Education Funding is a High Priority Goal for Many Families

1. Education Funding is a High Priority Goal for Many Families • After buying a home and funding a retirement plan, education funding will be the next most frequent client concern. • Focus of lesson is college funding. • However, be aware that paying for private elementary or secondary school can be costly and require careful planning.

2. Overall Family Goals Often Combine Providing Funding for: • Private school education at the elementary and secondary level. • All or a portion of college costs at a private institution for one or more children. • All or a portion of college costs at a publicinstitution for one or more children. • All or a portion of graduate school or professional school for one or more children. • An educational fund for grandchildren or others.

3. Computing the Required Education Funding Need • Estimate costs in current dollars. • Project costs allowing for inflation. • Determine the current required lump-sum investment. • Or, determine required periodic investment.

4. Estimating Expenses • Costs consist of : • Tuition and Fees • Room and Board • Everything Else • Books • Computers • Tutoring • Transportation • Entertainment, etc.

5. Finding Current Costs • Check online at school’s website • Ask financial aid officers at institution the client wants children to be able to attend • Check with parents of children currently enrolled to find out about expenses that financial aid officers often ignore • Use resources at: U.S. Department of Education

6. Is College Worth It?

7. Adjusting for Inflation College costs are rising more rapidly than general economy. 5-7% per year

8. Using Time Value of Money to Compute Lump Sum Deposit Currently Required • Two steps using financial calculator, spreadsheet software such as Excel, or special financial planning software. • Compute future value needed using assumed inflation rate formula: • FV = PV*(1+i)n where i is the inflation rate assumed and n is the number of periods (years) until the money will be needed • Compute present value needed using formula • PV = FV[1/(1+r)n] where r is the after-tax rate of return.

9. Example Using Financial Calculator • Assumptions • Inflation rate for tuition is 7%, Return on investment is 6%, Current tuition costs are $21,420 per year, child is 4 and will attend at age 18. • Step 1 (Finding Future Cost) : Enter into calculator: • PV = 21420 • I/Y = 7 • N = 14 (Age 18 - current age of 4) • PMT = 0 (Since we are computing a lump sum and no payment) • Compute FV = 55,232 • Total = 55232 x 4 years = 220,929

10. Example Using Financial Calculator (cont) • Step 2 (Discounting Future Cost back to present): Enter • FV = Result from Step 1 = 220929 • I/Y = 6 • N = 14 • PMT = 0 • Compute PV = 97,715 • Additional Needed = 97717 – 22500 Earmarked = 75,217

11. Most People Will Not Put Away a Lump Sum • To Compute the required periodic payment: • Additional Needed calculated in Step 2 = PV • Use r for I/Y if computing yearly payment, or Divide r by 12 and use for I/Y to compute monthly payments • N =number of years for yearly contribution, or number of months for monthly payment

12. Example Using Financial Calculator • Facts as given or calculated are: • Additional Needed (PV) = 75217 • Number of years to need = 14 • Return on Investment Assumption = 6 • Payments at Beginning of Period • Compute yearly payments = 7,634 • Approximate Monthly = 7634 / 12 = 636

13. Example Using Financial Calculator (cont’d) • To compute monthly payment needed: • PV = 75217 • N = 14 years x 12 = 168 • I/Y = 6 / 12 = 0.5 • Payments at Beginning of Period • Compute PMT = 660

14. Section 2: Some Methods of Funding Education Expenses • Pay as you go out of current assets and income. • Government tax incentives. • Scholarships and loans. • Children may work their way through school. • Parents engage in systematic plan of early savings and investment. • Parents give gifts to children set aside early enough to compound over time. • A combination of these techniques.

15. Pay as You Go • Most expensive, since takes least advantage of Time Value of Money or Tax Incentives. • Greatest strain on current disposable income. • Often, despite parents’ good intentions, requires the child to work, since there are other claims on current income.

16. Government Provided Tax Credits & Incentives • Hope Scholarship Credit • Lifetime Learning Credit • Withdrawals from IRAs for education purposes • Coverdell Education Savings Accounts (ESAs) • Exclusion for employer-provided educational assistance • Section 529 Plan (also called a Qualified Tuition Plan or QTP)

17. Hope Scholarship Credit • The Hope Scholarship Credit is not a scholarship, but a tax credit of up to $2,500 (in 2009 and 2010) on the family tax bill of an eligible learner. • Unlike the Lifetime Learning Credit, the Hope Scholarship Credit is based on the number of eligible students in family, not a total for the family. • Only families that file a tax return and pay taxes can receive the Hope Scholarship Credit.

18. Who is eligible for Hope Tax Credit? • Taxpayer must claim an eligible student as a dependent on the tax return, unless the credit is for the taxpayer or the taxpayer‘s spouse. (This means the eligible taxpayer may also be the eligible student.) • Cannot claim a Hope Scholarship Credit if Modified Adjusted Gross Income (MAGI) is $90,000 or more for a single taxpayer, or $180,000 or more for married taxpayers (in 2009 and 2010). • The credit amount is gradually reduced for families with incomes between $80,000 and $90,000 if single, or $160,000 and $180,000 if married (in 2009 and 2010).

19. Who is eligible for Hope Tax Credit? Eligible student must be: • Enrolled at least half-time in an eligible program leading to a degree or certificate at an eligible school during the calendar year. • Must not have completed the first two years (four years for 2009 and 2010) of undergraduate study. • Must not have been convicted of a federal or state felony drug offense before the end of the tax year in which the student is enrolled.

20. The Lifetime Learning Credit • This is another tax credit up to the amount paid in taxes for individuals who file a return and pay taxes. • Available for an unlimited number of years for postsecondary educational courses. The courses can apply toward an undergraduate, graduate, or professional degree; certificate program; or other academic credential. Credit can be claimed for taxpayer, taxpayer’s spouse, and any dependents claimed on the tax return. • Neither the Hope Scholarship nor the Lifetime Learning Credits is available to married taxpayers who file separate returns

21. The Lifetime Learning Credit (cont’d) • Credit of up to 20% of the first $10,000 ($2,000) in eligible expenses per family. • Phased out ratably for single return with MAGI between $50,000 and $60,000; $100,000 and $120,000 for joint return (in 2009). • To apply, fill out IRS Form 8863. The same student cannot claim the Hope Scholarship and Lifetime Learning Credit in the same year.

22. Deductions for Education Expenses • Student Loan Interest Deductions • Qualified higher education expenses • Eligible education institution • Above-the-line deduction • Limited to$2,500, reduced ratably for MAGI between $60,000 and $75,000 ($120,000 and $150,000 for a joint return) (in 2009). Married taxpayers filing separately cannot take the deduction. • If not deductible, consider home equity loan.

23. Deductions for Education Expenses • Higher Education Expense Deduction • Up to $4,000, for single taxpayers with MAGI up to $65,000, $130,000 for joint return. • Up to $2,000, for single taxpayers with MAGI between $65,001 and $80,000, $130,001 and $160,000 for joint return. • Married taxpayers filing separately cannot take the deduction.

24. More Education Deductions • Deduction for Employment-Related Education Expenses • (1) Maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or • (2) Meets the express requirement of the taxpayer’s employer (or requirements of applicable law or regulations) imposed as a condition of continued employment. • For an employee not reimbursed, must exceed 2% of AGI. • Must relate to CURRENT job. • Cancellation for Certain Education Loans • Under certain circumstances will not be considered income.

25. Scholarships and Loans • Scholarships • Loans • Perkins Loans • Stafford Loans • Plus Loans For many people, scholarships and loans are the only way that they can go to college. A planner should help clients make decisions about the most effective way to finance education.

26. Scholarships • Relying on scholarships, no matter how smart or athletically talented the child is, is a risky strategy. • Scholarships are mostly granted on need, and the maximum income and asset limits for need are usually quite low. No matter how needy, however, students must meet academic standards. • Students often end up working or borrowing to finance education. • Check for scholarships based on ethnic or cultural background – there may be less competition.

27. Loans • Many parents do not want to saddle the student with debt as they start in life. • However, for many students, loans are the only aid available. • Fortunately, current interest rates are relatively low, and consolidation of student loans offers a way to lock in current low rates.

28. Federal Loans • Perkins Loans • Stafford Loans • Subsidized • Unsubsidized • Plus loans • Note that a state may have a state loan program that will not be covered here.Let’s compare the different loan types….

30. Working Students • Whether or not children should pay for education is a key value that clients may have. • Some feel that the life lesson of working and paying is important. • Others feel that they want their children to have only one job – scholarship. • Those who work may choose to go into a Federal Work Study program, although wages are low.

31. Federal Work-Study • Part-time job program for those with financial need. • Work is supposed to be community service or related to their course of study. • Wages must equal or better federal minimum wage per hour (students must be paid by hour.) • Total earnings are limited by the amount of the Work-Study award.

32. Summer Work • Many parents prefer that students work only in summer months. • Student financial aid formulas assume that the student will work during the summer and contribute to the cost of his or her education.

33. Systematic Savings and Gifts • Using time to an advantage. An early start = lower payments required. • Taking advantage of tax deferral and lower tax brackets enhances return. • 529 plans and Coverdell Education Savings Accounts are tax-deferred options for deposit of systematic savings.

34. The College Aid Formula • Everything depends on the EFC – the Expected Family Contribution. • EFC = expected student’s contribution + expected parent’s contribution • Student’s contribution is usually expected to be 35% (50% for federal method) of assets plus 50% of income above an income protection allowance. • Parent contribution depends on many factors. Money set aside in a 401(k) or IRA is not usually counted in assets.

35. Planning Tips to Reduce the EFC • Shift assets from the child, since a higher percentage of the child’s assets are expected to be spent on education. • Spend down student’s assets first to lower EFC in subsequent years. • Even families with a high AGI that have more than one child in college at one time may qualify for aid. • 401(k) money does not count as assets in the formula • Consumer debt does not reduce available assets, but home equity loans do. Spend her money first.

36. Independent Student Status Precludes Counting Parent’s Income and Assets • Students are considered independent if they meet any of the following criteria: • They will be 24 years old by December 31 of the award year, even if they are still living at home. • They are orphans or wards of the state. • They are armed forces veterans. • They have legal dependents other than a spouse. • They are graduate students or students at professional schools and will not be claimed as a dependent by their parents for the first calendar year of the award year. • They are married and will not be claimed as a dependent by their parents for the first calendar year of the award year.

37. Income Shifting Techniques & The Taxation of Children • A child subject to the kiddie tax pays tax at parents’ highest marginal rate on unearned income above $1,900 (for 2009). • A child is generally subject to the kiddie tax if under age 19 (23 if a full-time student). • Under the kiddie tax rules, most income-shifting opportunities with young children are now all but extinct.

38. Taxation of Trusts • Due to the kiddie tax, compressed trust tax rates, and financial aid practices, the use of trusts for college educational funding has almost been eliminated. • Trusts still have uses in divorce situations, spendthrift protection, etc.

39. Taxation of Scholarships and Fellowships • Excludable from gross income to the extent of tuition and course-related expenses. • Non-degree candidates receive no exclusion. • Fellowships have to be divided between “scholarship” portion (non-taxable) and “service” portion (taxable).

40. Parents’ Support Obligation • For people of means, status in the community, etc., college educational expenses may be considered to be a support obligation. • In those circumstances, the child’s assets may not be used to pay for college and use of money in custodial accounts could be taxable to the parents.

41. Gifts to Minors • Generally qualifies for gift tax annual exclusion. • Some income from UGMA or UTMA account may be taxed at child’s rate. • Must be delivered to child at either age 18 or 21, and child may not be mature enough to use it for education.

42. Major Advantages of the Custodial Account • Simplicity. • Low cost. • Ease of administration.

43. Possible Disadvantages of the Custodial Account • Loss of parental control over assets. • Inflexible distribution requirements at termination of custodianship. • Questions about education as a “support” item. • Kiddie tax rules, which reduce or eliminate tax savings. • Prospect of the child receiving more money than he is capable of managing (or willing to apply toward the intended purposes).

44. Gifts of Appreciated Assets to Minors • Gifts of appreciated assets to minor children now have limited use for tax-favored college education funding because of the kiddie tax rules. • Possible use to pay off college debt after kiddie tax no longer applies.

45. Interest-Free and Below-Market Loans • In general, interest free or below-market loans result in the parents receiving deemed income at the applicable federal rate. • Up to $100,000 can be lent if the child has less than $1,000 investment income from all sources.

46. The Family Partnership • Sometimes used for income-shifting or splitting; but limited tax savings because of kiddie tax. • Several potential pitfalls: • Children may not be recognized as partners. • State may not recognize a trust as a legal partner. • If partnership interest is given by the parent, an independent trustee relationship should be established. • Control by the parent in any form can jeopardize recognition of the partnership interest.

47. The Family Partnership (cont) • Several potential pitfalls (cont): • If the trust for the children receives its partnership interest by gift and does not contribute any services, capital must be a significant factor in producing the income of the partnership for the Internal Revenue Service to recognize the children’s partnership interest. • A child’s interest in a personal service partnership (i.e., one in which most of the income is generated by commissions and fees) is generally not recognized by the Internal Revenue Service.

48. S Corporations • Avoids problems of family partnership with income not coming from capital. • Professional corporation shares cannot be transferred to a non-licensed family member. • S corporation can be used to shift income in two ways: • through payment for services performed for the corporation • through distributions of profits to children who are shareholders. • Limited income-splitting benefits unless child has attained age 19 (24 if a full-time student) • If trust used for children’s shares, may need to be QSST or ESBT.

49. Employing Children • One of the best methods for shifting income • Income is shifted to the lower tax bracket child • Business receives a tax-deduction for wages paid • Must conform to child labor laws for the child’s age. • Must actually perform work.

50. Gift-Leaseback Income-Shifting Technique • Business property transferred to a trust for the child. • Trust agrees to lease back the property to the business. • Business (high tax bracket) deducts the lease costs. • Child (low tax bracket) reports the lease payments as income.