Families with college-bound students should buckle down and do their homework this fall, particularly if their children are entering high school.
Those applying for financial aid for the 2017-18 school year will be permitted to complete and submit the Free Application for Federal Student Aid (FAFSA) as early as October 1, 2016, rather than having to wait until January 1, 2017. The application will now become available every October 1 to give families extra time to file.
In another policy shift, families will be required to apply for financial aid using what the industry refers to as “prior-prior year” tax returns instead of prior-year returns. Families must file the 2017-18 FAFSA using their 2015 tax return, the same as for the 2016-17 application. For students graduating high school in 2018, 2016 tax returns will create the baseline for filing financial aid forms.
“It’s a real sea change,” says Beth Walker, a financial planner with the Wealth Consulting Group, a Las Vegas-headquartered RIA firm, and the founder of College Funding Coaches, a firm that helps with all aspects of college planning. Parents must live for two years with the consequences of their 2015 tax returns, she says, and they need to understand how much earlier they must plan for the financial part of college.
“They need to get a grasp on the financial realities [by] freshman year of high school,” she says. “Proactive parents should be looking at anything to change the outcome of their expected family contribution and aid eligibility.”
Walker, based in Colorado Springs, Colo., has directly helped more than 350 families with college planning over the past 12 to 15 years. She also helps other advisors with college planning for their clients. Walker finds most parents panic when they see the “astronomical and frightening” sticker prices of college. What they often fail to realize, she says, is that college costs are not necessarily all additional expenses.
“When you really start to do good cash-flow planning for college, that’s where you identify all the areas in a family’s life where some of what you’re going to spend on college is already baked into lifestyle,” she says. For example, a family may be supporting club sports or music lessons—expenses that often stop when a child goes to college. At that point, this money can be used to help pay for school, she says.
Another thing Walker says families often overlook is education tax credits. The most common one, the “American Opportunity Tax Credit,” provides a maximum annual credit of $2,500 per eligible student. It can be used to pay for tuition, certain fees, books and other qualified expenses during the first four years of post-secondary education. Room and board, insurance and transportation do not qualify.
The tax credit starts to phase out when annual family income hits $160,000 and is phased out completely at $180,000 (for a married couple filing jointly). Walker encourages business owners with higher incomes to consider putting their children on their payroll. If the children can demonstrate that they provide half their support through their own income, they can file their taxes independently and qualify for the credit.
Tax Scholarship Plans
Walker recently implemented what she calls “a tax scholarship plan” for the three children of a physician and a business owner. “The kids are legitimately working in the business,” she says. “This is not just an accounting game.” They’ll receive annual incomes of $20,000 and benefit from “tax bracket arbitrage,” she says, because they’re taxed at a 15% rate instead of their parents’ 40%-plus rate. Additionally, she says, “they’re now eligible for the tax credit that mom and dad got phased out of.”
According to Walker, the family was able to redirect $7,907 per child toward college each year. Assuming each of the three children spends four years as an undergraduate student, this tax credit adds up to more than $94,000 combined. “That is huge,” she says. “[The parents] don’t have to go earn $1.40-plus to pay that dollar to the school.”
There are challenges with making kids independent tax filers. First, families can’t pinpoint how much income their children will have to demonstrate until they select a particular school. The annual published price tag can range from $24,000 for four-year public institutions to $68,000 for some private schools, notes Walker. Second, it can be tricky to pay children a fair wage that can be defended in an audit, she says.
When Walker talks to business owners who’d need to pay their kids an annual salary of $20,000 to $30,000 or more, she encourages them to consider, “What value are they bringing to my business that I would pay that kind of money for?”
The first suggestion that comes to Walker’s mind is hiring a child to manage a business’s social media. When she has inquired about the cost of creating content and managing social media for her own business, marketing agencies have quoted her monthly retainers of $1,500 to $ 3,000. “That’s here in Colorado,” she says. “I can’t even imagine in New York or L.A. what it would cost.”
Alternatively, a family that owns a lot of rental real estate can make the children members of the LLC, says Walker. This enables them to earn income without having to prove what work they’re doing. She had a dentist who gifted his equipment to an LLC that was owned by his children. The dental practice rented the equipment back, which generated income for the children without having to put them on the payroll.
Which strategies may work appropriately “depends on the facts and circumstances of the family, and the way their income and assets are organized,” she says. “The one thing you always want to err on is that it’s by the letter of the law.” For example, a family paying their child needs to be paying that child’s payroll taxes.