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.