,000, a return is required. Unearned income from $1,000 to $2,000 is taxed at the child’s rate.

(3) If your child’s unearned income exceeds $2,000, the Kiddie Tax kicks in. (If your child itemizes deductions and has more than $1,000 in deductible investment expenses, the floor is $1,000 plus the deductible investment expenses.)

(4) The actual Kiddie Tax due is the increase in your total tax that results from adding the amount of your child’s income subject to the tax to your own income.

(5) Your child’s income doesn’t increase your AGI for purposes of figuring limits on deductions or credits. For example, it won’t keep you from contributing to a Roth IRA.

The IRS treats your child differently depending on whether they earn money from work or through investments. All dependent children who earn more than $6,100 of income during the year must file a personal income tax return and might owe tax to the IRS. Earned income only applies to wages and salaries your child receives as a result of providing services to an employer, even if only through a part-time job.

However, even if your child earns less than $6,100 during the year, it may be a good idea to file a tax return for them, because they could be eligible for a tax refund. Regardless of the amount of income your child earns, their standard deduction is different than yours. It can never exceed the larger of $950 or their earned income plus $300, with the maximum equal to $6,100.

Strategy Example

Facts

John Doe, age 40, is a managing director in a private equity firm in New York City. He has W2 income each year of $750,000. As a resident of New York City, his combined marginal tax bracket is 48 percent. He participates to the maximum extent in his company’s 401(k) plan. He is married and has two children, ages 2 and 4. John and his wife (Mary) file a joint tax return and report investment income each year of approximately $350,000 per year.

Solution

John forms a LLC in Delaware – Acme Investments. John and Mary are the members. Acme is member managed by John and Mary jointly. John and Mary assign their investment accounts and holdings in various alternative investments – hedge funds and private equity – to Acme. John will receive a management fee of $100,000 per year. Mary will receive a management fee of $10,000 per year. They will add each of the children to the payroll for $6,100 each in 2013.  The LLC will deduct these payroll expenses.

John will contribute each child's earned income of  to a Roth IRA on their behalf up to the 2013 limit of $5,500. As the children become older and a stronger basis exists for justifying higher compensation exists, John can increase their salaries to fall within the 401(k) contribution limits. The children's earned income will not be subject to FICA and FUTA withholding taxation.  The Family LLC can adopt a 401(k) plan allowing each of the children to defer the full amount of salary up to the 401(k) plan.

The tax-advantaged accumulation is impressive. A Roth IRA contribution of $5,500 per year over 16 years invested at 8 percent is worth $180,000 as Junior is ready to enter  college. If Junior is able to take advantage of a 401(k) contribution for 15 years, the future value of Junior's 401(k) account is in excess of $500,000.  

As previously mentioned, early distributions are not subject to the ten percent early withdrawal penalty for higher education expenses. Distributions from a Roth IRA or Roth 401(k) will not be subject to any taxation on distributions. Distributions from the traditional IRA or 401(k) will be subject

Summary

The Family LLC has a lot of planning utility including saving for Junior's college education or down payment for his first home. If you don't own a family business, create one. The mechanics for doing so are straight-forward. A few tax provisions, make this strategy very powerful - (1) No FICA or FUTA withholding taxation for children under 18 (2) No taxation on earned income under the standard deduction of  $6,100  (3) Tax-deferral and tax-free distributions from a Roth IRA. (4) No early withdrawal penalty for distributions before age 59 1/2.

The strategy can be super-charged with compensation up to the 401(k) contribution limits. The full amount of Junior's earned income can be deferred within the 401(k). With a Roth 401(k), Junior will have a small amount of taxable income but no taxation on future distributions. With a traditional 401(k), the future distributions will be taxed at ordinary rates. The time value of money is a powerful weapon for accumulation particularly with tax deferral and pre-tax or lightly taxed contributions into the Plan.

Financing your children's education is stressful enough. Student loans are costly and harder to qualify for as well as the problem of paying them back when Junior isn't fully employed after graduation. The idea of allowing Uncle Sam to finance a portion of these costs on a tax-advantaged basis is very compelling considering the limits for the plan outlined in this plan provides greater tax-advantage and investment flexibility that a 529 plan using a self-directed 401(k) or IRA option.