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Monday, June 20, 2005

Paying for College Via Income Shifting

Steven Podnos has written an interesting article in the June issue of Investment Advisor magazine about how parents can use income shifting strategies to pay for college expenses. The whole idea behind inomce shifting is that almost all children have a lower tax bracket than their parents. Therefore, it makes sense to try to shift income from the parent's bracket to the kid's bracket.

In the article, he shows a couple of examples:

Example #1:

A student’s college expenses are $20,000 per year.

In this case, the parents would need to earn more than $30,000 (assuming a 35% tax bracket) to pay the educational costs out of ongoing earned income. Alternatively, they may elect to sell an investment with a $20,000 long-term capital gain and contribute $5,000 of earned income. They would be left with a $17,000 gain on the sale after a 15% capital gains tax, and $3,200 of their income after ordinary income tax. So the parents would be left with $20,200 for educational costs after a $4,800 tax bill.

If instead, the parent paid the child the same $5,000 of wages and also gifted the appreciated asset to be sold in the child’s tax bracket, the tax would be essentially zero on the wages (standard deduction of $4,850) and only $1,000 on the capital gain in the child’s lower tax bracket.

So by having your clients use income shifting, you have saved them almost $3,700 in one year.

Example #2:

A student’s college expenses are $30,000 per year.

The parents may earn $45,000 to cover the $30,000 cost while also facing income taxes of $15,000, or they may sell an asset worth $20,000 that has appreciated in a 15% long-term capital gain bracket. As in the first example, with a $20,000 capital gain there would be $3,000 due in taxes. To pay the remaining $13,000 in educational costs would require earning approximately $20,000. The family would accumulate $30,000 for their child’s education that year, but with a tax cost of $10,000.

But what if they paid the child $20,000 in wages for work such as a consultant or proofreader during the summer and on some school breaks, and gifted the appreciated asset to be sold in the child’s tax bracket? In that case, tax would be approximately $1,500 based on an adjusted gross income of $12,000, after the student uses the personal exemption of $3,100 and standard deduction of $4,850. The rationale for this action is discussed in the article. Since the child is not a dependent, he may then use a Hope or Lifetime Learning Credit to wipe out most of the $2,500 in tax liability for the student ($1,000 capital gains and $1,500 tax on earned income after deductions).

By using income shifting, you have saved your client between $7,500 and $10,250 in one year.

It's an interesting article that's well worth reading.

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