Last Minute Tax Breaks for Parents of the College Bound

This week, Gail tells you why timing is everything when it comes to maximizing the tax breaks available for college expenses.

Dear Friends-

Where did 2006 go?! If there's a college-bound child in your life, there is still time for some smart moves this year that can make it easier for him or her to pay for college and also reduce your own taxes.

For instance, starting this year the amount you can give to someone who is not your spouse without owing gift tax increased to $12,000.(1) If you invest that in a 529 college savings plan in the child's name, the annual appreciation is not taxed. Furthermore, provided the money is eventually used to pay for "qualified" tuition expenses, there will be no federal tax when you withdraw it and generally no state tax, either.(2)

But if you want to take advantage of the annual gifting exclusion for 2006, you have to make this contribution before the year runs out.

Thanks to a special provision in the tax code, you can contribute 5 years' worth of annual gifts in a single year — $60,000 — and still avoid gift tax. In the eyes of the IRS, your contribution will be treated as if you made separate gifts of $12,000 this year and in each of the next four years. (Since you will be making maximum use of your gift allowance, you should not make any additional gifts to that beneficiary over this timeframe.)

This strategy is especially helpful if your estate is large enough that it will trigger estate tax at your death. Contributions to a 529 plan move assets out of your estate, thereby reducing the amount of estate tax that will be owed. If your spouse agrees, you can double your gift, removing as much as $120,000 from your taxable estate.

Keep in mind that if you die before the start of the fifth year, a pro rata portion of your gift will be pulled back into your estate. For instance, say you make a $60,000 contribution to your grandson's 529 plan this year. If you die in 2009 — the fourth year — the fifth year's gift of $12,000 will be counted as if you still had it in your bank account when you died.

The ability to treat a lump sum gift as if it is spread over five years is only available with 529 plans. No similar privilege exists for another common college savings vehicle, the Coverdell Education Savings Account (ESA). Annual contributions to a Coverdell ESA are limited to $2,000, period. However, the deadline for making a 2006 contribution to an ESA is April 16, 2007. (These accounts were originally called "Education IRAs," so their contribution deadline was set to coincide with the deadline for other IRAs.)

What if you're not especially wealthy, don't anticipate having an estate tax problem, and just want to set some money aside for a child's education? Let's say the amount happens to be $2,000. At first glance it looks like a toss-up between a 529 and a Coverdell account. From the standpoint of federal taxes when a withdrawal is made, that's true.

However, CPA Joe Hurley, who founded the Web site www.savingforcollege.com, points out that "a big difference is that many states allow a tax deduction for a 529 contribution, but no state offers a deduction for contribution to an ESA." This does not come without strings attached: the tax deduction only applies if your contribution is made to your own state's 529 plan. None-the-less, in states that offer this, it can significantly reduce your state tax bill.

If a child's 529 account is worth less than the amount invested in it, Hurley says it is possible to claim it as a "miscellaneous itemized deduction" on your 2006 tax return. The catch is you've "got to liquidate all of the 529s for that same beneficiary" before the end of this year. Keep in mind that you'll see no benefit from this unless: 1) after taking all of the child's 529 accounts into consideration there is still a net loss, and 2) the sum of all your itemized deductions exceeds 2 percent of your adjusted gross income (AGI).

If you have a child that is a senior in high school who will be applying to colleges next year, the earlier his or her application is submitted, the better his or her chances of receiving financial aid. Each college receives a limited amount of federal financial aid money and once all of this is committed, there's no more available.

Timing is everything when it comes to maximizing the tax breaks available for college expenses. For instance, say you meet the income requirements for either the Hope or Lifetime Learning tax credits, but haven't spent enough on college expenses to take advantage of the full credit amount. This might be the case if your student just started college in the fall and is only attending part-time.

In "Year End Planning for Education Tax Benefits," which Hurley co-authored with attorney Kaye Thomas, they point out that the credit can be used to offset expenses paid by the end of this year for classes taken next year provided the classes begin before the end of March 2007.

On the other hand, the opposite might make more sense: delaying the payment of college expenses until January so they count toward 2007. Take the case of someone who earns too much income this year to be eligible for either education credit, but who knows their income is going to be lower in 2007 (perhaps because they're quitting their job to become a full-time student or their spouse has decided to be a stay-at-home parent). This individual would be better off paying next semester's tuition bill in January so that they have enough total expenses in 2007 to take full advantage of one of the credits.

Which brings up another important "timing" issue: to the extent you have some control over when you receive your income, you might be able to move up or push back when you get paid so that you are eligible to take advantage of either the Hope or Lifetime Learning credits. Self-employed individuals probably have the most leeway in this regard. Billing your clients in late December pretty much guarantees you won't get paid until next year. That might be enough to decrease your 2006 income so that it falls below the cut-off.

For single taxpayers, the credits start phasing out once your income reaches $45,000 and disappears entirely at $55,000. For married individuals who file jointly, the magic number for eligibility is income of less than $90,000; at $110,000 and higher, the credit is completely phased-out. All of these income limits apply to 2006.

Another way to manipulate your annual income is to increase your contribution to an employer retirement plan or tax-deductible IRA. This is especially effective if your income is just slightly over the threshold amount. Every dollar you contribute to your retirement plan reduces a dollar of taxable income. This lowers your income tax bill, to the extent it enables you to qualify for one of the education tax credits, and you'll see your taxes decline even further.

There is also a limited tax deduction available for up to $2500 of interest paid on outstanding student loans. This is another area where it can make sense to either accelerate your January payment into December or, conversely, postpone December's payment until January (assuming, of course, you are not going to face an onerous late charge from your lender). Income limits apply to this deduction, as well.

Finally, it's also extremely important to correctly time when you take a 529 withdrawal. The key is to make sure this occurs in the same calendar year in which you paid the corresponding expense.

"You don't want to pay the tuition on December 31st and request reimbursement from the 529 plan that isn't disbursed until January 2007," says Hurley. If the dates on the two don't match up, your 529 withdrawal might be deemed "non-qualified," resulting in both income tax and a 10 percent penalty.

In other words, if you're planning to pay next semester's tuition bill this year and expect to use 529 money to cover it, the sooner you submit the paperwork, the better.

Hope this helps,
Gail

1. Gifts between spouses are not subject to gift tax; there is no limit on how much you can give your spouse tax-free.

2. Even if the money is used to cover a "qualified" expense such as tuition or room and board, certain states, such as Illinois and Alabama, tax 529 withdrawals if they come from a out-of-state plan.

If you have a question for Gail Buckner and the Your $ Matters column, send them to: yourmoneymatters@gmail.com, along with your name and phone number.