Many families simply earn too much for their child to qualify for need-based college aid, so they need to shift their focus to what I call tax aid; tax savings that help lower the overall cost of college. With the stock market at all-time highs, parents can combine their investment gains with this tax strategy to wipe out $27,000 in capital gains each year while a child is in college. That's a pretty good way to save for college, and it can pay dividends in retirement, too.
In the following hypothetical example you will gift your daughter appreciated stock or other investments like mutual funds or ETFs, and your daughter will use the standard deduction, personal exemption and American Opportunity Tax Credit to offset $28,000 of long-term capital gains in a single year.
Standard Deduction and Personal Exemption
Typically parents will claim the $4,050 personal exemption for their child because the parents are providing greater than half of the child’s support throughout the year. However, during the college years, if your daughter uses her own income and assets to provide more than half of her own support (roughly half the total cost of college), then she would also be able to claim the personal exemption of $4,050 (for 2016) for herself, instead of you (the parent) claiming it.
The standard deduction (for 2016) for a dependent child (i.e. parents claim the personal exemption for the child), is the child’s earned income +$300 up to the maximum of $6,300. However, if you child is claiming the personal exemption for herself (i.e. passed the support test), then she can automatically claim the personal exemption and the full standard deduction of $6,300, regardless of earned income.
Furthermore, as long as you do not claim the AOTC on your tax return, and do not claim your daughter as a personal exemption, she can claim the AOTC on her tax return.
The AOTC is worth up to $2,500 per student for four academic years. The income phase-out is $160,000 - $180,000 of modified adjusted gross income on joint tax returns. The amount of the credit is calculated as 100% of the first $2,000 in qualified tuition and fees costs paid, plus 25% of the next $2,000 paid for such fees.
2016 Kiddie Tax
The kiddie tax is a tax on unearned income paid to minors. For 2016, the first $1,050 of such income is tax free, the second $1,050 is taxed to the child at his/her tax rate and all unearned income over $2,100 is taxed at the parents’ tax rate. The kiddie tax rule now applies to children under age 19 and full-time college students under the age of 24.
In 2016, the only way that college students under age 24 will be able to avoid the kiddie tax is if they provide over half of their own support from their own earned income (i.e., wages and salaries, not income from selling stocks). Notice that this is different from the support test for the personal exemption mentioned above which allows the student to use their earned income in addition to their unearned income and personal assets to pass the test.
Tax Saving Example
Let’s assume that you have been gifting your daughter appreciated assets ($14,000 per year, per donor permitted in 2016; $28,000 on joint return) over the years and your daughter will sell the investment during her first year of college, realizing $27,000 in long-term capital gains. Note: the $27,000 in realized gains has nothing to do with the $28,000 annual exclusion on a joint tax return. To make it clearer, assume she has $77,000 in her account and only invested $50,000, thus she has a $27,000 long-term capital gain she'll be taxed on if she sells the investment in her UTMA. She will then use the proceeds from the sale of assets to pay to enroll at a flagship state university with a total cost of attendance of $50,000 per year, including out-of-state tuition.
She will be able to take advantage of the standard deduction, personal exemption and the American Opportunity Tax Credit to offset her $27,000 of unearned (long-term capital gains) each year.
The standard deduction and personal exemption will reduce her capital gain income of $27,000 ($26,000 - $4,050 - $6,300 = $16,650), leaving a remaining taxable income of $16,650 that is taxed at the parent’s capital gain tax rate of 15%, for a total tax of $2,498.
Her overall federal tax of $2,498 will be eliminated by the American Opportunity Tax Credit (see the math below).
Long-term capital gains $27,000
Student's personal exemption –$4,050
Student's standard deduction (single) –$6,300
Net taxable income $16,650
Capital gains rate (parents' rate of 15%) x 0.15
Gross federal tax = $2,498
American Opportunity Tax Credit ($2,500)
Federal tax due $0
For clients in the highest tax bracket who are subject to the 3.8% net investment income surtax, the capital gains tax would be 23.8%, or $6,426 per year on $27,000 in gains. The child’s tax would be $830 (20% x $16,650 = $3,330 - $2,500 AOTC = $830 owed; and the 3.8% surtax would not apply to the child), thus saving the family $5,834 per year in taxes; $23,336 over four years of college, even under kiddie tax rules. Even with a modest rate of return, the $23,336 in tax savings should grow to $50,000 by the time most parents reach retirement age. This underscores my longstanding philosophy that college planning is retirement planning.
Financial Aid Planning Note: This strategy is primarily intended for college students who do not qualify for need-based college aid. By shifting assets into the child’s name, the child’s Expected Family Contribution (EFC) toward the cost of college will increase by 20-25% of the value of the assets in the child's name (depending on which aid formula is being used Federal or Institutional; under the Consensus formula, assets are treated at 5% regardless of who the owner is, the parents or student). The resulting increase in the student's EFC may or may not decrease the student's need-based financial aid eligibility.
