You are financially successful and have a child who will be attending college. You begin the process of completing a FAFSA application (Free Application for Federal Student Aid) and quickly discover that you earn too much money to qualify for need-based college aid.
A typical scenario is that the parents use their investment funds to pay for their child’s college education, claim the child as a dependent on their tax return, and figure that they can claim the cost of the tuition on their tax return. What the parents may learn when their income tax return is prepared is that there are capital gains taxes due on the sale of the stocks or mutual funds, because they are subject to the AMT (alternative minimum tax) they receive no tax savings by claiming their dependent college-bound child, and they make too much money to claim an education tuition tax deduction or tax credit.
How can the parent better position themselves financially? Let’s look at the parents using the annual gift tax exclusion to help pay for college. Each person can gift $14,000 to any person in any calendar year without incurring a gift tax. If the parents make a joint gift, they can gift $28,000 to their college-bound child gift tax-free.
If the parents gift $28,000 to a College Savings Plan (IRS Sec. 529 plan), many states allow an income tax deduction. For example, PA-resident parents would receive a $28,000 income tax deduction on their PA-40 tax filing and save $860 in PA income taxes.
Let’s assume that the parents wish to pay $28,000 of the child’s annual college costs by selling appreciated stocks, bonds, or mutual funds and these securities have a zero tax basis and have been held greater than one year. If the parents sell these securities to pay for the child’s education, assume that they will recognize a $28,000 long-term capital gain (LTCG) that will be taxed at the 20% LTCG rate. This will cost the parents $5,600 in federal taxes.
However, there is another gifting strategy that may yield significantly better income tax savings. Rather than the parents selling the appreciated securities, have the parents make a joint gift to their child. Also assume that the child uses the proceeds from the sale of the securities to pay for his/her college education and that this amount exceeds the monies expended by the parents to support their child. In other words, since the parents are not providing greater than 50% of the support of their child, they are not allowed to claim their child as a dependent and the child can claim himself/herself. Remember, in our assumptions, the parents received no dependency benefit by claiming the child because of the AMT. The child will be allowed to claim a $3,900 personal exemption and a $6,100 standard deduction. Thus, the child gets to offset $10,000 against the $28,000 LTCG and will have $18,000 of taxable income. Due to the Kiddie Tax Rules, the child will pay income taxes at the parents’ 20% rate and owe $3,600 in taxes before applying any tax credits. Since the child paid for the college expenses, the child can claim the American Opportunity Tax Credit of $2,500 (which the parents could not use because they made too much money) and owe the IRS $1,100. The total family tax savings is a significant $4,500.
Note: Because each individual has unique factors that need to be examined when determining that individual’s tax situation, we invite you to call 610-594-2601 today to make an appointment to discuss your personal tax situation. When analyzing strategies such as the one discussed above, the author believes that it is imperative that pro-forma tax returns be prepared to properly evaluate the potential tax savings because of the various variables that affect this type of computational analysis. You can also schedule a free consultation at Click Here. To learn more about various tax and business services, visit Tax Preparation Services and Small Business Accounting Services
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