This week Gail offers advice on planning for financing college, in light of some recent tax changes...
I’m 15 and plan to work again this summer to earn money for college.
My parents started a 529 plan for me several years ago (worth about $28,000) and my grandparents set up a “Uniform Gift to Minors Account” for me when I was born (I think there’s about $50,000 in bonds). I’ve also got some stock that I inherited. I’d like to hang on to these shares and maybe even not sell them, if I don’t have to.
I know I’m lucky. I figure I won’t need to take out any student loans until my junior year.
Where would be the best place for me to invest the money I earn this summer, figuring I won’t touch it for about 4-5 years?
I’m glad you recognize how fortunate you are that loved ones have provided a significant portion of the money you’ll need for college. I’m impressed that, despite the assets already set aside on your behalf, you are committed to contributing your own money, as well.
The five-year, $70 billion tax package just passed by Congress will have a significant impact on many teenagers. They could end up paying more tax than before.
Officially, this new law is called the “Tax Increase Prevention and Reconciliation Act of 2005" (TIPRA) because work on it started last year. The most important provision affecting minors relates to something fondly called the “kiddie tax.”
Under the rules in effect for 2005, a child under the age of 14 who could be claimed as a dependant on his/her parents’ tax return paid no income tax on the first $800 of income she/he received. In your case, this would include the interest earned on bank accounts and the bonds in your Uniform Gift to Minor Account (UGMA), income from last year’s job, and dividends paid on your stock.
The next $800 in income — from all sources — was taxed at the child’s tax rate. Since minors don’t typically have very high incomes, they qualify for the lowest rates available: 10 percent or 15 percent on ordinary income and 5 percent on capital gains and dividends.
If a child’s income exceeded $1600 ($800 + $800), the excess amount was taxed at the parents’ applicable tax rate, which is usually a lot higher — in some cases three times higher — than the rate paid by minors: the parental rate on ordinary income could be as much as 35 percent, while the rate on capital gains and dividends would top out at 15 percent.
The purpose of this was to discourage wealthy individuals from putting their assets in their kids’ names and thereby reducing their taxes.
However, once a child turned 14, the “kiddie tax” rules disappeared. Even income above the threshold became taxable based on the minor’s tax bracket, not mom and dad’s.
All this did was cause people to delay shifting assets to their kids until their 14th birthday.
Provided a child’s total taxable income could be kept within the 15 percent ordinary income tax bracket or less, he/she would pay less in taxes on the assets than if mom and dad still owned them. If the investments were going to be sold to pay for Junior’s college education anyway, why not gift them to Junior on his 14th birthday and let him sell them, since he qualifies for a lower capital gains rate?
Thanks to TIPRA, gaming the kiddie tax is O-V-E-R. The new law extends the kiddie tax rules until the child reaches age 18. Only then will a minor pay tax solely based on her/his own income tax bracket. Furthermore, this change is retroactive to January 1st.
John Battaglia, tax director of Deloitte’s Private Client Advisors Practice, sums it up this way: “Because you’re under the age of 18, if your investment income exceeds $1,700 this year, you’re going to get taxed on amounts above that at your parents’ rate. You’ll lose the benefit of the lower dividend and capital gains rates” on this excess investment income."
Figuring out whether you might actually be affected requires a two-step approach:
1. Estimate your income tax bracket
a. If you’re in the 25 percent bracket or above, capital gains and qualified dividend income will be taxed at the higher rate of 15 percent.
b. If you’re in the 10 percent or 15 percent bracket, go to Step 2.
2. Determine how much — if any — of your investment income exceeds $1,700 (this year’s kiddie tax threshold).
a. If the answer is “none,” then all of your long-term capital gains and qualified dividends will be taxed at just 5 percent.
b. If a portion of your investment income exceeds the threshold, then this portion will be taxed at your parents’ rate.
As you may know, the tax rate on long-term capital gains and qualified dividends is slated to fall to 0% in 2008 for individuals in one of the two lowest income tax brackets. (For everyone else the rate stays at 15 percent.)
The good news is that TIPRA extends the reduced tax rates on dividends and capital gains through 2010. “In light of the new law, the timing of when to realize gains is very important now,” says Battaglia. “Before, you would wait until your kid turned 14, but now you should wait until they turn 18.”
In other words, Danny, you should avoid selling any of your long-term assets until you reach age 18. At that point, the kiddie tax rules will no longer apply and, assuming you fall into one of the two lowest tax brackets, you will qualify for the 0 percent tax rate on capital gains, making your profit tax-free, at least in terms of federal taxes.
What if you don’t need the money for college at that point? At the very latest, you’ll want to sell these assets before the end of 2010, because that’s when the 0 percent and 15 percent tax rates expire and long-term capital gains rates revert back to either 10 percent or 20 percent. (Of course, there’s nothing to prevent Congress from changing the rules before then.)
However, Battapaglia says even if a child is under age 18 in 2010 (and, thus, still subject to the kiddie tax) it may still be beneficial to sell assets held in his/her name “in order to take advantage of the 15 percent capital gains rate versus 20 percent if you wait a year.”
In light of these changes, there are several things to consider.
In terms of what to do with the money you earn from your summer job, find out if your state is one of 27 (plus the District of Columbia) that offers a tax deduction to individuals who contribute to the state’s 529 college savings plan. If your total income this year will require you to pay state income tax, contribute to your 529 plan up to the deductible amount. (Nothing stops you from contributing to your own 529 account.)
This won’t reduce your federal income tax, but it will save you money you’d otherwise pay to your state. As you probably know, investments in a 529 plan grow tax-deferred. And, provided it’s used for qualified higher education expenses, money you withdraw completely escapes federal income tax.
On the other hand, Joe Hurley, CEO and founder of the website www.savingforcollege.com points out that “a state deduction for 529 contributions only has value if your income is high enough to be taxable at the state level.”
If your state doesn’t offer a 529 deduction or if your income will be less than the level at which state taxes kick in, your first choice should be a Roth IRA. If used for college expenses, contributions made to a Roth can be withdrawn at any age without penalty or tax consequences. (Just be careful you don’t withdraw the earnings on your contributions! These are subject to the 10% penalty until you reach age 59 ½.)
This year, a single individual who is under age 50 and who has earned income (from a job) can contribute up to $4,000 to a Roth IRA — as long as her/his Modified Adjusted Gross Income doesn’t exceed $95,000. (Which would be one heck of a summer job!)
Because you’re under the age required to own assets in your own name, your Roth IRA would technically be controlled by a guardian; once you attain the “age of majority” in your state, it’s all yours.
Like a 529 plan, you don’t get a federal tax-deduction; Roth contributions are made with after-tax money. But as Hurley points out, “You may be in a zero tax bracket where the lack of a deduction doesn’t matter, anyway.” The benefit from a Roth is that the earnings on your contributions can eventually be withdrawn tax-free, provided you follow the rules.
Since you will need the money to cover your college expenses in a relatively short period of time (whether you go with a 529 or Roth IRA or both), you should probably choose conservative investments for contributions. Consider a short-term bond fund. You might also want to allocate a portion of your money to large company “value” stocks which typically pay dividends.
One more recommendation: Depending upon how much income your UGMA is generating, it might make sense to sell the bonds in it and invest the proceeds in your 529 plan. You’ll owe tax on any capital gains tax you have, which could trigger the kiddie tax this year. But in light of the fact that interest rates have gone up considerably in the past 12 months (which causes bond prices to decline), you might not have any.
The benefit is that once this transfer takes place, you eliminate the taxes you have to pay each year on the bond interest because income earned by a 529 is sheltered from tax. This, in turn, reduces the chances that you’ll have enough investment income to push you above the kiddie tax threshold in future years. In addition, all future capital gains would be eliminated if you use the transferred assets to pay for qualified higher education expenses.
Since the money would be coming out of an UGMA account, it would need to go into an UGMA-coded account inside the 529.
If it turns out that you do need financial aid, moving assets out of your UGMA and into an UGMA inside a 529 plan “will also help for financial aid purposes,” says Hurley, who has written several books about paying for college. If you have assets in a non-529 UGMA, you’re expected to use 35 percent of them to pay for your college expenses which, in Hurley’s words “kills you for financial aid purposes.”
However,starting July 1st, an UGMA account inside a 529 has zero impact on whether or not you will qualify for financial aid.
I know this all sounds complicated, so don’t try to do this on your own. (As minor, you can’t, anyway.) Have your parents contact an experienced tax or financial planning professional, who should be able to steer you in the right direction.
Congratulations for thinking ahead. Have you ever considered running for public office once you graduate? We need representatives in Congress who have your work ethic and are committed to simplifying the tax code!
All the best,
If you have a question for Gail Buckner and the Your $ Matters column, send them to: email@example.com, along with your name and phone number.