Financial Planning for Education Expenditures

By Lawrence C. Phillips and Thomas R. Robinson

In Brief

Tax Act Provides Additional Education Savings Incentives

Education has been a high priority in the administrations of both former President Clinton and President Bush. The Small Business Job Protection Act of 1996 and the Taxpayer Relief Act of 1997 included numerous changes that substantially affected financial planning with regard to the funding of college education costs. The Economic Growth and Tax Relief Reconciliation Act of 2001 expands upon or modifies several of the 1996 and 1997 tax legislative changes and adds additional incentives toward college and elementary and secondary school expenditures. The authors detail the recent education-related tax changes and their financial planning implications.

The value of a college education in the labor market has increased significantly. In 1979, the average male college graduate earned only 49% more than the average male high school graduate did; by 1993, the differential had increased to 89%. According to the College Board, the average annual total cost for a four-year private college education in 1999/00 was about $25,000; a public four-year college (resident) cost about $11,500. The cost of a college education has been increasing at about 5% per year, approximately twice the rate of inflation and three times the growth of the average family income. Historically, college cost increases have exceeded the rate of inflation on average about 2%. The U.S. Department of Education estimates that the average cost of attending a public university for four years will exceed $60,000 by 2007 ($200,000 for a private university).

Financial Aid Considerations

Financial aid includes federal grants, loans, and work-study programs. Additional aid can be obtained from state programs, colleges themselves, and private groups.

The amount of aid is based upon the expected family contribution, which is based upon the income and assets of both the parents and the student. Parents are expected to contribute from 22% to 47% of their discretionary income and up to about 5.6% of their discretionary assets. Students are expected to contribute 50% of their available income and 35% of their assets. Using the College Board’s online service (, a family of four with $80,000 income and $100,000 discretionary net worth has an expected family contribution of about $17,000, assuming the student is a dependent and has no assets. In these circumstances, the child would receive no aid from a public institution and only modest aid from the average private institution. If assets are gifted to the student for a college fund, the amount of available aid will be reduced because of the relatively high student contribution rate.

The timing of the sales of investments and withdrawals of funds (e.g., IRA accounts or state-sponsored prepaid tuition or savings plans) may affect the availability of need-based financial aid. For example, if the student’s college fund consists of growth stocks that are sold in the current year, the amount of aid for the following year may be substantially reduced. Selling securities by a child’s junior year of high school can prevent this problem.

If financial aid is received by children of a wealthy family, it will most likely to be limited to student loans or merit scholarships rather than federal or other aid. The planning focus for wealthy families should therefore be on tax minimization strategies such as the transfer of income-producing assets to children. Many of the tax incentives for education that were enacted during the Clinton administration contain income phase-out levels that preclude their use by children of wealthy parents. Some of these income phase-out limits have been liberalized by the 2001 tax law changes to permit increased use by upper-middle-income parents.

Education-Related Tax Credits and Deductions

Nonrefundable education tax credits for qualified tuition and fees were provided by the 1997 tax act and continued under the 2001 tax law. The Hope scholarship credit, which consists of a 100% credit per eligible student for the first $1,000 of tuition and fees and a 50% credit for the second $1,000 (or a total of $1,500), is applicable for the first two years of college. To claim the credit, the parent must pay the education expenses and claim the child as a dependent. A child can claim the credit only if she is not a dependent for the year the credit is claimed. The Lifetime Learning credit, equal to 20% of the first $5,000 of qualified tuition and fees (up to $1,000, increasing to $2,000 after 2002), is available for all years that the Hope credit is not claimed and applies to undergraduate, graduate, and professional degree programs and to non-degree continuing education programs. Both of these credits are phased out ratably for taxpayers with AGI of $41,000– 51,000 ($82,000–102,000 for married taxpayers filing jointly).

Either the student or the parent may claim the credits, depending upon the case. For example, if the student is a dependent of another during the tax year of the credit, the dependent student is not allowed either of the education credits even if the qualified tuition and fees are paid from the student’s funds. In such a case, the parent is entitled to the credit. The Hope credit is allowed on a per student basis, whereas the Lifetime Learning credit is calculated on a per taxpayer basis, and both credits are nonrefundable. In most cases the children will be dependent upon their parents during college years and will not, therefore, be eligible to claim the education credits.

The 2001 tax changes provide a for-AGI (above the line) deduction for qualified higher education expenses paid for taxable years beginning in 2002 and ending in 2005. In 2002 and 2003, the maximum deduction is $3,000 and the AGI phase-out level is $65,000 ($130,000 for married individuals filing jointly).

The Congressional rationale for adding this deduction was to provide an alternative for those upper-middle-income individuals that currently receive only limited or no benefit from the Hope and the Lifetime Learning credits because of the AGI phase-outs.

In general, the planning for college funding should begin several years before children enter college. In the early stages, parents may be uncertain whether they will be eligible for the tax credits (even though the credit phase-out ranges will be adjusted for inflation after 2001). In addition, there is substantial uncertainty whether the deduction for higher education expenses will be extended beyond year 2005. Recent tax changes also liberalize the rules applicable to education IRAs and state tuition programs, thereby offering numerous alternatives for funding education costs.

Coverdell Education Accounts

Under the prior law, education IRAs were of limited benefit because the annual contribution limit for a beneficiary was only $500; the contributed amounts were nondeductible; and neither the Hope credit or Lifetime Learning credit could be used in the same year that amounts were distributed from the education IRA. In addition, the use of an education IRA precluded making contributions (for the same child) to a state-sponsored prepaid tuition or savings plan and there were phase-out limits of $95,000–110,000 ($150,000–160,000 for married individuals).

Under the 2001 tax changes, Coverdell Education Accounts (CEA) replace education IRAs. The maximum annual contribution increases from $500 to $2,000, effective in 2002. A contribution of $2,000 per year to the account of a newborn child for 18 years compounded at 6% annually could accumulate a fund of $61,800, versus only $15,500 from an annual contribution of $500. Distributions can now be used for elementary and secondary school education expenses for public, private, or religious schools in addition to higher education expenses. The AGI phase-out limits for married individuals filing jointly have increased to $190,000–220,000. The CEA rules are now coordinated with the education credit and qualified tuition program provisions. Under the new law, the Hope or the Lifetime Learning credit may be used (subject to restrictions) in the same year that distributions are made from a CEA or from a qualified IRC section 529 tuition program account. Under the new rules, the total amount of qualified education expenses is initially reduced by tax-free scholarships, then further reduced by the amounts taken into account to determine the education credit (e.g., $2,000 for the Hope credit). Any residual is allocated to distributions made from the CEA and the qualified tuition program. Contributions to a CEA remain nondeductible. Distributions that are not used to pay qualified education expenses are taxable under the IRC section 72 annuity rules. For example, if the contributed amounts plus untaxed earnings from a CEA are not otherwise used to pay for the beneficiary’s qualifying education expenses, the accumulated earnings are taxed and the previous nondeductible contributions are treated as a tax-free return of capital.

Qualified higher education expenses include tuition, fees, books, supplies, and equipment. Room and board costs qualify if the beneficiary is at least a part-time student (the same definition used to calculate federal financial aid). Qualified expenditures for elementary and secondary education also include academic tutoring and the purchase of computer technology or equipment.

Traditional and Roth IRAs

Traditional and Roth IRAs may also be a source of funds for education when parents have sufficient alternative retirement savings. The 1997 tax changes removed the 10% premature distribution penalty applicable to withdrawals from IRAs, including Roth IRAs, if the funds are used for qualified education expenses of the taxpayer, spouse, child, or grandchild. For this purpose, qualified education expenses include tuition, fees, books, supplies and equipment, but not room and board.

Under the financial aid formula, retirement IRAs do not affect aid eligibility unless the funds are withdrawn. Since Roth IRA distributions are deemed to first come from contributions, the amounts withdrawn for education expenses would most likely be tax- and penalty-free. The Roth IRA can be an effective tool for educational funding because parents retain control over the assets if the children choose not to attend college.

Interest Deduction on Education Loans

A for-AGI deduction is now permitted for interest paid on education loans up to $2,500 in 2001 and thereafter. Interest paid on qualified education loans made after December 31, 2001, is deductible even if the payments are made during a period of forbearance or deferral (i.e., under prior law, voluntary payments of interest were not deductible). Eligible student loans include those for the costs of tuition, fees, room and board, and books and supplies. The fact that the deduction is for-AGI rather than an itemized deduction is significant because most education loans are incurred by students that often do not itemize their deductions during the loan repayment period. The 60-month limitation under prior law no longer applies to loan interest payments made after 2001. AGI phase-out limits have been increased (effective in 2002) to $50,000–65,000 ($100,000–130,000 for married individuals) and will be adjusted for inflation after 2002. Because of the recent increases in the AGI phase-out ranges, parents that take out student loans may now benefit more than students from the interest deduction. If the child is still a dependent when the loans are repaid, the interest deduction is not available to them.

Qualified State Tuition Programs

Congress initially authorized qualified state tuition plans in 1996. IRC section 529 was amended in 1997, and significant changes are incorporated within the 2001 tax legislation. Prepaid tuition plans and savings plans are now offered by most states; savings plans have become more popular in recent years. Prepaid tuition plans function as a tuition inflation hedge: Participants purchase tuition credits or certificates toward higher education expenses on behalf of a beneficiary. Funds accumulated in a prepaid tuition plan can also be used to pay higher education expenses in an out-of-state public or private school.

Savings plans are similar to mutual fund investments and administered by money-management firms such as TIAA-CREF, Fidelity, and Merrill Lynch. Most states offer a range of investment options. In most plans, the asset allocation is heavily weighted with equities and gradually shifts to more conservative, fixed-income investments as the beneficiary nears college age. A contributor residing in one state may use a plan that is established in another state. Recent tax changes will permit private educational institutions to offer prepaid tuition programs (but not savings plans) for tax years beginning after 2003.

Contributions to qualified tuition plans are not currently deductible, although some states offer state income tax benefits for residents. There are no AGI phase-out limits for participants and, in most states, substantial amounts can be contributed to each beneficiary’s account (more than $150,000 in some states). Treasury regulations limit the total contributed amounts to the cost of five years of undergraduate education at the most expensive school allowed under the state’s program.

The fund earnings are deferred until distributed, and, under the 2001 tax act, the accumulated earnings are excluded from income if the withdrawals are used to pay qualified education expenses. Under prior law, distributions of accumulated income amounts were generally taxed to the beneficiary under IRC section 72 annuity rules, a difficult prospect for many students.

The definition of qualified higher education expenses is the same as for the education IRA (i.e., room and board expenses have been expanded to conform with the amounts allowed under federal financial aid). This change will permit greater use of qualified tuition plan (QTP) distributions to fund higher education expenses.

Contributions to QTPs receive favorable gift and estate tax treatment. Contributed amounts are treated as a completed gift when the contributions are made and are eligible for the $11,000 ($22,000 if gift splitting is elected by married individuals) donee exclusion. Favorable gift tax treatment applies despite the contributor’s retention of ownership and control over the account and of the power to designate another family member as beneficiary. The contributor (donor) can also cancel the account and receive the accumulated funds by paying a 10% penalty on the withdrawals and taxes on the accumulated income.

Under the gift tax rules, contributions greater than the annual donee exclusion can be treated as if made ratably over a five-year period. If this election is made, a contribution of $55,000 ($110,000 for married individuals) could be made to a QTP in 2002 and be spread over a five-year period, resulting in a taxable gift of zero. Amounts contributed to such plans are treated as completed gifts and exempt from the estate tax of the contributor. Because of the favorable gift and estate tax rules and the absence of AGI phase-out limits upon contributions, QTPs are excellent funding vehicles for wealthy individuals.

Subject to limitations on the amount of qualified education expenses, the tax law now permits the use of distributions from both a CEA and a QTP, as well as the Hope and Lifetime Learning credits in the same year.

Educational Assistance Programs

The 2001 tax changes provide an exclusion of up to $5,250 annually for employer-provided educational assistance payments for graduate education for courses beginning after December 31, 2001. Under prior law, the annual exclusion for an employee was limited to undergraduate education. The exclusion under IRC section 127 applies to a broad range of educational expenditures, so an employer is not required to determine whether the education is job-related.

Under both current and prior law, reimbursements of educational expenses that do not qualify for exclusion under IRC section 127 may qualify as a tax-free working condition fringe benefit under section 132(d). To be excludible, the education must be incurred to maintain or improve existing employment-related job skills. For example, under pre-2002 law, a corporate management employee reimbursed for an executive MBA program would be able to exclude the reimbursement from gross income under the section 132(d) working condition fringe benefit rules; if the employee worked in a non-supervisory capacity, the graduate tuition would be taxable. In 2002, the non-supervisor employee could exclude up to $5,250 of the employer assistance payments under section 127; anything above this would be taxable because the working condition fringe benefit rules do not apply. The Congressional Committee Reports indicate that extension of the section 127 exclusion to graduate education will lessen the complexity of the tax law and lead to fewer disputes between taxpayers and the IRS.

Undergraduate students considering employment opportunities before graduate education should consider the benefits and availability of employer assistance programs and the tax consequences associated with employer reimbursements. Consideration should be given to the availability of tax-free scholarships and tuition waivers associated with graduate assistantships.

Tax Minimization Strategies

Any tax minimization strategy should also consider non-tax factors such as family relationships, the financial aid process, and investment considerations. For example, some individuals prefer not to make gifts to children regardless of tax consequences. Others are concerned by the partial loss of control over the gifted assets. In such cases, state-sponsored qualified tuition programs may be preferable to making gifts to a custodial account under the Uniform Gifts to Minors Act or the Uniform Transfers to Minors Act.

The following discussion of tax minimization strategies assumes that gifts are made to a custodial account. The advantages that are associated with tax-favored investments may be mitigated by investment preferences. Tax-favored investment strategies should vary by the following time periods, determined by the beneficiary’s age:

Early years. The tax rates of the parents and their children, opportunities for tax deferral, and control over the management of the funds if assets are gifted to the children are the primary considerations during this period. Care must be taken to consider the impact of the “kiddie tax,” whereby unearned income exceeding $1,500 (2001) for a child under age 14 is taxed at the parent’s tax rate. If the child has no earned income, the first $750 of unearned income is not taxed because it is offset by the child’s standard deduction. The next $750 is taxed at the child’s rate and the remainder is taxed at the parent’s highest tax rate.

The kiddie tax may be avoided by making gifts of low-dividend growth stock or gifting cash that is invested in growth stocks. For example, a parent could transfer $150,000 to a child while avoiding the kiddie tax if the dividend yield is only 1%. The dividend income would then be taxed at an effective rate of only 5% (the first $750 of income is offset by the standard deduction and the remaining $750 is taxed at the child’s 10% marginal rate).

The purchase of Series EE savings bonds may also avoid or minimize the kiddie tax. Non-tax considerations such as low investment yield may, however, outweigh the favorable tax treatment. Because the current interest rate on these bonds is about the same or less than recent increases in college costs, even on a pre-tax basis, it could be difficult to accumulate adequate educational funds using Series EE bonds.

Immediate pre-college years. The kiddie tax no longer applies during this period, so any unearned income over $1,500 is taxed at the child’s rate. In 2002, taxable income up to $6,000 is taxed at a 10% rate and taxable income from $6,000 to $27,050 is taxed at a 15% rate, so shifting income to the child is generally desirable from a tax standpoint. During this period, it may be advisable to shift the investment portfolio mix toward shorter-term fixed-income securities and minimize risk exposure. If high-growth stocks were gifted to the child during the early years, the sale of stock and recognition of long-term capital gains by the child may produce favorable tax consequences. Furthermore, appreciated stock held by parents can be gifted before sale, shifting the unrealized gains from to the child. The capital gains is taxed at 10% if the child’s marginal rate is 15% or less (if the stock is sold in 2002).

During the pre-college years, employment of a child in a family business may have favorable income tax consequences and increase the total college fund accumulation if saved. Salary payments, if reasonable, are deductible by the employer and taxable to the child at a very low rate. In many cases, the salary is not taxed because the standard deduction for a dependent child with earned income exceeding $250 is the greater of $750 or earned income plus $250, up to the standard deduction amount ($4,550 in 2001).

In addition to the realization of income tax savings, self-employed parents can realize payroll tax savings by employing their children in the business. A minor child employed in a parent’s sole proprietorship is not subject to FICA taxes on salary or wages. Additionally, the wages paid to the child decrease the parent’s earnings for purposes of the self-employment tax. A child’s employment-related earnings or distributions from an education IRA can fund precollege education expenses (e.g., private school tuition).

Another income-shifting technique is to make a gift of a family partnership interest or S corporation stock (subject to certain restrictions) to a child whereby a distributive share of the income from the business is taxed to the child.

College years. If parents fail to accumulate adequate funding for a child’s college education, they should consider a home equity loan of up to $100,000. By the time a child is 18, their parents usually have substantial equity in their home. The interest payments on the loan are deductible, and the after-tax cost of borrowing may be lower than student loan rates.

Another source for a loan is a parent’s 401(k) or life insurance policy. Many 401(k) plans permit participants to borrow up to one-half of the amount in the account and provide for flexible repayment arrangements. However, interest payments are not tax deductible, and overborrowing may be detrimental to the retirement savings objectives.

The tax law provides for a $250,000 ($500,000 for married individuals) exclusion of gain from the sale of a principal residence. Parents might consider trading down, taking their equity out of the residence tax-free and using a portion of the proceeds to pay for college.

Student loans, such as Stafford loans, should also be considered. The interest is added to the principal amount unless subsidized because of financial need. As previously discussed, the interest portion of the payments may be tax deductible by the student or the parent depending upon how the loans are structured.

Tax-free scholarships should be viewed as an ancillary source of funding. Students should also consider work-study programs or other part-time or summer employment.

Investment Alternatives

Over the long term, equity investments have generally provided a greater return than bonds. While there is risk associated with equity investments, a carefully selected mutual fund or portfolio of common stocks can provide returns commensurate with the risk. If bonds are selected, care must be taken to match the duration (not maturity) of the bond portfolio to the time the child begins college, to reduce risk.

The best saving strategy will depend upon the time horizon, tax status, and risk preferences. A typical strategy is to make gifts to children in lower tax brackets and invest in growth-oriented equities during a child’s pre-college years. As college nears, these investments can be sold and the proceeds invested in short-term fixed-income investments, providing for safety for the college fund’s principal.

Lawrence C. Phillips, PhD, CPA, is a professor of accounting and Deloitte & Touche Accounting Scholar, and
Thomas R. Robinson, PhD, CFP, CFA, CPA, is an associate professor of accounting, both at the University of Miami, Fla

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