U.S. tax laws provide a variety of tax breaks for higher education expenses, but high-income people are usually shut out of these goodies. Example: Joint filers can't claim the above-the-line deduction for tuition expenses if their adjusted gross income exceeds $160,000 ($80,000 if you are unmarried).
In a pinch, you can set aside money in custodial accounts for your kids, but then you must contend with the "kiddie tax" on investment earnings.
Strategy: Set up a Section 2503(c) trust (sometimes called a "minor's trust") for your children or grandchildren. The income is taxed directly to the trust. The kiddie tax never comes into play.
A Section 2503(c) trust has another distinct advantage over the better-known custodial ac-count: The trust can continue past the age of majority in the state where you live. That means you don't need to worry about a child squandering the dollars set aside for college. If you're the trustee, you can continue to call the shots all the way to graduation day.
Here's the whole story: The tax savings on funds set aside for your children are often eroded by the kiddie tax. That tax kicks in once the unearned income of a child under age 14 exceeds an annual threshold ($1,600 for 2005). In that case, the excess is taxed at the highest marginal tax rate of the child's parents, regardless of the income's source.
In other words, instead of income being taxed at the lower tax rates—as low as 10 percent—a large chunk of the income could be taxed at up to 35 percent.
Example: Say your three-year-old child has investments generating $5,000 in taxable income each year. You're normally in the 33 percent tax bracket. (For simplicity's sake, assume the annual kiddie tax threshold remains at $1,600 for the next 10 years.) That means your family must fork over $11,220 to Uncle Sam, thanks to the kiddie tax ($3,400 excess income times 33 percent times 10 years).
But suppose you establish a Section 2503(c) trust for your child and transfer investments to the trust that will generate $3,400 a year. Now, the entire $3,400 income is taxed to the trust. Under the special tax rates for trusts, the annual tax bill is only $650 (based on 2005 rates). Ignoring the future benefit of tax-bracket inflation indexing, the total tax over 10 years would be only $6,500. Bottom line: You save $4,720 in tax ($11,220 minus $6,500) by using the trust.
In comparison, the income in a custodial account is subject to the kiddie tax, even if it's established under your state's Uniform Gifts to Minor Act (UGMA) or Uniform Transfers to Minor's Act (UTMA). Plus, the account is legally turned over to the child when he or she reaches age 18 or 21.
Extra benefit: You can structure a 2503(c) trust so that it automatically continues beyond the age of majority if the child doesn't exercise a limited right to withdraw the funds. That exercise period can be as short as one month.
Any transfers to the trust are subject to gift tax, but that's easy to skirt around. Under the annual gift-tax exclusion, you can give each child or grandchild up to $11,000 in 2005 without paying any gift tax. The exclusion is expected to increase to $12,000 for 2006. Furthermore, the annual exclusion is doubled for joint gifts by a married couple. Just make your gifts when the children are young and watch their savings grow.
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