Lower the cost of saving for education

January 25, 2012

Other than your home, your largest lifetime expense may well be paying for your children's or grandchildren's educations. Here's how to start.

Fortunately, several tax-advantaged techniques are available to pay some or all of your children's educational expenses. Using these techniques can lower your total bill by up to one third in some cases.

Financial planning for the costs of education is a highly individual process. Each family has unique expected costs, incomes, savings, and tax brackets. Consulting a financial adviser is almost always highly cost-effective, and the farther in advance, the better.

THE IMPORTANCE OF THE 'KIDDIE TAX'

Some doctors' families prefer not to segregate funds for their children's educations. Instead, they keep control of the funds and disperse them as needed. However, they incur a tax cost by doing so, because having at least some of the funds in the child's name, and using other tax-favored techniques, usually saves money year after year.

The concept of income shifting relies on the fact that your children are in a lower tax bracket than you. This is true for earned income at any age, and for some unearned income (income derived from sources such as interest, dividends, and capital gains).

Understanding the "kiddie tax" is important when developing an income-shifting strategy. This tax regulation currently states that unearned income of more than $1,900 per year is taxed at the parents' marginal tax bracket rate for:

Students older than 19 who are supplying more than one-half of their annual expenses personally are not subject to the kiddie tax.

If your children are subject to the kiddie tax, then limiting their unearned income to $1,900 or less makes sense. If they are not subject to the tax, then shifting even more unearned income to them may make sense. Why? Most of you reading this article have income from wages and interest taxed at a 35% rate and capital gains (and some dividends) taxed at 15%. Your children's rates are likely to be at or less than 15% for earned income. If your child is a student and has not yet reached his or her 24th birthday, then unearned income less than $1,900 is taxed at a blended rate at or below 5%. If the child is a student older than 23, or younger than 23 and not a dependent, then unearned income over $1,900 is taxed at much lower rates than what you pay.