Tax-Efficient Learning - By Troy Onink , Lloyd Paradiso - 11/5/2009 
After affluent clients have accomplished the goal of getting their children into the school or college of their choice, a key objective is to pay for the education as tax-efficiently as possible.

The good news for advisors, and their clients, is that there are a number of tools and strategies that allow even high-net-worth clients to achieve substantial savings on a four-year college education.

These strategies include income-shifting, the strategic use of tools such as the Hope Tax Credit and avoidance of the so-called "kiddie tax."

An in-depth analysis of these strategies will also show that advisors can, by making a college plan tax efficient, also enhance a client's retirement outlook.

Admission Consultants
Before delving into tax planning strategies, it should be pointed out that advisors can go a long way toward solving their clients' college planning issues by working with an admissions consultant.

In one example, Princeton Retirement Planning and Wealth Management in Princeton, N.J., has partnered with two leading independent educational consultants with the goal of "being able to deliver a client's best strategy to pay for the college that is the best fit for the student," says Kevin Graham, a principal of the firm.

The firm's clients have responded favorably. Graham says he can now have a whole new dialogue with clients, and it is around one of his clients' most important concerns: their child's private school and college education.

"Getting into the right private day school, boarding school or college isn't always easy these days, but it is always expensive," he says. "The counselor/advisor combination is able to address both issues seamlessly."

Experienced admissions consultants visit dozens of colleges each year and get to know admissions staffs and how the admissions process works at different colleges and universities. Their job is to get their clients' children optimal consideration at their schools of choice.

The top admissions consultants are highly responsive, do a lot of hand-holding, understand adolescents, are comfortable with family dynamics and know what works and what doesn't for a particular applicant at a particular institution.  Wealth managers and admissions counselors work well together. There is little redundancy as each is an expert in his or her respective field and their combined wisdom allows families to proceed with confidence that they are giving their children every possible edge in an expensive, complicated and hyper-competitive arena.  

The combination can produce cost-effective results by helping families choose the right school or college, where the child can be productive and happy the first time around, and by using the tax code to the client's advantage when paying for it.

"It's usually not a matter of whether clients can write a check for the most expensive colleges; it's a matter of writing the check using tax-efficient dollars," says James Hedstrom, a CPA and CFP with Carroll Financial in Charlotte, N.C.

Hedstrom analyzes each family's ability to pay for education costs tax-efficiently by starting with a review of all of the client's assets and sources of income. "The right balance of assets, income and conservative tax strategies can produce some very nice results," he says.

Although there are a number of tax strategies, such as direct payment of tuition to qualified higher education institutions, pre-payment of private school and college tuition costs, the use of various forms of business entities and various types of trusts, the classic way to save on income tax is through income-shifting.

Shifting Earned Income To A Child
Shifting earned income essentially means the client pays his child instead of paying himself. If the client works for somebody else, he cannot "shift" part of his income to his son or daughter. But if your client owns a business, he can hire his child to do a legitimate job for a reasonable wage. The child may have to pay FICA and Medicare withholding taxes on his earned income (there are exceptions), but our example will focus on eliminating the federal income tax.

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

Shifting Unearned Income
Shifting unearned income in the form of unrealized capital gains involves gifting appreciated assets. Existing gift tax rules provide for a $13,000 annual exclusion per person, per donor ($26,000 on joint tax returns). Outright gifts of larger amounts to individuals in a single year reduce the donor's lifetime exemption and require a gift tax return to be filed.

Standard Deduction And Personal Exemption
Typically, parents will claim the $3,650 personal exemption for their child because the parents are providing greater than half of the child's support throughout the year. However, if your client's daughter uses her own income and assets to provide more than half the total cost of college, she would be able to claim the personal exemption for herself.

In 2009, the standard deduction for a dependent child-if the parents claim the personal exemption-is the child's earned income, plus $300, up to a maximum of $5,700. However, if the child is claiming the personal exemption for herself, then the child can automatically claim the personal exemption and the full standard deduction of $5,700, regardless of earned income.

Hope Tax Credit
As long as your clients do not take the Hope Credit on their tax return, and do not claim their daughter as a personal exemption, she can claim the Hope Credit, the Lifetime Learning Tax Credit or the tuition and fees deduction on her tax return.

The American Opportunity Credit provision that was part of the recent stimulus legislation increased the Hope Tax Credit from $1,800 per student for the first two academic years to $2,500 per student for four academic years. Although this provision is scheduled to expire at the end of the 2010 tax year, it is widely believed that it will be extended or made permanent. The income phase-out ranges were also raised, from  a range of $100,000 to $120,000, to a range of $160,000 to $180,000 of modified adjusted gross income on joint tax returns. Affluent clients will typically still be in the phase-out range, but the child can claim the credit on her own tax return as long as the criteria outlined above are met.

Avoiding The Kiddie Tax
The kiddie tax is a tax on unearned income paid to minors. For 2009, the first $950 of such income is tax free, the second $950 is taxed to the child at his or her tax rate and all unearned income over $1,900 is taxed at the parents' tax rate. The kiddie tax rule now applies to children under age 19 and full-time college students under the age of 24.

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 own earned income-wages and salaries, but not income from selling stocks. Notice that this is different from the support test for the personal exemption mentioned above, which allows the student to use their earned income in addition to their unearned income and personal assets to pass the test.

Breaking It Down
As an example, let's assume your client hires his daughter to set up and administer a new computer network for the family business and pays her $17,000 per year. We will also assume that your clients have been gifting their daughter appreciated assets over the years and that she will sell some of the assets during each year of college and realize $26,000 in annual capital gains. She will use the proceeds from the sale of assets in combination with her $17,000 of earned income to pay for the full cost of her first year at Penn State University, the University of North Carolina at Chapel Hill, the University of Texas or some other flagship state university with a total cost of attendance of around $33,000 per year, including out-of-state tuition.  

The daughter will be able to take advantage of the standard deduction, the personal exemption and the Hope Credit to offset her $17,000 of earned income and $26,000 of unearned income each year.

The standard deduction of  $3,650 and the personal exemption of $5,700 get applied against her earned income of $17,000 first, leaving a remaining earned income of $7,650, which is taxed at 10%, for a total of $765. Combined with her capital gains, it leaves her with a net taxable income of $33,650.

A key component to the overall strategy is that, because the 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 capital gains tax rate is 15% for taxpayers in the 25% tax bracket and above but, for 2009 and 2010, the rate is 0% for taxpayers in the lower 10% and 15% brackets for regular tax purposes. Her net taxable income of $33,650 falls in the 15% tax bracket for single taxpayers, which means that her capital gains tax rate is zero percent from now through the 2010 tax year.

The Hope Credit will eliminate her overall federal tax of $765 and because 40% of the Hope Credit is now refundable to a maximum of $1,000, she will actually get a refund of $1,000. The refund would not be available to her if she was claimed as a personal exemption on her parents' tax return, but since she passed the support test for the exemption, she is eligible to claim a refund because she didn't use all of the Hope Credit.  

Assuming her parents are in the 35% tax bracket, they would have paid $9,850 in federal taxes on the combined capital gain and earned income each year of college if they had not implemented this income-shifting strategy.

Recovering The Cost Of Education
Over time, income-shifting strategies can lead to significant savings. In the example we've just outlined, clients would achieve a total savings of close to $40,000 by the end of their daughter's four years of college.

By the time they are finished paying for college, most parents have about 15 years until retirement. During that time, the $40,000, if properly invested, could grow into sizable portion of a client's retirement nest egg. In that sense, the income-shifting strategies we have described allow you to help clients both pay for their childrens' college cost and add to a client's bottom line at retirement.

These tax-saving strategies may not eliminate 100% of the federal tax when paying for the most selective and most expensive colleges, some of which can cost more than $50,000 per year. But in combination with other tax strategies that can also minimize estate taxes, you can go a long way toward providing clients with a relatively tax-free college education at the college that is the best fit for their children.

Troy Onink is the CEO of Stratagee.com, the developer of the Smart Search and Stratagee college planning software solutions. More information is available at www.stratagee.com.

Lloyd Paradiso is an executive vice president of Stratagee.com, the founder of The Admissions Authority and a leading college admissions consultant.