Affluent families sending children to college don't typically think of filling out financial aid applications: They assume they won't qualify for help, and for good reason.

Specifically, their obstacle is the expected family contribution, the annual amount parents are expected to pay for their dependent children's college expenses before becoming eligible for aid.

For example, if the expected family contribution is $25,000 and the cost of attendance is less, the family cannot qualify for needs-based financial aid. Since most scholarships, grants and government-subsidized loans are based on financial need, unless the student is an exceptional scholar or has unusual athletic prowess, the family is forced to foot the entire cost.
One might argue this is fair. After all, why should the government underwrite the education of a kid whose family earns a couple hundred thousand dollars a year and has garnered a quarter million in assets (excluding their house)? Their lot seems pretty rosy.

And yet maybe it's not as rosy as it sounds. Wealthy people often face a catch-22: They are reaching their highest earning potential only when their children are reaching college age. They might have experienced lean years, but then their later success, in effect, disqualifies them from traditional college help.

Let's take, for example, a hypothetical couple, Mike and Becky Miller, a modestly affluent couple in their early 40s. Mike owns a small advertising agency and Becky practices family law. Since Becky worked only part time when the children were young, her law practice is still in the client acquisition phase. Their combined gross income after business expenses is $200,000 to $250,000.

With three children, ages 15, 12 and 10, Mike and Becky anticipate college and graduate school expenses of $400,000 to $500,000 in today's dollars. They will start paying these expenses in their mid-40s to late 50s, in what they hoped would be their prime saving and accumulation years. They face a quandary: How do they fund their retirement plans and simultaneously help their children complete their education with minimal debt?

Mike and Becky realize that because of their financial success, society expects them to pay the full price of their children's education. But because they are in a high tax bracket and their effective tax rate will increase in the foreseeable future, they will devote much more in pretax earnings to their educational expenses than the average family would.

The good news is that the Millers might be able to turn their financial aid disqualification into an advantage. By focusing on IRS rules rather than financial aid rules, they could take maximum advantage of the available tax opportunities, including the children's lower income and capital gains tax rates, the children's personal exemption, 529 college savings plans, education tax credits and IRAs (both the traditional and Roth versions).

Tax Dependent Strategies
The IRS considers any full-time student children under 24 to be dependents of the parents. The exception to this rule is children who provide more than one-half of their own support. The word support is broadly defined to include not only food, clothing and shelter, but also educational expenses, health insurance, car repairs, etc.

Children of an affluent family can ease their tax burden if they are independent of the parents for income tax purposes. Children who meet the one-half support test are able to claim the personal exemption ($3,650 for 2010) and the standard deduction ($5,700 for 2010) and they can benefit from a low 10% tax rate on the first $8,375 of their taxable income and a 15% rate on the next $25,625 (the tax rate for singles for 2010).

Children can reap great benefits from internships, co-op education programs and work study programs, which not only help them establish tax independence, but also give them much needed job skills, a competitive edge that will help them after college.

One of the things keeping parents from shifting unearned income to a dependent full-time student under the age of 24 is the so-called kiddie tax. Under this tax, only $1,900 of a child's investment income escapes the parent's higher tax rate. But the tax does not apply to income earned by a student working part time or during summer vacation. If the student's earned income exceeds one half of his or her support, the kiddie tax no longer applies at all. Nor would the tax apply to qualified income-tax-free withdrawals from the student's 529 college savings plan.

Tuition Assistance Program
Since Mike Miller owns a small ad agency, he might want to consider hiring his children when they are of legal age under state law. Doing so will shift some income into the offspring's lower bracket and help them qualify as tax independent. Mike may also want to consider implementing a tuition assistance program (IRC Section 127), whereby he can provide up to $5,250 per year in tax-free reimbursements for tuition, books and supplies, even if the courses are non-job related. Tuition assistance program payments are a tax-free fringe benefit to the employee and a deductible business expense to the employer.

A tuition assistance program can only be offered to employees, must be in writing and cannot discriminate in favor of highly compensated employees. Therefore, the children will have to be legitimate employees and the plan will have to be liberally drafted to include them despite their part-time status. Mike will probably know whether any of his other employees are likely to take advantage of this benefit and will have to weigh the possible additional expense before implementing the program.

Tax Credits
Establishing the children as tax independent students may also make them eligible for tax credits for which the parents don't qualify.

The Hope Scholarship Credit is a non-refundable credit against an individual's federal income tax liability. The maximum credit is $1,800 per year.  This means that the taxpayer has to owe at least $1,800 in federal income tax to use the full value of the credit. (The American Opportunity Tax Credit is a temporary expansion of the Hope Tax Credit as part of the economic stimulus package enacted in February 2009. But the American Opportunity Tax Credit is only valid for tax years 2009 and 2010. For those years, taxpayers can get up to $2,500 to help pay for up to four years of college for each student.) Because of phase-out rules, Mike and Becky would be ineligible for this credit, whereas their tax independent children would probably qualify.

The Hope Scholarship Credit can only be used for undergraduate tuition and fees, but these expenses do not have to actually be paid by the student. The parents or grandparents can make the payment directly to the educational institution and the student gets credit for the payment. The grandparents in our example may want to make an occasional tuition payment for their grandchildren.

The Lifetime Learning Credit has a higher $2,000 maximum, but is calculated based on 20% of qualified tuition expenses. If the student is attending school on a part-time basis, the Hope Scholarship Credit may give them a higher tax credit. The Lifetime Learning Credit can also be used for graduate or professional degree programs.

529 Plans
While parents can control the timing of withdrawals from a 529 college savings plan, an important feature for an affluent family is that the withdrawals are considered to be the child's income for purposes of establishing tax independence. In addition, 529 plan withdrawals for qualified education expenses are income tax free and can be excluded from income in the same tax year that a Hope Scholarship Credit or Lifetime Learning Credit is claimed. The 529 plan withdrawals cannot, however, be based on the same expenses as education credits; no double counting. But this is usually not a problem since the 529 deduction is available for a much broader array of education costs.

Application
Let's go back to the Miller family. Assume for a moment that their oldest child, Scott, is now a freshman in college. Scott earns $12,000 working for his father's advertising agency over the summer months, during holiday vacations and on the occasional weekend during the school year. From investment assets that his parents transferred to him by way of an account set up according to the rules of the Uniform Transfer to Minors Act, he earns $1,750 in interest. His grandparents make a $5,000 tuition payment on his behalf direct to the university. His parents distribute $10,000 from a 529 college savings plan and his father $5,250 from his company's tuition assistance program for a total of $34,000. The $12,000 of earned income, $1,750 of interest earnings and $10,000 of 529 plan monies ($23,750 in total) all count toward Scott being independent for income tax purposes.

The $5,000 tuition payment/gift, the $5,250 from the tuition assistance program and the $10,000 from the 529 plan are all income tax free to Scott and his family. His father's business even gets a tax deduction for the tuition assistance program payment.

Scott has $12,000 in earned income and $1,750 in interest income, a total of $13,750 in taxable income, none of which is subject to the kiddie tax. After he applies his standard deduction of $3,650 and his personal exemption of $5,700, Scott is now left with taxable income of $4,400. At a 10% federal income tax rate, Scott would owe $440 in taxes. With his eligibility for the Hope Scholarship Credit, his tax liability falls to zero.
Hopefully the tax "scholarship" for the children will enable Mike and Becky to continue their tax-deductible retirement plan contributions.

David M. Dalton, JD, CFP and Megan R. Dalton are partners with Dalton Wealth Management in the Cincinnati/Dayton, Ohio area. Contact the authors at [email protected] or www.DaltonWealth.com.