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Chapter 10: Education funding.

OVERVIEW

The expense of educating children has become today's greatest financial burden facing parents because of the large, and constantly escalating, annual costs, the increasing number of years of college for undergraduates, and the graduate and/or professional school education required for many careers. Except for the purchase of a home and the accumulation of a retirement fund, paying for school is one of the highest priorities--and one of the most expensive decisions--that parents will ever make.

Although this discussion will focus on college education expenses, financial planners need to also consider that many clients will provide secondary--and even primary--school education for their children at private institutions with costs approaching, and in some cases even exceeding, college tuition costs. Ironically, attendance at a fine private high school may increase the probability of admission to one of the better (spelled expensive) colleges.

How much financing is actually needed will depend upon many factors, including the family's educational goals and the time remaining until the goals have to be met. Families often have some combination of the following goals:

1. to provide private school education at the elementary and secondary levels;

2. to provide funding of all or a portion of the college costs of one or more children at private institutions;

3. to provide all or a portion of the college costs of one or more children at public institutions;

4. to provide funding for all or a portion of the other educational programs (e.g., graduate or professional school education) for one or more children; or

5. to provide an educational fund for grandchildren or others.

As with other financial goals, parents must determine education funding goals for their children and set priorities. Many parents will not be able to achieve all their goals and must weigh potential tradeoffs among them. For instance, parents who send their children to private elementary and secondary schools are using resources they could be applying to a college education fund. However, if the private elementary and secondary schooling provides a child with a sufficiently advanced education, the child may qualify for the more elite and well-endowed private college institutions that typically have more financial resources for aid and scholarships. Consequently, resources spent on elementary and secondary school education may be an investment that pays off in lower absolute dollar expenditures for college education at what are considered the more prestigious and elite colleges or universities.

The balance of this chapter is divided into two major sections. Part I is a procedure and worksheet section to show you how to compute how much funding is necessary. Part II deals with the tools and techniques available for funding educational expenses.

PART I: COMPUTING THE REQUIRED EDUCATION FUNDING NEED

Estimating college education costs and funding requirements involves essentially four steps:

1. estimating education costs in current dollars;

2. projecting future education costs in inflated dollars;

3. determining the required current lump-sum investment; and

4. calculating the required periodic investment.

Each of these steps is discussed in turn below followed by a simplified college cost worksheet.

Estimating Expenses

For more and more children, college is becoming a normal stop in the road to a career and adulthood. About half of the nation's high school graduates enrolled in college in 1980, but by the late 1990's, two-thirds were college bound. As a result of these continuing trends, financing college has become one of the largest costs that many families face.

College costs also continue to increase. If recent average annual increases of approximately 7% were to continue at the same pace, the total expenses of one year in a 4-year private college would balloon from an estimated average of about $35,000 for the 2009-2010 school year to about $70,000 in 10 years and $137,000 in 20 years.

Despite these trends, paying for a child's college education is more within reach than many people think. For one thing, tax legislation enacted over the past decade has included provisions intended to make college more affordable. Still the costs of higher education can be expected to put a strain on the finances of most families, especially when more than one child is in college. Scholarships and financial aid may be insufficient or unavailable for many students. Also, the use of loans can stretch college financing for parents well beyond graduation day and saddle graduates with a heavy load of debt.

Understanding college costs

What are parents paying for when their child attends college? There are several components to college costs, but for simplicity we will divide the components into three categories:

1. tuition;

2. room and board; and

3. everything else.

Tuition costs vary widely, as Figure 10.1 shows.

Private 4-year colleges and universities, which teach about 20 percent of students in the U.S., charge the highest tuition. Their estimated average tuition, fees, and room and board of about $35,000 for the 2009-2010 school year for 4-year private institutions is almost 2.2 times the $16,000 estimated average tuition, fees, and room and board charged by 4-year public colleges and universities.

The wide disparity between tuition levels arises because, unlike their public counterparts, private institutions cannot rely on tax revenues for support. (Note that many students may not be charged full tuition, especially the higher amounts listed by private schools, because colleges sometimes "discount" their published tuition as part of a financial aid offer.)

Room and board expenses typically constitute the next highest costs after tuition and fees. As you would expect, these costs take up a greater portion of total college costs--about twice as much--for resident students than for commuters. Everything else (i.e., books and supplies, transportation, laundry money, football tickets, pizza, activity fees, and so forth) makes up the rest of the costs.

When all of the costs of attending college are added up, one year of school in 2009-2010 might cost an average of well more than $16,000 for a four-year public institution, $35,000 for a private four-year school, and even exceeding $50,000 for the most prestigious and expensive private colleges and universities!

Is a college Education Worth the cost?

One important question arises: Is the time, money, and effort of attending college worthwhile? When looked at strictly from an earnings point of view, the answer is a resounding yes (see Figure 10.2). United States Census data show that college graduates earn an average of 80% more than high school graduates--an income advantage that has increased significantly over the years.

The President's Council of Economic Advisors also offers a rough estimate of the worth of a college degree. They have estimated that the return on an "investment" in a college education is between 11% and 13% a year for life.

Adjusting for Inflation

Recently, college costs at private institutions have been climbing at an annual rate from 4% to 10%. Inflation rates for college costs through 2008 (the most recent year for which data was available) and dating back to 1984 have compared to the overall inflation rates as follows:
                            Inflation Rate

Year                        College   CPI

Last 5 years  (2004-2008)   7.02%     3.49%
Last 10 years (1999-2008)   6.56%     2.98%
Last 15 years (1994-2008)   6.26%     2.80%
Last 20 years (1989-2008)   7.02%     3.11%
Last 25 years (1984-2008)   7.42%     3.18%

Source-CPI Data: Consumer Price Index, AH Urban Consumers
(CPI-U), U.S. city average All items, 1982-1984=100, September 1
to August 31.

Source-College Inflation: CPI-U, College Tuition and Fees.


Although the annual rate of increase for college education costs has slowed, the increases continue to be two or three times the rate of inflation. Figure 10.3 shows current and projected college costs for selected colleges.

If costs do grow at the 7% annual rate that many financial advisers suggest using as a reasonably conservative, high-end inflation rate for planning purposes, future college costs will quickly grow to incredible numbers. As Figure 10.4 shows, the parents of a child born in 2009 who expect their child to start college in about the year 2028 should anticipate average total 4-year college education costs to range from about $227,000 as a resident student at a public 4-year college to over $512,000 as a resident student at a private 4-year college). Moreover, surveys indicate that most people are not saving enough for college and that they also tend to underestimate how much college will cost.

If your clients can identify some particular college or university that they favor and to which they plan to send their children, up-to-date and accurate information about current and projected costs can be obtained by calling the placement director or financial aid officer of that school. Keep in mind, though, that in addition to tuition and room and board, students will also need funds for books, fees, clothes, and miscellaneous entertainment expenses and, if they are away from home, travel. Costs for books and lab fees in the sciences, for example, can run as high as $1,000 per semester.

[FIGURE 10.4 OMITTED]

Planners can estimate future college costs by using the formula for computing the future value of a lumpsum value:

FORMULA 1

FV = PV x [(1 + I).sup.n]

Where FV is the Future Value (future costs) of oneyear's college education;

PV is the Present Value (current cost) of one-year's college education;

I is the assumed inflation rate; and

n is the number of years until the payment must be made.

Most planners, however, prefer to use financial tables, financial calculators, or computer programs such as The Financial and Estate Planner's NumberCruncher to perform this computation. The Future Value of a Lump Sum Table in Appendix D has the necessary factors to compute future education costs using the following formula:

FORMULA 2

FV = PV x FV factor

Where FV and PV are defined as above; and

FV is the factor from the Future Value of a Lump Sum Table of Appendix D for the selected values of I (the assumed inflation rate) and n (the number of years until the child begins college).

For example, assume that

1. The current annual costs (PV) for your client's choice of college are $21,420 per year.

2. Your client's child is now four years old (which means n = 14 years assuming the child will be age 18 when beginning college).

3. The assumed college cost inflation rate (I) is 7% (very conservative).

The future value factor from the Table in Appendix D when I = 7% and n = 14 years is 2.5785. Applying Formula 2, the estimated first-year cost after adjustment for inflation is $55,231.

FV = $21,420 x 2.5785 = $55,231

For each successive year of college, the cost could be estimated in a similar manner using the FV factors from the table for n = 15, 16, 17, etc., until the end of the projected college term. In most cases, a suitable estimate of the total cost can be determined by multiplying the first-year cost by the number of years of college (generally four). In this case, the total estimated cost is $220,924 ($55,231 x 4) for four years of college.

Determining the Required current Lump-Sum Investment

According to a government survey, 70% of families with annual incomes of $30,000 or more are managing to set aside money for future college bills. But the median amount being set aside is obviously inadequate (i.e., $904 a year). As described above, assuming annual costs rise 7% per year from our assumed cost of $21,420, parents with a four year-old child in 2009 will confront college bills that could total over $220,000. To be ready to handle bills of that magnitude, the parents would have to set aside in 2009 a lump-sum investment of about $97,715 in an account earning 6% net after tax, or about $825 a month net after tax, every year until the child is age 18. Even if the parents could earn 10% net after tax on their money, they would still need a lump-sum investment of about $58,200 in2009, or would have to save almost $600a month until their child is age 18. (Examples of how to compute these amounts follow.) Few investments can provide such returns over such a long period of time--especially after taxes are considered. Those few investments that might provide such returns do so with significant risk to capital, and income may be lost. Clearly, many parents may find themselves grossly underfunded when it comes time to pay college bills for their children.

To estimate the current lump-sum investment required to fund future education expenses the following time value formula may be applied:

FORMULA 3

PV = FV x 1/[(1 + r).sup.n]

Where FV is the total estimated future education cost as determined above;

PV is the present value (required investment) of the future costs;

r is the assumed after-tax rate of return; and

n is the number of years until the child begins college.

The critical assumption when determining the required current investment is r, the assumed after-tax rate of return. The after-tax rate of return depends both on the type of assets in which the funds will be invested and on the tax that will apply to the earnings on those assets. Later in this chapter, the tax aspects of various accumulation strategies are discussed. A reasonable conservative estimate of the long-term after-tax rate of return should be used when projecting accumulations. If more aggressive investments and/or tax-deferring strategies are contemplated, a higher effective after-tax rate may be reasonable.

The Present Value of a Lump Sum Table in Appendix A may be used with the following formula to derive the same result as Formula 3:

FORMULA 4

PV = FV x PV factor

Where PV and FV are defined as above, and

PV factor is the factor from the Present Value of a Lump Sum Table in Appendix A for the selected values of r (the assumed rate of return) and n (the number of years until the child begins college).

For example, assume that

1. the total future costs are calculated (from above)

to be $220,924;

2. the child will begin college in 14 years; and

3. the assumed after-tax rate of return is 6%.

In this case the PV factor from the Present Value of a Lump Sum Table in Appendix A is 0.4423. Applying Formula 4, the estimated current lump-sum investment required to fund the child's education is $97,715:

PV = $220,924 x 0.4423 = $97,715

If the parents have already earmarked assets for the child's education, the current value of these assets should be subtracted from the present value amount derived using Formula 4, to determine their current deficit. For example, if in the case described above the parents have already earmarked $22,500 for their child's education, their current deficit would be $75,215 ($97,715 - $22,500).

Determining the Required Periodic Investment

Most clients will not have sufficient assets to fully fund their children's education without some additional periodic investing. The amount they must save each year (or each month) depends principally on how long they have to accumulate the necessary funds--the earlier they start their funding, the less they will have to save each period. The level of required periodic investment necessary to fund their current deficit is determined using the following time value formula:

FORMULA 5

Pmt = Current Deficit / [(1 - [(1 + r).sup.-nf]/r) x (1 + r)]

To compute the annual payments that are necessary to fund the deficit, use r, the assumed after-tax rate of return used when determining the current funding deficit (as described above), and nf, which equals the number of years over which the funding will take place.

To compute the monthly payments that would be required, divide the annual rate of return (r) by 12 to determine the monthly rate of return and multiply the number of years (nf) by 12 and use these values in Formula 5 for r and n, respectively.

Note: The rate of return (r) assumed when using Formula 5 must be equal to the rate of return used in Formula 3. However, the number of years for funding (nf) do not have to equal the number of years until the child begins college (n). For example, a client may wish to determine the amount required each year to fund the deficit in five years, even though the child will not begin college for 10 years. More commonly, clients will want to know how much they will have to invest each year until the child's last year of school, which is typically three years longer than the number of years until the child begins college; however, this could result in underfunding because as principal is removed each year, the rate of return is received on an increasingly smaller amount. For purposes of the calculations below, the number of years for funding will equal the number of years until the child begins college.

The Present Value of an Annuity Due Table in Appendix B can be used with the following formula to compute the same result as in Formula 5:

FORMULA 6

Pmt = Current Deficit / PVAD factor

Where Pmt is defined as above; and

PVAD factor is the Present Value of an Annuity Due factor from Table B for the selected values of r and nf.

For example, assume that

1. The current deficit is $75,215 (as determined above).

2. The number of years of annual funding (nf) is 14 years (until the child who is currently age four begins her first year of college at age 18).

3. The assumed after-tax annual rate of return (r) is 6%.

The PVAD factor from Appendix B when r equals 6% and nf equals 14 years is 9.8527. Therefore, the required annual funding is:

Pmt = $75,215 f 9.8527 = $7,634

The required monthly funding can be approximated by dividing the required annual funding by 12. In the case presented, the client would need to invest about $636 per month at a 6% after-tax rate of return for the next 14 years to fully fund the current deficit in the estimated amount required for the child's education.

Assuming that the rate of return on the assets already earmarked for the child's education equals that assumed in Formula 6, the combined amounts will equal the FV amount in Formula 4.

Simplified college cost Worksheet

For many clients, the Simplified College Cost Worksheet (Figure 10.5) will provide adequate estimates to get them started on a savings program to meet their college funding requirements. The Simplified College Cost Worksheet incorporates the four steps discussed above in one simple planning tool. In Figure 10.6, the numbers from the example above are illustrated.

In cases where clients must fund the education of several children, planning to "smooth out" the required funding schedule, so that the required payments are not too burdensome in any given year, involves additional complexity. However, a "unified" funding schedule can be devised in the following manner:

1. Using steps 1 through 10 of the Simplified College Cost Worksheet, determine the current required lump-sum investment for each child.

2. Add together the amounts derived in step (1) for all children to find the aggregate current required lump-sum investment. Place this value in step 10 of the Simplified College Cost Worksheet.

3. Use the remaining steps in the Simplified College Cost Worksheet to derive a level funding schedule over the desired funding period.

For example, assume that your clients

1. have an annual before-tax family income of $100,000;

2. have three children, ages 4, 6, and 10;

3. plan to fund 75% of the cost of their children's education at a private institution whose current tuition, fees, and room and board are about $21,420 per year (your clients believe the children should assume responsibility for 25% of the cost of their schooling);

4. believe they can invest at about a 6% after-tax rate of return;

5. have $30,000 currently earmarked to pay for their children's education;

6. estimate college costs will rise at 7% per year; and

7. want to fund their current deficit over the period until their youngest child begins his senior year in college.

Figure 10.7 shows the analysis for this case. Based on these assumptions, your clients would have to invest about $18,725 per year, or about $1,560 a month, for the next 14 years to pay 75% of their children's estimated college expenses. The annual payment represents more than 18% of the family's current before-tax income. As this example demonstrates, funding college education can be a substantial burden for most families, even for those with considerable incomes.

Clearly, if a family can raise its effective after-tax rate of return through the use of income-shifting, tax-reducing, and tax-deferring techniques, they can substantially reduce their required funding. For example, Figure 10.8 shows the analysis for the client described above assuming that the effective after-tax rate of return is raised to 8%. In this case, the required annual funding is $16,122 (monthly, $1,343), or about 14% less than that required when the after-tax rate of return is assumed to be 6%. The following sections of this chapter discuss various income-shifting, tax-reducing, and tax-deferring strategies and techniques that can help your clients increase their effective after-tax rate of return on their education funds.

PART II: TOOLS AND TEcHNIQUES FOR FUNDING EDUcATION EXPENSES

There are a number of methods for financing a child's education:

1. on a pay-as-you go basis out of current assets and income;

2. through government tax incentives;

3. through scholarships and loans;

4. working your way through school;

5. the parents engage in a systematic plan of early savings and investment;

6. the parents give gifts to children set aside sufficiently early to compound over a long period of time; and

7. through a combination of these techniques.

Most parents will use some combination of these techniques.

Pay-As-You-Go

From a planning perspective, the least favorable methods for financing education expenses are (1) using current assets and income on a pay-as-you-go system, and (2) depending on scholarships and loans. Financing an education out of current income or assets is the most expensive alternative because it takes the least advantage of the time value of money and the favorable tax treatment available for funds that might have been set aside for this purpose. In addition, this method places the greatest strain on current disposable income.

Government Provided Tax credits and Other college Financing Tax Incentives

Hope Scholarship and Lifetime Learning credits for Higher Education Expenses

Some taxpayers will be able to take advantage of the Hope Scholarship Credit and the Lifetime Learning Credit.

Hope Scholarship Credit

Individual taxpayers are allowed to claim a nonrefundable Hope Scholarship Credit against federal income taxes for each student, per year in an amount in 2009 and 2010 equal to the sum of (1) 100% of the first $2,000 of "qualified tuition and related expenses," and (2) 25% of the next $2,000 of qualified tuition and related expenses (including course materials in 2009 and 2010). Thus, for 2009 and 2010, the maximum credit available is $2,500 ($2,000 + (25% x $2,000)). The credit may be claimed only with respect to expenses of a student for two taxable years (four years for 2009 and 2010) and only with respect to expenses for a student who has not completed the first two years (four years for 2009 and 2010) of post-secondary education before the beginning of the taxable year in which the credit is claimed.

This credit can only be used if the student is an "eligible student" for at least one academic period that begins during the taxable year. An "eligible student" is one who: (1) is enrolled in a degree, certificate, or other program (including a program of study abroad approved for credit by the institution at which such student is enrolled) leading to a recognized educational credential at an eligible educational institution; (2) carries at least one-half the normal full-time work load for the course of study the student is pursuing; and (3) has not been convicted of a felony (under state or federal law) relating to the possession or distribution of a controlled substance by the end of the taxable year with or within which the academic period ends.

Furthermore, only the tax filer who claims the student as a dependent (or the student, if independent) can claim the credit; married taxpayers who file separately are not eligible for the credit.

In addition, the Hope Scholarship Credit is limited by the amount of the claimer's income. If the claimer is married and filing a joint return, the amount of the Hope Scholarship Credit for 2009 and 2010 is gradually reduced (phased out in a pro-rata fashion) if modified adjusted gross income (MAGI) is between $160,000 and $180,000. Therefore, no Hope Scholarship Credit is permitted for married taxpayers filing jointly with MAGI above $180,000. For single filers, the phase-out range is between $80,000 and $90,000.

In 2009 and 2010, the Hope Scholarship Credit can be used to offset the alternative minimum tax in addition to regular tax. Also, a portion of the credit may be refundable if the kiddie tax rules do not apply.

Planning Point--If qualified tuition and related expenses are paid during the taxable year for an academic period that begins during the first three months of the following year, the academic period is treated as beginning during the current year. This permits, for example, the payment in December of 2009 for the college term beginning on February 1, 2010 to qualify for the tax credit in 2009. It has other implications as well. For moderate-level expenses, the operation of the above rules and the increased Hope Scholarship Credit in 2009 and 2010 (also referred to as the American Opportunity Tax Credit) may lead many to making sure that the full amount of qualified tuition and related expenses be paid during the 2009 and 2010 tax years.

Lifetime Learning Credit

The taxpayer may also claim a nonrefundable Lifetime Learning Credit against federal income taxes in an amount equal to 20% of "qualified tuition and related expenses" incurred during the taxable year that do not exceed $10,000. In contrast with the Hope Scholarship Credit, the Lifetime Learning Credit is applied on a per taxpayer basis rather than on a per student basis for the taxable year. The Lifetime Learning Credit, unlike the Hope Scholarship Credit, was not expanded to include course materials in 2009 and 2010.

The "qualified tuition and related expenses" to which the Lifetime Learning Credit applies do not include those expenses with respect to an individual for whom a Hope Scholarship Credit is allowed for the taxable year. Expenses related to educational programs leading to a degree or certificate programs and, in certain cases, those that do not lead to a degree or certificate, may qualify for the Lifetime Learning Credit. Expenses incurred at either the undergraduate or graduate level (or professional degree program) may qualify for the credit. In addition to allowing a credit for the tuition and fees of a student who attends classes on at least a half-time basis as part of a degree or certificate program, the Lifetime Learning Credit is also available with respect to expenses related to any course of instruction at an "eligible education institution" (whether enrolled in by the student on a full-time, half-time, or less than half-time basis) to acquire or improve the student's job skills. In contrast to the Hope Scholarship Credit, the maximum amount of the Lifetime Learning Credit that may be claimed on a taxpayer's return will not vary based on the number of students in the taxpayer's family.

Qualified tuition and fees paid with the proceeds of a loan generally are eligible for the Lifetime Learning Credit (rather than the loan itself).

The Hope Scholarship Credit and the Lifetime Learning Credit share certain common features (See Figure 10.9):

* "Qualified tuition and related expenses" are those expenses (1) for the enrollment or attendance of (2) the taxpayer, the taxpayer's spouse or any dependent for whom the taxpayer is allowed a personal exemption (3) at an eligible education institution for courses of instruction of such individual at the institution.

Planning Point--In the case of divorced or divorcing parents, consideration of projected levels of adjusted gross income is a factor to be considered in determining who is entitled to the dependency exemption, since only a spouse who can claim the exemption and meets the AGI limits can take full advantage of the credits. This can, in appropriate circumstances, suggest that the divorce or separation agreement be structured so that the credits are available to one of the spouses.

* Expenses involving sports, games, or hobbies are not qualified tuition and related expenses unless this education is part of the student's degree program. Charges and fees associated with meals, lodging, student activities, athletics, insurance, transportation, and similar personal, living or family expenses are also not included. Neither credit is available for expenses incurred to purchase books. Qualified tuition and related expenses do not include expenses covered by educational assistance that are not required to be included in the gross income of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and related expenses are reduced by any scholarship or fellowship grants excludable from gross income under IRC Section 117 and any other tax-free educational benefits received by the student during the taxable year (such as employer provided educational assistance excludable under IRC Section 127 or payments received from educational savings accounts or qualified tuition plans). In addition, such qualified tuition and related expenses and fees are also reduced by any payment (other than a gift, bequest, devise, or inheritance within the meaning of IRC Section 102(a)) that is excludable under any United States law. Moreover, a Lifetime Learning Credit is not allowed with respect to any education expense for which a deduction is claimed under IRC Section 162, or any other IRC section.

* If a student is claimed as a dependent by the parent (or other taxpayer), the student is not entitled to claim either credit for that taxable year on the student's own tax return. If a parent (or other taxpayer) claims a student as a dependent, any qualified tuition and related expenses paid by the student are treated as paid by the parent (or other taxpayer) for purposes of the credits. On the other hand, if a child is not claimed as a dependent by the parent (or by any other taxpayer) for the taxable year, then the child has the option of electing either the Hope Scholarship or Lifetime Learning Credit for qualified higher education expenses paid during that year.

Planning Point--Because a parent (or other taxpayer) who claims a student as a dependent may treat qualified tuition and related expenses paid by the student as paid by the parent (or other taxpayer) for purposes of the credit, income-shifting to the eligible student becomes attractive because the source of the funds for payment is taxed at presumably no more than a 15% rate, yet it applies as an offset against the perhaps 25% tax rate of the taxpayer (based on tax rates in 2009). The expansion of the kiddie tax rules to full-time students through age 23 essentially eliminates the benefit of this planning unless the student is not subject to those rules.

* "Eligible educational institutions" are defined by reference to Section 481 of the Higher Education Act of 1965. Such institutions generally are accredited post-secondary educational institutions offering credit toward a bachelor's degree, associate's degree, or another recognized post-secondary credential. Certain proprietary institutions and post-secondary vocational institutions also are eligible educational institutions. The institution must be eligible to participate in United Stated Department of Education student aid programs.

* Neither credit is allowed unless the taxpayer includes the name and taxpayer identification number on the taxpayer's tax return.

Caution--Neither credit is available to married taxpayers who file separate returns. This is particularly a problem in the context of a divorcing couple. In determining whether a couple is married, their legal relationship is generally examined as of the end of the taxable year. If they are legally separated under a divorce decree (or separate maintenance), they are not considered married. In a typical scenario, there will be at least one taxable year in which the couple is separated or estranged to the point that (assuming good advice) one of them will not subject themselves to the joint and several liability of the tax return. Should this occur at the time the couple's children are going to college (or one of the estranged couple is taking graduate work or other courses), the credits are threatened. It is another issue that must be negotiated in the divorce process.

* The Hope Scholarship Credit amount that a taxpayer may otherwise claim is phased out ratably for taxpayers with "modified adjusted gross income" (AGI) for 2009 and 2010 between $80,000 and $90,000 ($160,000 and $180,000 for joint returns). The Lifetime Learning Credit amount that a taxpayer may otherwise claim is phased out ratably for taxpayers with "modified adjusted gross income" (AGI) for 2009 between $50,000 and $60,000 ($100,000 and $120,000 for joint returns) (indexed annually). "Modified AGI" includes amounts otherwise excluded with respect to income earned abroad (or income from Puerto Rico or United States possessions).

Planning Point--The phaseout suggests tax strategies to reduce the taxpayer's adjusted gross income, which might include increasing the amount of the employee's IRC Section 401(k) elective deferrals, increasing the level of contribution to a self-employed individual's Keogh plan, and shifting investment income to another family member, including the student. Each of these strategies can be justified independent of the credit, but under certain circumstances--especially for taxpayers on or near the cusp--the available credit together with other new features makes each of these more attractive.

Example: A sole proprietor whose filing status is married filing jointly has an AGI of $165,000 in 2009 and a child about to enter college, which will incur $10,000 of annual qualified tuition expenses. How should he handle this?

Strategy One--Pay expenses out of current income. Assuming the sole proprietor does not have a large amount of itemized deductions and personal exemptions, this will be paid out of 28% income (i.e., income taxable at about 28%, based on 2009 rates). Grossing up, the proprietor is (with respect to the tuition) out-of-pocket $13,889 [$10,000 / (1 - 0.28)]. If the Hope Scholarship Credit is used, there is a $2,500 credit "phased down" to $1,875--that is, the $2,500 credit is reduced by $625 ($2,500 - [$2,500 x {$165,000 - $160,000}/$20,000]). Thus, net cost is, on an after-tax basis, $12,014 ($13,889 after-tax cost of tuition--$1,875 tax savings by credit).

Strategy Two--Reduce AGI to $160,000 by setting up a Keogh profit-sharing plan and contributing the $5,000 from Strategy One to the Keogh plan. This may well require borrowing the $5,000 to pay the tuition--but more on that later. This frees up from "phase out" the $625 credit reduction in Strategy One. Now, the net after-tax cost of college is $11,389 ($13,889 after-tax cost of tuition--$2,500 tax savings by credit).

Note: The application of the Hope Scholarship or Lifetime Learning Credit is elective. A taxpayer can claim either credit and exclude a distribution from a Coverdell ESA on behalf of the same student if the distribution is not used to pay the same educational expenses for which the credit was claimed.

Planning Point--Taxpayers may not allocate qualified tuition and related expenses to the Hope Scholarship and Lifetime Learning Credits for the same student in the same tax year. For example, the payment of $7,500 tuition for one individual cannot be broken down into a $2,500 Hope Scholarship segment and a $5,000 Lifetime Learning segment. On the other hand, tuition and related expenses can be allocated to different credits on a per student basis. Thus, a taxpayer may claim the Lifetime Learning Credit for a taxable year with respect to one or more students, even though the taxpayer also claims a Hope Scholarship Credit (or claims an exclusion from gross income for certain distributions from qualified tuition programs or Coverdell ESA) for that same taxable year with respect to other students. If, for a taxable year, a taxpayer claims a Hope Scholarship Credit with respect to a student, then the Lifetime Learning Credit will not be available with respect to that same student for that year (although the Lifetime Learning Credit may be available with respect to that same student for other taxable years).

Withdrawals from IRAs for Educational Purposes

An individual generally is not subject to income tax on amounts held in a traditional IRA, including earnings on contributions, until the amounts are withdrawn from the IRA. Amounts withdrawn from a traditional IRA are includable in gross income (except to the extent of nondeductible contributions). In addition, a 10% additional early distribution penalty tax generally applies to distributions from IRAs made before age 59%, unless the distribution is made: (1) on account of death or disability; (2) in the form of annuity payments; (3) for medical expenses of the individual and his spouse and dependents that exceed 7.5% of AGI; or (4) for medical insurance of the individuals and his spouse and dependents (without regard to the 7.5% AGI floor) if the individual has received unemployment compensation for at least 12 weeks, and the withdrawal is made in the year such unemployment compensation is received or the following year.

An important exception to the 10% early distributions penalty tax is available for distributions from an IRA to the extent such distributions (other than those already excluded from the penalty) do not exceed the "qualified higher education expenses" of the taxpayer for the taxable year. For these purposes, "qualified higher education expenses" are those furnished to (1) the taxpayer, (2) the taxpayer's spouse, or (3) any child or grandchild of the taxpayer or the taxpayer's spouse, at an eligible educational institution. A child includes a son, daughter, stepson, or stepdaughter, an adopted child and, in certain circumstances, a foster child. Qualified higher education expenses are reduced by any amount excludable from gross income relating to the redemption of a qualified United States savings bond and certain scholarships and veterans benefits.

Note--The amount of qualified higher deduction expenses for any taxable year is reduced by (1) the amount of scholarships or fellowship grants excludable from gross income under IRC Section 117, (2) any other tax-free educational benefits received by the student during the taxable year (such as employer provided educational assistance excludable under IRC Section 127), and (3) any payment (other than a gift, bequest, devise, or inheritance within the meaning of IRC Section 102(a)) that is excludable under any United States law.

Coverdell Education Savings Accounts (ESAs)

Coverdell Education Savings Accounts (ESAs) allow for tax-free savings for certain educational expenses. An ESA is a trust or custodial account created or organized in the United States exclusively for the purpose of paying the "qualified education expenses" (see below) of the designated beneficiary of the account. The account must be designated as an ESA when it is created, in order to be treated as such for tax purposes. (1)

Taxpayers may deposit cash of up to $2,000 per year into an ESA for a child younger than 18. Anyone may contribute to the child's ESA provided the total contributions (on behalf of a particular beneficiary) for a taxable year do not exceed the $2,000 limit. Any contribution to an ESA on behalf of a designated beneficiary is a completed gift. Therefore, the gift qualifies for the gift tax annual exclusion. An ESA may be considered an asset of the designated beneficiary (i.e., the child's asset) under the financial aid formulas. As discussed more fully in the section covering the college financial aid formula, this could reduce the amount of financial aid the family receives.

Amounts deposited in the ESA grow tax-free until distributed. Once distributed, the child will not owe tax on the amount withdrawn from the account if the child's "qualified education expenses" at an eligible educational institution for the year equal or exceed the amount of the withdrawal.

The $2,000 contribution limit is subject to phaseout provisions for taxpayers (i.e., contributors) with modified adjusted gross income (MAGI) in excess of specified limits. The phaseout range begins at $190,000 for joint filers and $95,000 for single filers. The contribution limit is reduced proportionately for MAGI over these amounts, and is effectively eliminated once a taxpayer's MAGI reaches $220,000 for joint filers and $110,000 for single filers. Like IRAs, contributions to ESAs for a given year must be made by April 15 of the following year.

Example: T, a joint return filer, has MAGI of $195,000 in 2009. Therefore, T is $5,000 into the $30,000 phase out range. The maximum amount T may contribute to an ESA is $1,666.67 ($5,000 / $30,000 x $2,000 = $333.33 phase out). T must make the contribution by April 15, 2010.

Planning Point: The phaseout rules could prompt some taxpayers to indirectly fund an ESA by making a cash gift to a relative whose income is less than the threshold amount of the phaseout rules. The relative would then make the contribution into the ESA of the taxpayer's child. While this may still be attempted, this method is subject to attack by the IRS. In fact, a 2000 Tax Court case (not related to ESAs) held in favor of the Service where there was a pre-arranged plan of gifts. Taxpayers should be cautious because there is a 6% annual excise tax applied to excess contributions to an ESA. If the phaseout rules are an issue, EGTRRA 2001 made it clear that the rules applied only to individuals. Therefore, interpreters of the law have taken this to mean that corporations and other entities could be contributors, regardless of their income levels.

Distributions from an ESA are not included in the gross income of the distributee to the extent of the beneficiary's (1) qualified higher education expenses or (2) qualified elementary and secondary school expenses during the taxable year (together referred to as "qualified education expenses"). "Qualified higher education expenses" are defined as tuition, fees, books, supplies, and equipment required for the enrollment or attendance at a college or university (or certain vocational schools). In addition, reasonable costs for room and board are qualified expenses provided the student is taking at least one-half the normal load for the particular program. However, the amount cannot exceed the minimum amount included for room and board for such period in the cost of attendance (as defined in Section 472 of the Higher Education Act of 1965, 20 U.S.C. 1087II, as in effect on August 5, 1997) for the eligible educational institution for such period. For students who live in housing owned or operated by the eligible educational institution, the actual invoice amount charged for room and board will be includable in qualified higher education expenses if that is greater than the standard allowance.

"Qualified elementary and secondary school expenses" are defined as expenses for tuition, fees, academic tutoring, special needs services, books, supplies, and other equipment incurred in connection with the enrollment or attendance of the beneficiary at a public, private, or religious school providing elementary or secondary education (kindergarten through grade 12) as determined under state law. Also included in the definition is (1) room and board, uniforms, transportation, and supplementary items or services (including extended day programs) required or provided by such a school in connection with such enrollment or attendance of the beneficiary; and (2) the purchase of any computer technology, equipment, or Internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in school. Computer software primarily involving sports, games, or hobbies is not considered a qualified elementary and secondary school expense unless the software is educational in nature.

If the qualified expenses of the beneficiary for the year are less than the total amount of the distribution from an ESA, then the qualified expenses are deemed to be paid from a pro rata share of both the principal and earnings components of the distribution. An otherwise taxable distribution may be rolled over within 60 days into another ESA for the benefit of the same beneficiary, or a "member of the family," which means:

1. a spouse of the taxpayer;

2. a son or daughter of the taxpayer (or a descendant of either);

3. a stepson or stepdaughter of the taxpayer;

4. a brother, sister, stepbrother, or stepsister of the taxpayer;

5. the father or mother of the taxpayer (or an ancestor of either);

6. a stepfather or stepmother of the taxpayer;

7. a son or daughter of a brother or sister of the taxpayer;

8. a brother or sister of the father or mother of the taxpayer;

9. a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law of the taxpayer;

10. any spouse of an individual named in (2) through (9); or

11. any first cousin of the taxpayer.

Rollovers of account balances may be made from an ESA benefiting one beneficiary to an ESA benefiting a different beneficiary (as well as redesignations of the named beneficiary), provided that the new beneficiary is a member of the family of the old beneficiary and is under age 30. Any balance remaining in an ESA is deemed distributed within 30 days after the date that the beneficiary reaches age 30 (or, if earlier, within 30 days of the date that the beneficiary dies). The age limitations with respect to rollovers and required distributions do not apply in the case of a special needs beneficiary. Thus, a deemed distribution of any balance in an ESA does not occur when a special needs beneficiary reaches age 30. Finally, the age 30 limitation does not apply in the case of a rollover contribution for the benefit of a special needs beneficiary or a change in beneficiaries to a special needs beneficiary.

Distributions from an ESA that are not offset by any qualified expenses are included in the distributee's gross income to the extent of the earnings on the accumulated contributions. In other words, the distributions are taxed under IRC Section 72 in the same manner as distributions from traditional IRAs that include nondeductible contributions. The taxpayer recovers the nondeductible contributions in essentially a pro rata fashion. To the extent a payment or distribution from an ESA is includable in gross income, the recipient is subject to an additional penalty tax of 10% of the amount that is so includable. This 10% additional penalty tax can be avoided in the following circumstances:

1. The payment or distribution is made to a beneficiary (or his estate) on or after the death of the designated beneficiary.

2. The payment or distribution is attributable to the designated beneficiary's being disabled.

3. The payment or distribution is made on account of a scholarship, allowance, or payment described in IRC Section 25A(g)(2) received by the account holder to the extent the amount of the payment or distribution does not exceed the amount of the scholarship, allowance, or payment.

4. The distribution of any excess contribution to an ESA made during the taxable year on behalf of a designated beneficiary, which is received on or before the day prescribed by law (including extensions of time) for filing the contributor's return for that taxable year and is accompanied by the amount of net income attributable to the excess contribution. For these purposes, the net income attributable to the excess contribution is included in gross income for the taxable year in which such excess contribution was made. The additional 10% penalty does not apply to the distribution of a contribution if such distribution is made before the first day of the sixth month (i.e., June 1) of the taxable year following the taxable year in which the contribution was made.

Planning Point: A taxpayer may claim a Hope Scholarship or Lifetime Learning Credit for a taxable year and exclude from gross income amounts distributed (both the contributions and the earnings portions) from an ESA on behalf of the same student, so long as the distribution is not used for the same educational expenses for which a credit was claimed.

Contributions may be made to an ESA and a qualified tuition program (QTP also known as a 529 plan) in the same year for a designated beneficiary.

For estate tax purposes, the value in an ESA is generally not included in the gross estate of the donor or beneficiary. The exceptions are as follows:

* Amounts distributed on account of the death of the beneficiary are included in the gross estate of the designated beneficiary.

* If the donor made an election to treat certain excess contributions as made ratably over a 5-year period and dies before the close of such 5-year period, the gross estate of the donor includes the portion of such contributions properly allocable to periods after the date of death of the donor.

If the account holder's surviving spouse or family member acquires such holder's interest in an ESA by reason of being the designated beneficiary of such account at the death of the account holder, the ESA will be treated as if the spouse or family member were the account holder (provided the surviving spouse or family member has not yet attained age 30).

If anyone other than the account holder's surviving spouse acquires such holder's interest in an ESA, by reason of being the designated beneficiary of such account at the death of the account holder, it ceases being an ESA as of the date of death. If that is the case, an amount equal to the fair market value of the assets in the ESA on that date will be includable (if such person is not the estate of such holder), in the person's gross income for the taxable year which includes the date of death; or if the person acquiring it is the estate of such holder, in the gross income for the last taxable year of the estate. An appropriate deduction is allowed for estate tax attributable to the ESA under IRC Section 691(c) (for income in respect of a decedent) to any person (other than the decedent or the decedent's spouse) with respect to amounts included in gross income by the person.

Any balance remaining in an ESA at the end of the 30-day period following the designated beneficiary's death will be deemed distributed.

An ESA will be tax-exempt in the event of a prohibited transaction, and any pledge of the account is treated as a distribution to the extent of the amount pledged. For these purposes, an individual for whose benefit an ESA is established and any contributor to the account are not considered engaged in a prohibited transaction with respect to any transaction concerning the account (which would otherwise be taxable) if IRC Section503(d) applies with respect to the transaction.

Exclusion for Employer Provided Educational Assistance

An employee's gross income and wages do not include amounts paid or incurred by the employer for educational assistance provided to the employee if such amounts are paid or incurred pursuant to an educational assistance program that meets certain requirements. This exclusion is limited to $5,250 of educational assistance with respect to an individual during a calendar year. The exclusion applies to both undergraduate and graduate-level courses. In the absence of the exclusion, educational assistance is excludable from income only if it is related to the employee's current job.

Section 529 Plans

Section 529 plans, as the name implies, are governed by IRC Section 529, which deals with qualified tuition programs (QTPs). For simplicity purposes, we will refer to these programs as "529 plans" or "QTPs."

A QTP is a program established and maintained by a state, state agency, or an eligible education institution. The basic thrust of the program is to permit persons to; (1) purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary (a prepaid tuition plan); or (2) make contributions to an account that is established for the purpose of meeting qualified higher education expenses of the designated beneficiary of the account (a savings account plan). The terms and conditions of these programs vary from plan to plan. (2) However, there are some standard federal income tax rules that apply to these programs. (3)

There are two different types of 529 plans: (1) prepaid tuition plans; and (2) college savings plans or savings account plans. With a prepaid tuition plan, the account owner (e.g., a parent) contributes cash to a plan account for a beneficiary (typically a child), and the contribution purchases tuition credits (i.e., credit hours) based on then-current tuition rates. The account owner's contribution qualifies for the gift tax annual exclusion. When the beneficiary attends a college participating in the program, the beneficiary's tuition credits may be used to pay for all or a portion of the beneficiary's tuition and certain other college expenses, regardless of tuition rates at that time. If the beneficiary does not go to college, or goes to a nonparticipating college, the tuition credits will be refunded in cash (based on a set formula or index), which may then be used to pay tuition and other college expenses at a nonparticipating college.

Generally, any difference between (1) the value of the tuition and other expenses covered by the plan and (2) the total amount of the account owner's contributions to the plan is recovered tax-free.

With a college account plan, the account owner contributes cash to a plan account for a beneficiary, and the contribution is invested according to the terms of the plan. The account owner's contribution qualifies for the gift tax annual exclusion. When the beneficiary attends virtually any college, the funds in the account (i.e., the account owner's contributions plus all of the investment earnings thereon) may be used to pay for the beneficiary's tuition and certain other college expenses.

A specified individual must generally be designated as the beneficiary at the commencement of participation in a 529 plan (i.e., when contributions are first made to purchase an interest in such a program) unless interests in such a program are purchased by a state or local government or a tax-exempt IRC Section 501(c)(3) charity as part of a scholarship program operated by such government or charity under which beneficiaries to be named in the future will receive such interests as scholarships.

QTPs are themselves exempt from income tax. Cash distributions from QTPs are excluded from gross income to the extent that the distribution is used to pay for "qualified higher education expenses" (as reduced by any in-kind distributions). This exclusion from gross income also applies to distributions from QTPs established and maintained by an entity other than a state (or agency or instrumentality thereof).

The funds in the plan can be used for tuition, fees, books, and supplies needed for higher education. For 2009 and 2010, computer technology and equipment, internet access, and related services may be paid for using QTP funds. Room and board are also eligible expenses for such plans for beneficiaries who are at least "half-time" students. If the funds are not used for such expenses, the beneficiary will be taxed on the excess of the funds received over the amounts contributed.

For room and board expenses, QTPs may be used up to a specified level (generally the school's posted room and board charge).

QTPs may be used to pay expenses not only at public and nonprofit institutions but also at "proprietary schools" (i.e., any school that is an eligible educational institution for purposes of the Hope Scholarship or Lifetime Learning Credits).

Contributions by donors are eligible for the $13,000 (in 2009) gift tax annual exclusion ($26,000 for "split" gifts by married couples). Therefore, for transfer tax purposes, such contributions are treated as a completed gift to the beneficiary. If the contribution is larger than the amount of the gift tax annual exclusion, the donor may prorate the contribution to the QTP over five years for purposes of claiming the gift tax annual exclusion. This allows a contribution of up to five times the amount of the annual exclusion (up to $65,000 for an individual in 2009 and up to $130,000 for split gifts) to be made without gift tax consequences. Note that the gift tax annual exclusion is indexed for inflation.

A QTP is controlled by the account owner, not the beneficiary. The account owner retains all the rights of ownership, including the right to name a new beneficiary, roll over assets from one plan to another, and receive distributions (albeit with possibly taxable results). Despite these facts, a QTP is generally not includable in the owner's estate for estate tax or generation-skipping transfer tax purposes, even though the owner retains the same degree of control over a QTP that, with respect to any other transfer of property, would cause inclusion for estate tax purposes.

An UTMA account can be the owner of a 529 account. When the minor reaches the age of majority, the minor would become outright owner of the 529 account.

The limits on the amount of contributions imposed by plans vary. Some, however, have limits high enough to take advantage of the full amount allowed under the election.

Example: In 2009, John (age 70) wants to put $130,000 into a college savings plan for his granddaughter. By using the gift-splitting technique, allowing John and his wife, Mary, (age 65) a $26,000 annual exclusion, and by electing to prorate the gift over a 5-year period, John can transfer the entire $130,000 in 2009 without using any of his or his spouse's unified credit or generation-skipping transfer tax exemption (i.e., there would be no gift tax or generationskipping transfer tax consequences). If John dies during the next five years, his gross estate would include only that portion of the contributions allocable to periods after his death.

A 10% additional tax is imposed on any QTP earnings that are includable in taxable income because they are not used for "qualified higher education expenses." Note that QTPs are not precluded from imposing their own penalties. However, it is anticipated that both states and educational institutions will welcome the administrative convenience, and would not receive sufficient revenues to warrant the competitive disadvantage they might suffer by imposing penalties.

The additional tax for nonqualifying distributions does not apply to distributions that are rolled over to a new QTP for the same beneficiary, or to a QTP for a new beneficiary who is a family member of the old beneficiary; nor does it apply to distributions made on account of (1) the death or disability of the beneficiary, or (2) the beneficiary receiving a scholarship equal to or greater than the amount of the distribution.

A change in the designated beneficiary of an interest in a QTP is generally not treated as a distribution if the new beneficiary is a "member of the family" (see below) of the old beneficiary. Thus, in the above example, if John and Mary's granddaughter decides not to go to college, they can change the beneficiary to their grandson without an adverse effect.

A transfer of credits (or other amounts) from an account benefiting one designated beneficiary to another account benefiting a different beneficiary is considered a distribution unless the beneficiaries are members of the same family. For this purpose, the term "member of the family" is defined as

1. a spouse of the beneficiary;

2. a son or daughter of the beneficiary (or a descendant of either);

3. a stepson or stepdaughter of the beneficiary;

4. a brother, sister, stepbrother, or stepsister of the beneficiary;

5. the father or mother of the beneficiary (or an ancestor of either);

6. a stepfather or stepmother of the beneficiary;

7. a son or daughter of a brother or sister of the beneficiary;

8. a brother or sister of the father or mother of the beneficiary;

9. a son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law of the beneficiary;

10. any spouse of an individual named in (2) through (9);

11. any first cousin of the beneficiary.

A transfer of credits (or other amounts) from one QTP for the benefit of a designated beneficiary to another QTP for the benefit of the same beneficiary is not considered a distribution. However, this "rollover" treatment does not apply to more than one transfer within any 12-month period with respect to the same beneficiary. This is intended to permit, for example, transfers between a prepaid tuition program and a savings program maintained by the same state, and between a state plan and a private prepaid tuition program.

One of the disadvantages of a QTP (at least in the eyes of some) is the prohibition against the owner or beneficiary from "directing the investment" of the contributions. Accordingly, choosing a QTP involves consideration of the program's investment strategy. The addition of rollover provisions may permit dissatisfied investors to monitor account performances, and where appropriate, change to programs employing investment methods that are more effective.

Changes in many existing programs are bound to occur and one should never assume that any two or more plans are substantially identical in their terms or operation, or even that the terms of a plan are the same as they were previously. In this dynamic situation, individuals exploring their college funding options will require, in many cases, consultation with an attorney, accountant, or other financial advisor to assist in the review of all of the new particulars provided by a specific plan.

Many states have provided state tax advantages that mirrored to some extent the federal tax potential of tax deferral and the shifting of income to the presumptively lower tax bracket beneficiary. How states will treat educational institution sponsored trusts is not clear.

Taxpayers may claim a Hope Scholarship or Lifetime Learning Credit for a taxable year and exclude from gross income amounts distributed (both the principal and the earnings portions) from a QTP on behalf of the same student as long as the distribution is not used for the same expenses for which a credit was claimed (assuming that the other requirements for claiming the Hope Scholarship or Lifetime Learning Credit are satisfied and the modified AGI phase-out for those credits does not apply).

If, following a rollover or a change of beneficiary, the new beneficiary is in a generation lower than that of the old beneficiary (determined under the generationassignment rules), the old beneficiary may be subject to gift tax on the amount rolled over, or, in the case of a change of beneficiary, on the entire QTP. If the new beneficiary is two or more generations lower than the old beneficiary, the old beneficiary may also be subject to a generation skipping transfer tax on such amount. In either case, the relevant amount should qualify for the gift tax annual exclusion and, if greater than the annual exclusion, such amount should be eligible for 5-year proration as discussed above, Any such amounts not thus covered by annual exclusions would either consume some of the gift and estate tax unified credit (and perhaps generation-skipping transfer tax exemption), or cause gift tax (and perhaps generation-skipping transfer tax) to be payable by the old beneficiary.

The Department of Education treats savings account plans as an asset of the owner for federal financial aid purposes. This is much more favorable than having the account treated as an asset of the beneficiary. Moreover, because the earnings portion of a distribution used for the beneficiary's qualified higher education expenses is not generally included in the beneficiary's income, it should not affect the beneficiary's federal financial aid calculation in subsequent years.

Prepaid tuition plans are treated neither as an asset of the owner or the beneficiary, but are considered to reduce the beneficiary's cost of attendance on a dollarfor-dollar basis, depending on the amount of tuition credits available to the beneficiary.

Grants, scholarships, and Loans

Reliance on scholarships or special student loans is quite questionable, especially given the present financial aid trend away from outright grants and favorable loans. Even if favorable student loans are available, a client may not wish to saddle a child with large loans that must be paid off at a time when the child begins a career. Loans to parents are generally made at market interest rates and repayment commences shortly after the loans are taken out.

Most college aid packages include a combination of grants, loans, and work-study programs.

Federal Grants

Four federal grants are available: Pell Grants, Supplemental Educational Opportunity Grants (FSEOG), Academic Competitiveness Grants (ACG), and Nation Science and Mathematics Access to Retain Talent Grant (National Smart Grant). Unlike loans, grant recipients do not have to repay the grants unless, for example, the recipient is awarded funds incorrectly or withdraws from school.

Pell Grants are limited. The maximum award for the 2008-2009 award year was $4,731. Due to federal funding limits, the actual maximum grants may be less than this amount. Students who are eligible for Pell Grants receive the full amount they qualify for--each school participating in the program receives enough funds to pay the Pell amounts for all its eligible students. The amount of other student aid students might qualify for does not affect the amount of their Pell Grants.

Supplemental Educational Opportunity Grants (FSEOGs) range from a minimum of $100 to a maximum of $4,000 per year. Both the Pell and Supplemental federal grants are awarded only to academically promising students who also qualify under the financial needs formulas. Unlike Pell Grants, the FSEOG amounts received depend not only on their financial need, but also on the amount of other aid the students gets. Therefore, receiving other aid might reduce the amount of a student's FSEOG award. In addition, not all schools participate in the FSEOG program and the funds available to those that do is limited. Each school participating in the FSEOG Program receives a certain amount of FSEOG funds each year from the United States Department of Education. When all of those funds have been disbursed for that award year, no more FSEOG awards can be made for that year. This is one reason why it is so important to apply early to be considered for these funds. Not everyone who qualifies for an FSEOG will necessarily get one.

Academic Competitiveness Grants (ACGs) began in the 2006-07 award year for full-time undergraduate students enrolled in an eligible program, who receive Federal Pell Grants, and are United States citizens. Students also must have completed a rigorous secondary school program of study and be enrolled in at least a two-year academic program acceptable for full credit toward a bachelor's degree or enrolled in a graduate degree program that includes three academic years of undergraduate education.

A rigorous secondary school program of study includes one of the following:

* Programs proposed by a state in response to the United States Department of Education's request.

* An advanced or honors diploma program.

* A required set of courses similar to the State Scholars Initiative. (4)

* Advanced Placement (AP) courses or International Baccalaureate (IB) courses.

* Completion of two or more AP courses and a score of 3 or better on at least two AP exams for the courses completed or completion of two or more IB courses and a score of 4 or better on at least two IB exams for the courses completed.

In addition, first academic year undergraduate students must:

* be enrolled in an eligible program;

* have completed a rigorous secondary school program of study;

* not have been previously enrolled as a regular student in an undergraduate education program; and

* have graduated from high school after Jan. 1, 2006.

The award is up to $750 for first academic year undergraduate students.

Also, second academic year undergraduate students must:

* be enrolled in an eligible program;

* have completed a rigorous secondary school program of study;

* have graduated from high school after Jan. 1, 2005 and;

* have at least a 3.0 GPA for the first academic year for their eligible program.

The award is up to $1,300 for second academic year undergraduate students.

National Science and Mathematics Access to Retain Talent Grants (National SMART Grants) were first offered in the 2006-07 award year and are designed for full-time undergraduate students who are enrolled in the third or fourth academic year of an eligible program, who receive Federal Pell Grants, and are U.S. citizens. An eligible program in the National SMART Grant is one that leads to a bachelor's degree in an eligible major or a graduate degree program in an eligible major that includes at least three academic years of undergraduate education. The award is up to $4,000 for each of the third and fourth academic years.

To qualify, students must:

* be pursuing an eligible major in physical, life, or computer sciences, engineering, technology, mathematics, or a critical-need foreign language; and

* have at least a 3.0 cumulative GPA.

Non-Federal Grants and scholarships

Most states have programs similar to the Supplemental Educational Opportunity Grants program for students who are residents of and attend school within the state. These grants generally provide amounts less than $4,000 per year and are available only to students who demonstrate need.

Most colleges and universities also offer their own grants or scholarships. These funds are predominantly given to students who demonstrate financial need and superior academic potential. Many schools offer some scholarships to the most gifted students, regardless of need, but competition for these grants is especially intense.

Loans

Low interest federal loans are still available and some high income families may qualify.

Perkins Loans (formerly called National Direct Student Loans) are awarded by colleges on a first-come, first-served basis. The college decides whether the applicant needs the loan. Students from families with lower incomes are typically given preference, but gifted students with solid academic credentials may also qualify under this program. Depending on when a student applies, the level of need, and the funding level of the school, a student can borrow up to (1) $4,000 for each year of undergraduate study up to a total of $20,000, and (2) $6,000 for each year of graduate or professional study up to a total of $40,000, including any Federal Perkins Loans borrowed as an undergraduate. Interest is only 5% and payments on these loans do not begin until after graduation. The loans are repaid over 10 years.

Stafford Student Loans are generally available to students who have financial need remaining after their Expected Family Contribution (EFC), Federal Pell Grant eligibility, and aid from other sources are subtracted from the cost of their attendance. There are two kinds of Stafford loans. The Direct Stafford loan is a direct government loan. The Federal Family Education Loan (FFEL) is a government-guaranteed bank loan. While the terms and conditions of these loans are similar, they differ in the source of the loan funds, the application process, and the available repayment plans. The government will pay the interest on the loan while the student is in school, for the first six months after the student leaves school, and when the student qualifies to have payments deferred. This type of loan is called a "subsidized loan."

Students who do not have financial need remaining may still utilize the Stafford Loan program for the amount of their EFC, or the annual Stafford Loan borrowing limit for their grade level, whichever is less. Because an unsubsidized loan is not awarded on the basis of need, the Student's EFC is not taken into account. In this case the loan is "unsubsidized" (i.e., interest is charged from the time the loan is disbursed until it is paid in full).

However, the borrower may elect either to pay the interest as it accrues, or allow the interest to accumulate and be added to the principal amount of the loan. Students may receive a subsidized Stafford Loan and an unsubsidized Stafford Loan for the same enrollment period.

The maximum amounts students can be permitted to borrow under this program can vary year to year. The borrowing limits for the 2008-2009 academic year are discussed below.

Dependent undergraduate students can borrow up to the following amounts:

* $5,500 if they are first-year students enrolled in a program of study that is at least a full academic year;

* $6,500 if they have completed their first year of study and the remainder of their program is at least a full academic year;

* $7,500 a year if they have completed two years of study and the remainder of their program is at least a full academic year; and

* $31,000 total until they graduate.

Independent undergraduate students, or dependent students whose parents are unable to get a PLUS Loan (i.e., a parental loan), can borrow up to the following amounts:

* $9,500 if they are first-year students enrolled in a program of study that is at least a full academic year (no more than $3,500 of this amount may be in subsidized loans)

* $10,500 if they have completed their first year of study and the remainder of their program is at least a full academic year (no more than $4,500 of this amount may be in subsidized loans)

* $12,500 a year if they have completed two years of study and the remainder of their program is at least a full academic year (no more than $5,500 of this amount may be in subsidized loans)

* $57,000 total with no more than $23,000 of this amount being subsidized loans.

Graduate students can borrow up to $20,500 for each academic year, only $8,500 of which may consist of subsidized Stafford loans. In total, graduate students may borrow up to $138,500 with no more than $65,500 of this amount being in subsidized loans. This graduate student limit includes Stafford Loans received for undergraduate study.

The amounts described here are the maximum annual amounts students can borrow in both subsidized and unsubsidized Stafford Loans (individually or in combination). Because students cannot borrow more than the cost of attendance minus the amount of any Pell Grant they are eligible for and/or any other financial aid they will get, the amount they actually receive may be less than the annual maximum amounts.

For unsubsidized Stafford loans first disbursed after June 2006, the interest rate is fixed at 6.8%. For subsidized Stafford loans first disbursed after June 2009 and before July 1, 2010, the interest rate is fixed at 5.6% (after June 2010 and before July 1, 2011, 4.5%.; after June 2011 and before July 1, 2012, 3.4%). For earlier loans, the interest rate on Stafford Loans is variable (adjusted annually) but will never exceed 8.25%. The rate is determined based on the 91-day T-bill rate plus 1.7% during the time the student is in school. A 0.6% increase is added upon graduation. Students who have loans outstanding are notified any time there is a rate change.

After students graduate, leave school, or drop below half-time enrollment, they have a six-month grace period before they must begin repayment. During this period, borrowers will receive information about repayment and will be notified of the date repayment begins. However, borrowers are responsible for beginning repayment on time, even if they do not receive this information. Payments are usually due monthly.

Most states also have subsidized state loan programs similar to the federal loan programs. To qualify, students typically must (1) demonstrate need, (2) be a resident of the state, and (3) attend a state college or university.

Parental Loans for Undergraduate Students (PLUS) to meet students' education costs are available through both the FFEL and Direct Loan programs. Parents who have a good credit history can borrow a PLUS Loan to pay the education expenses of a child who is a dependent student enrolled at least half-time in an eligible program at an eligible school. These loans are available from most banks.

To be eligible to receive a PLUS Loan, parents generally will be required to pass a credit check. A parent cannot be turned down for having no credit history--only for having an adverse one. If parents do not pass the credit check, they might still be able to receive a loan if someone, such as a relative or friend who is able to pass the credit check, agrees to endorse the loan. An endorser promises to repay the loan if a student's parents fail to do so. Parents might also qualify for a loan even if they do not pass the credit check as long as they can demonstrate that extenuating circumstances exist. The student and the parents must also meet other general eligibility requirements for federal student financial aid.

The annual limit on a PLUS Loan is equal to the student's cost of attendance minus any other financial aid the student gets. If the cost of attendance is $10,000, for example, and a student receives $6,000 in other financial aid, the parents can borrow up to $4,000.

The student's school will receive the money in at least two installments. No single payment may exceed 50% of the loan amount. The school may require the parents to endorse a disbursement check and send it back to the school. The school will then apply the money to the student's tuition and fees, room and board, and other school charges. If any loan money remains, the parents will receive the amount as a check or in cash, unless they authorize that it be released to the student. Any remaining loan money must be used for education expenses.

For PLUS loans first disbursed after June 2006, the interest rate is fixed (7.9% for Direct PLUS loans and 8.5% for FFEL PLUS loans). For earlier loans, the interest rate is variable, but will never exceed 9%. The rate is tied to the 52-week T-bill rate plus 3.1% and is adjusted each year of repayment.

Parents will be notified of interest rate changes throughout the life of the loan. Interest is charged on the loan from the date the first disbursement is made until the loan is paid off.

For PLUS loans first disbursed after June 2008, the parent borrower has two options: begin repayment 60 days after the loan is fully disbursed or wait until six months after the student ceases to be enrolled on at least a half-time basis. For earlier loans, generally, the first payment is due within 50 days after the final loan disbursement for the year. There is no grace period on these loans. Interest begins to accumulate at the time the first disbursement is made, and parents will begin repaying both principal and interest while their child is in school.

A Stafford Loan or PLUS Loan may be canceled under any of the following conditions:

* The borrower dies (or the student on whose behalf a parent borrowed dies).

* The borrower becomes totally or permanently disabled.

* The loan is discharged in bankruptcy.

* The school closes before the student completes the program of study.

* The school falsely certifies the loan.

Even if a student does not complete the program of study at the school, does not like the school or the program of study, or does not obtain employment after completing the program of study, these loans must nonetheless be repaid. Neither type of loan (Stafford or PLUS) can be canceled for these reasons.

Repayment assistance (i.e., not a cancellation, but another way to repay) may be available if a student serves in the military. For more information, contact a recruiting officer.

Most colleges and universities have their own loan funds as well. The qualifying criteria are generally similar to those used for loans, although most schools use the funds to help attract top students as well, regardless of the family's financial need. For example, the Consortium on Financing Higher Education, which encompasses the Ivy League and other schools, provides annual loans of up to $15,000 for 15 years at a variable rate that floats 200 basis points (2%) above the prime rate.

Students who qualify as "independents" are rated for college aid without considering parents' income or assets and, therefore, are much more likely to qualify for subsidized loans. However, qualifying for independent status is not an easy affair. (See "Independent Student Status" below.)

If parents incur unexpected expenses or if their accumulated savings are less than anticipated, student loans combined with loans to parents may be good planning supplements. However, relying solely upon the future availability of loan programs as the centerpiece of a plan for financing education is risky. Careful consideration of alternative (or at least supplementary) planning vehicles will help insure a client's ability to finance a child's education.

See Figure 10.10 for a comparison of the federal loan programs.

Deductions for Educational Expenses

student Loan Interest Deduction

The deduction of student loan interest is permitted in certain circumstances. An individual who has paid interest on a "qualified education loan" may claim a deduction for such interest expenses under IRC Section 221. A "qualified education loan" is any indebtedness incurred by the taxpayer solely to pay "qualified higher education expenses" that are incurred on behalf of the taxpayer, the taxpayer's spouse or a dependent (as of the time the debt was incurred), that are paid or incurred within a reasonable period of time before or after the debt was incurred, and that are attributable to education furnished during a period during which the recipient was an "eligible student." However, a debt owed to a related person cannot be a qualified education loan. In contrast, a refinancing of a qualified education loan is treated as a qualified education loan.

"Qualified higher education" expenses are the cost of attendance at an "eligible education institution," reduced by the amount excluded under an educational assistance plan, qualified education bonds, or qualified tuition program distributions, and the amount of any scholarship, allowance, or payment excluded with respect to the Hope Scholarship and Lifetime Learning Credits. An "eligible education institution" is the same as for the Hope Scholarship and Lifetime Learning Credits (above), but the term also includes an institution conducting an internship or residency program leading to a degree or certificate awarded by an institution of higher education, a hospital, or a health care facility that offers postgraduate training.

An "eligible student" is defined the same as for the Hope Scholarship and Lifetime Learning credits above. In addition, the following requirements apply:

* The deduction is taken "above-the-line" in computing adjusted gross income (AGI).

* All student loan interest including voluntary payments are now potentially deductible, without limitation as to the length of time the payments are required. (Under earlier law, the deduction was allowed only with respect to interest paid on a qualified education loan during the first 60 months in which interest payments were required.)

* No deduction is allowed to an individual if that individual is claimed as a dependent on another taxpayer's return for the taxable year.

The amount of the deduction is limited in two ways:

* First, the amount allowable cannot exceed $2,500.

* Second, for 2009, the maximum amount otherwise allowable as a deduction is reduced by the maximum amount deductible (according to the limits above) multiplied by the ratio that the excess of the taxpayer's "modified adjusted gross income" (MAGI) over $60,000 ($120,000 for married taxpayers filing jointly) bears to $15,000 ($30,000 for married taxpayers filing jointly). For these purposes, "modified adjusted gross income" is computed after applying the Social Security inclusion, moving expenses, and passive loss rules, but without regard to either the student loan interest deduction, the exclusion for amounts received in redemption of qualified education savings bonds, the exclusion for certain adoption expenses, the foreign earned income exclusion and foreign housing exclusion, and amounts excluded from certain United States possessions or Puerto Rico.

* The maximum deduction amount is not indexed for inflation; however the phaseout amounts listed above are indexed for inflation (rounded down to the next closest multiple of $5,000). As a result of this reduction based on MAGI, in 2009, for single taxpayers no deduction may be taken if MAGI exceeds $75,000 and the amount that may be deducted is reduced proportionately if MAGI is between $60,000 and $75,000. For married taxpayers filing a joint return in 2009, no deduction may be taken if MAGI exceeds $150,000, and the amount that may be deducted is reduced proportionately if MAGI is between $120,000 and $150,000. Married taxpayers filing separately may not take the deduction.

Certain eligible education institutions, or any person in a trade or business, or any governmental agency, that receives $600 or more in qualified education loan interest from an individual during a calendar year must provide an information report on such interest to the IRS and to the payor.

Given the limitations on deductibility, many parents may not qualify to deduct interest on educational loans or may not be able to deduct all of the interest they pay on such loans. One possible alternative is to use home equity loans to help finance college education expenses. Interest on home equity loans of up to $100,000 may be deductible regardless of how the proceeds are used. In many cases, this may be a more tax-effective and less costly means to finance college education expenses than various educational loan programs.

Higher Education Expense Deduction

For tax years 2004 through 2009, taxpayers can deduct up to $4,000 of college tuition and fees paid for them, their spouses, or any other persons claimed as a dependent on their returns. This is an "above-the-line" deduction, which means taxpayers do not have to itemize in order to take advantage of the break. However, the $4,000 amount is the annual maximum, regardless of how many students taxpayers may have in their families. The other ground rules are as follows:

* Taxpayers do not get the full deduction if they are unmarried with modified adjusted gross income above $65,000, or are joint filers with modified AGI above $130,000. However, if their modified AGI is between $65,001 and $80,000 for singles or between $130,001 and $160,000 for joint filers, they are entitled to a reduced deduction which allows them to deduct up to $2,000 of college tuition and fees.

* Taxpayers are completely ineligible if they are married and file separately from their spouses.

* Any taxpayer who can be claimed as a dependent on another taxpayer's returns is ineligible for the deduction. Thus, taxpayers' dependent collegeage children cannot claim the deduction when the parents' own AGI is too high to qualify.

* Taxpayers may not claim a deduction for expenses paid with earnings from a Section 529 plan or withdrawals from a Coverdell Education Savings Account. Also, taxpayers cannot claim the deduction in the same year they claim the Hope Scholarship or Lifetime Learning tax credit for the same student.

* Unless extended once again by an act of Congress, the Higher Education Expense Deduction expires after 2009.

Deduction for Employment Related Education Expenses

A deduction for certain education expenses is generally allowed under IRC Section 162 if the education or training (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. As a general rule, education expenses are not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. In the case of an employee, education expenses (if not reimbursed by the employer) may be claimed as an itemized deduction only if such expenses relate to the employee's current job, and only to the extent that the expenses, along with other miscellaneous deductions, exceed 2% of the taxpayer's adjusted gross income (AGI).

cancellation of certain student Loans

In the case of an individual, gross income subject to federal income tax does not include any amount from the forgiveness (in whole or in part) of certain student loans, provided that the forgiveness is contingent on the student's working for a certain period of time in certain professions for a broad class of employers.

Student loans eligible for this special rule must be made to an individual to assist the individual in attending an educational institution that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where its education and activities are regularly carried on. Loan proceeds may be used not only for tuition and required fees, but also to cover room and board expenses (in contrast to tax free scholarships under IRC Section 117, which are limited to tuition and required fees). In addition, the loan must be made by (1) the United States (or an instrumentality or agency thereof), (2) a state (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a state, county, or municipal hospital and whose employees have been deemed to be public employees under state law, or (4) an educational organization that originally received the funds from which the loan was made from the United States, a state, or a tax-exempt public benefit corporation. Thus, loans made with private, non-governmental funds are not qualifying student loans for purposes of the IRC Section 108(f) exclusion.

The exclusion is also available with respect to forgiveness of loans made by tax-exempt charitable organizations (e.g., educational organizations or private foundations) if the proceeds of such loans are used to pay costs of attendance at an educational institution or to refinance outstanding student loans and the student is not employed by the lender organization. Again, the exclusion applies only if the forgiveness is contingent on the student's working for a certain period of time in certain professions for any of a broad class of employers. In addition, in the case of loans made by tax-exempt charitable organizations, the student's work must fulfill a public service requirement. The student must work in an occupation or area with unmet needs and such work must be performed for or under the direction of a tax-exempt charitable organization or a governmental entity.

Working students

Parents are widely divided on whether children should help to pay for their college education by working during the school year. Some parents believe that their children will appreciate their college education more and apply themselves more diligently to their college studies if they have to work to pay for part of their education. Other parents are concerned that work during the school year may distract children from their studies and adversely affect their performance. Should the parents favor children working during the college months? Some studies indicate that students who work up to 20 hours per week during the school year perform no worse, and in some cases perform better, than their colleagues who do not work during the school year.

Students who decide that their financial situation requires them to work during the school year to make ends meet may qualify for the Federal Work-Study (FWS) Program. The FWS Program provides part-time jobs for undergraduate and graduate students with financial need, allowing them to earn money to help pay education expenses. The program encourages community service work and work related to the recipient's course of study. FWS can help students get a foot in the door by allowing them to gain valuable experience in their chosen field before they leave school.

Students in the FWS Program are paid by the hour. No FWS student may be paid by commission or fee. The school must pay students directly at least once a month. Wages for the FWS program must equal at least the cur rent federal minimum wage, but may be higher depending on the type of work the student does and the skills required. The total FWS award depends on when the student applies, financial need, and the funding level at the student's school. The amount FWS students can earn cannot exceed their total FWS award. When assigning work hours, the employer or financial aid administrator will consider the award amount, the student's class schedule, and the student's academic progress.

The jobs available under the FWS program are usually provided by the student's school or by private nonprofit organization or public agencies, and the work performed must be in the public interest. In some cases, a FWS student's school may also have agreements with private for-profit employers for FWS jobs. This type of job must be relevant to the student's course of study.

Parents are more likely to favor their children working during the summer months. The planner should advise the parents that the college aid formula used when awarding aid to students presumes that students will work during their summer vacations and will contribute that money to the payment of their college expenses.

Systematic saving and Gifts

For most parents, careful and early planning is essential to financing their children's education. Tax benefits can be used to increase the efficiency of long-term savings. In addition to the value of long-term compounding over time, the client may find that shifting the ownership of dollars saved to the child (or to an entity taxed at the child's tax bracket) may increase the after-tax yield on the fund. The earlier the client implements a long-term savings plan, and the younger the child is at the time the savings program is undertaken, the longer the interest and dividends produced by the fund will be compounding. These factors in turn enhance the efficiency of the savings effort. Although tax law offers only minimal opportunities for income-shifting to lower tax bracket children, some very limited opportunities are available. For example, with the reduced rates (e.g., 0% in 2009 and 2010--see Chapter 27) on most long-term capital gains for taxpayers in the 15% or 10% income tax brackets, gifts of appreciated property to children may result in tax savings. However, the potential application of the kiddie tax rules may eliminate or greatly reduce any potential savings. For details, see "Taxation of Children" and "Gifts of Appreciated Assets of Minors" later in this chapter.

The College Aid Formula

Unfortunately, shifting assets from a client to a child may have adverse consequences with respect to the child's eligibility for financial aid. As will be discussed in more detail below, a standard formula is used for all applicants for financial aid to determine what is called the "expected family contribution (EFC)." The federal formula approved by Congress to calculate the EFC is called the Federal Methodology (FM). The federal methodology is used to determine eligibility for federal funds. If a college or university relies on a different formula for awarding its own funds, that formula is called the Institutional Methodology (IM). Different colleges and universities may use different institutional methodologies.

The EFC is the sum of the expected student contribution (ESC) and the expected parental contribution (EPC):

EFC = ESC + EPC

The calculation of the expected student contribution may differ from school to school if they use the institutional methodology, but is generally 20% to 35% of the student's assets and 50% of the student's income above an income protection allowance of about $2,500 to $4,000. (For the 2009-2010 academic year, the federal methodology contribution formula is 50% of income above a $3,750 income protection allowance ($4,500 for 2010-2011) and 20% of the student's reported assets.) (5)

For example, a student who has $5,376 of income in 2009 and qualifying assets of $10,000 is applying for aid in the 2009-2010 academic year. According to the federal methodology, fifty percent of the student's income of $1,000 (the amount in excess of the student's adjustments, including a $3,750 income protection allowance), or $500, and $2,000 of the student's assets (20% of $10,000), or $2,500 total, will be treated as available to pay college education expenses when computing the student's aid package for the 2009-2010 academic year.

The federal methodology computes the expected parental contribution (EPC) in essentially the same way as the ESC with some addition adjustments to account for the number of parents with earned income, their income and assets, the age of the older parent, the family size, and the number of family members enrolled in post-secondary education. Income for this purpose includes not just the taxable income from the parents' tax return, but also nontaxable income such as Social Security benefits and child support. Home equity is not included in calculating the expected family contribution (EFC) under the federal methodology, but many private schools and universities include the parents' home equity when computing the aid formula using the institutional methodology as a way of rationing their school's own grant and scholarship funds. Money set aside in retirement plans such as a 401(k), IRA, Keogh, or 403(b) is usually not counted as an asset. However, the funds contributed to a tax-deferred retirement program during the previous year must be included on the official financial aid form (FAFSA) as "other untaxed income." In addition, an asset protection allowance shelters a portion of the assets from the calculation of the parental contribution. The asset protection allowance increases with the age of the parents to allow for emergencies and retirement needs.

To illustrate using the federal methodology, assume the value of the parents' qualifying assets is $75,000, their income for this purpose is $50,000, they have three children, two of which are currently students in college, the oldest parent is age 55, and they are residents of Ohio. In this case, for the 2009-2010 award year, the parents' education savings and asset protection allowance is $63,000, so $12,000 ($75,000 - $63,000) of their assets enter the formula. At their ages and in their family circumstances, their total adjustments to income are $32,365, so $17,635 ($50,000 - $32,365) of income enters the formula. The amount of their expected contribution is computed by first adding 12% of their asset contribution, or $1,440 ($12,000 x 0.12), to their $17,635 income contribution, to derive an "adjusted available income" amount (AAI) of $19,075. Then they look up their AAI in a table, similar to a tax table, to determine the expected parental contribution. In this case, the parents' total expected contribution is $4,394.

Assuming both of the colleges that the two children attend employ the federal methodology, the parents would be expected to contribute $2,197 ($4,394 -f 2) for each child.

Low-income families are most likely to qualify for aid, but even families with incomes in excess of $70,000 or even $100,000 may qualify, depending on circumstances. Do not arbitrarily assume children will not qualify for aid if a client's income is substantial--a family's income is only one factor in determining who receives aid. The parents' real estate assets, investments, and savings (and, in some cases, home equity, if the college employs the institutional methodology) are all counted when determining the parents' contribution.

The family financial burdens, such as medical bills, the size of the family, the number of children in private schools or colleges, and the years until the parents expect to retire may all reduce the required parental contribution amount. In addition, the larger is a student's income and savings, the smaller is the aid award--all else being equal.

Planning Tips for Reducing the EFc

There are several consequences of the structure of the needs analysis formula that are worth noting.

If a child is unlikely to qualify for aid, the family may be able to successfully employ income-shifting techniques to help accumulate funds for education (but see the discussion below regarding "Taxation of Children"). However, if a child would otherwise qualify for aid in the absence of income shifting and asset shifting to the child, employing income-shifting techniques may be counter-productive and parents would often do better accumulating funds themselves.

The obvious disincentives of the formulas for computing the expected family contribution put parents in a "Catch-22" position. Lower-income parents who are conscientious and thrifty may be less likely to receive aid than higher income, but more profligate parents. In addition, the assets and income of parents are "taxed" by the federal methodology need analysis formula at a much lower rate than those of the student. This means that it may not be to the advantage of the parties to shift income and assets to their children, despite potential income tax savings.

For example, parents who have managed to save $50,000 might be expected to contribute about $2,400 of it to help pay for a child's college expenses when the college works out the aid package for the child. If these assets had been transferred to the child, in general, at least $10,000 (20%), or $7,600 more than if the parents owned the assets, would be used when computing the child's aid award. Although a family's financial status is equal in either case, the aid award from the college will be considerably smaller when the assets are owned by the child.

Generally, after application of the federal methodology aid formulas, the practical effect is that no more than about 5.6% of a parent's assets (above an educational savings and asset allowance and excluding their home equity and retirement programs) are expected to be used for the child's educational costs. For virtually all parents, the first $40,000 to $50,000 of their assets (depending on their age and family size) will be ignored completely (sheltered by the asset protection allowance) in the federal methodology needs analysis formula.

Since the student's assets are "taxed" at a much higher rate than the parents' assets, the family should spend down the student's assets before using any of the parents' assets to pay for the student's education. Otherwise, the student's assets will again be subject to the high "tax" rate during the next year's needs analysis. Just because the formulas assumes that students contribute at least 20% of their assets and parents only about 5.6% does not mean that a client must treat those percentages as targets.

The federal aid methodology divides the parents' contribution by the number of children in college to determine the parents' contribution for each child. Changes in the number of family members in college can significantly affect the amount of aid received. For example, even families that are well off may become eligible for financial aid when two or more children are enrolled in college at the same time. So parents should not assume that they are ineligible for aid just because they earn a sizeable income.

The financial aid award or "package" for a given academic year is based on the assets and earnings for the calendar year before the academic year. For example, the financial aid award for the 2009-2010 academic year is based on the parents and student assets and earnings in 2008. So parents should be careful about their financial activity the year before their children enter college. For example, parents who avoid creating or recognizing capital gains during the child's senior year in high school will be at an advantage in the federal methodology need analysis system.

If the parents' income varies substantially from year to year, they should try to rearrange income fluctuations in their favor. For example, they should try to defer income from the base year for determining aid to the next year. Also, they should try to defer deductions from the year prior to the base year, or accelerate deductions from the year after the base year, to the base year.

Business property is not treated in the same manner as the primary residence (which is only considered, in some instances, when schools use the institutional methodology, not the federal methodology) or any other real estate holdings in the needs analysis. If part of the primary residence is used for business purposes, be sure to indicate it on the financial statement.

Consumer debt (e.g., car payments, credit card payments, payments on personal notes, and so on) is not counted in the federal methodology needs analysis formula, but may or may not count in part, for exceptional items, in the institutional methodology However, home equity loans do reduce the home equity reported in the needs analysis when colleges use the institutional methodology. Therefore, using home equity loans to replace other consumer debt will sometimes lower the family assets in the institutional needs analysis formula and increase the potential aid award.

Parents should consider making any large, planned purchases in cash to reduce liquid assets immediately before filling out the financial aid forms. For example, if your client has been planning on buying a new car or making home improvements, he should be advised to pay for it using up liquid assets (savings) prior to filling out the form. The decreased savings reduce the family asset value and, thus, the expected parental contribution.

Clients should maximize elective deferrals to company-sponsored savings plans such as 401(k) plans or tax-deferred annuity plans (for clients who are employees of non-profit institutions). These retirement assets do not count as available assets on the needs analysis forms.

Additionally, tax-deferred investments such as singlepay life, whole life, variable life, and universal life insurance and annuities do not count as available assets in the needs analysis formula. This makes these instruments especially attractive investment vehicles if one is trying to maximize the potential financial aid award.

Independent student status

As noted earlier, students who qualify as independents are rated for college aid without including their parent's income or assets. This status may benefit some students who would otherwise not qualify to receive aid.

Students are considered independent if they meet any of the following criteria:

1. They will be 24 years old by December 31 of the award year, even if they are still living at home.

2. They are orphans or wards of the state.

3. They are armed forces veterans.

4. They have legal dependents other than a spouse.

5. 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.

6. They are married and will not be claimed as a dependent by their parents for the first calendar year of the award year.

The school may ask students who claim to be independent to submit proof before they can receive any federal student aid. Students who think they have unusual circumstances (other than one of those conditions listed above) that would qualify them as independent students may talk to their school's aid administrator. Aid administrators can change a student's status if they think a student's circumstances warrant it based on the documentation provided. But remember, aid administrators will not automatically do this. The decisions are based on the aid administrators' judgments, and they are final--students cannot appeal the aid administrators' decisions to the U.S. Department of Education.

Income-shifting Techniques

Before the reach of the "kiddie tax" was broadened to include 18-year olds and students under age 24, parents and their student/children could often optimize their education funding by shifting income and assets and accumulating funds in a tax-advantaged way. Under the expanded kiddie tax rules, most of these opportunities are now all but extinct.

Taxation of Children

A child subject to the kiddie tax pays tax at his or her parents' highest marginal rate on the child's unearned income over $1,900 (for 2009) if that tax is higher than the tax the child would otherwise pay on it. (6) The parents can instead elect to include on their own return the child's gross income in excess of $1,900 (for 2009). (7)

A child is subject to the kiddie if

(1) (a) he or she has not attained age 18 before the close of the tax year; or

(b) he or she turned 18, or 19 to 23 if a full-time student, before the close of the tax year and has earned income for the tax year that does not exceed one-half of his or her support;

(2) either parent of the child is alive at the end of the tax year; and

(3) the child does not file a joint return for the tax year. (8)

The expansion of the kiddie tax rules was an attempt by Congress to curtail a strategy some wealthy (and some moderate-income) parents were previously advised to use to take advantage of a beneficial feature of the long-term capital gains rates--a feature that became even more beneficial in 2008.

Specifically, in 2008 to 2010, the top tax rate on "adjusted net capital gain"--i.e., most long-term capital gains and corporate dividends--is 15%. But to the extent a taxpayer's adjusted net capital gain would otherwise be taxed in the two lowest income tax brackets--i.e., the 10% and 15% brackets--it's taxed at 0% for 2008 to 2010. Some families sought to benefit from these rates by giving appreciated stock, mutual-fund shares, and other securities to their low-income, young-adult children who (if no longer subject to the kiddie tax rules and if in one of the two lowest tax brackets) could then sell the securities tax-free in 2008, 2009, and 2010. The new law changed, or otherwise eliminated the opportunity to do this in many cases. However, if the earned incomes of children over age 18, or age 19 to 23 if a full-time student, exceeds one-half their support, the kiddie tax rules will not apply and he or she may be able to take advantage of the 0% capital gains rate in years 2008 through 2010.

Because earned income is always taxed at the child's tax rates, one way of providing a child with income without triggering increased tax liability under the kiddie tax rules is to employ the child (at reasonable compensation) in, for example, a trade or business owned by the parent. Computer literate children, for example, could help with a variety of tasks. As a result, the child's earnings will not be subject to the kiddie tax and will generate a deduction for the family business (assuming the wages are reasonable for the work actually performed). As an added bonus, this could help to avoid the kiddie tax on unearned income of a child age 18 or age 19 through age 23 if a full-time student.

For purposes of the kiddie tax, support is defined the same as it is for the dependency deduction requirement that a qualifying child not provide more than one-half of his or her own support for the tax year. However, any scholarships received by a student for study at an educational organization (9) are excluded in determining the total support paid for the student for the tax year. (10)

Consequently, because of the changes, any planned transfers of income-generating stocks, bonds, and other investments to children age 18, or those age 19 to 23 who are full-time students, must be reconsidered or postponed to eliminate or decrease the child's unearned income.

Although the opportunity to lower taxes by transferring income-producing assets to children age 18, or children age 19-23 who are full-time students, is curtailed by the kiddie tax rules, investing a child's funds in investments that produce little or no current taxable income, can help avoid the kiddie tax. These investments include, for example, stocks and mutual funds oriented toward capital growth that produce little or no current income; vacant land expected to appreciate in value; stock in a closely-held family business that pays little or no cash dividends; tax-exempt municipal bonds and bond funds; and United States series EE savings bonds for which interest reporting may be deferred.

Investments that produce no taxable income, and that are therefore not subject to the kiddie tax, also include tax-advantaged savings vehicles, such as, traditional and Roth IRAs (which the child, or the parents acting for the benefit of the child, can establish or contribute to if the child has earned income); qualified tuition programs (529 plans); and Coverdell education savings accounts (ESAs).

Under the kiddie tax rules, a parent can elect (on Form 8814) to include in the parent's gross income for the tax year the child's gross income in excess of $1,900 (for 2009) if certain requirements are met. Doing so avoids the need to file a separate return for the child, and except where the child can claim certain deductions the electing parent cannot (see below), the tax on the child's income will generally be the same whether the parent elects to report the income or the child files a separate return. However, whenever parents make the election, they should consider that the addition of the child's income to the parents' adjusted gross income (AGI) may affect the various floors and ceilings for, and thus the amount of, the parents' deductions.

In addition, an electing parent cannot take certain deductions that the children could take on their own returns absent the parents' election--for example, the children's itemized deductions such as the children's investment expenses or charitable contributions. Therefore, whenever a child can claim any of these deductions, the parents should evaluate whether they may save taxes overall if the child files a separate return.

Taxation of Trusts

Trusts are required to use a calendar year for tax purposes; however, tax-exempt and charitable trusts are exceptions to this rule.

For tax years beginning in 2009, the indexed tax rate brackets for trusts are: 15% on the first $2,300 of taxable income; 25% on taxable income between $2,300 and $5,350; 28% on taxable income between $5,350 and $8,200; 33% on taxable income between $8,200 and $11,150; and 35% on taxable income over $11,150. (11)

The 2% floor on miscellaneous itemized deductions applies to trusts and estates as well as to individuals.

Quarterly payments of estimated tax are required of trusts in the same manner as they are of individual taxpayers.

The combination of the compressed trust tax rate schedule for undistributed trust income, the kiddie tax rules for distributions of trust income to children under the age of 19 (or under age 24, if a full-time student), and the college aid formulas that apply a "tax" (contribution) rate on assets held by children at a minimum rate of 20% as compared to an effective average parental asset "tax" (contribution) rate of about 5.6% has essentially eliminated the opportunity for the effective use of trusts for income and asset shifting to children for college funding purposes. Parents may still use trusts effectively for other financial planning purposes or special cases (such as in the case of divorce, special needs for children, and the like) that may include funding for a child's education among their other support objectives, but these are uses beyond the scope of this discussion of college education funding.

Taxation of Fellowships and Scholarships

Scholarships and fellowship grants of degree candidates are excludable from gross income only to the extent spent on tuition and course-related expenses. Any portion of the money that pays for room and board and other non-education costs is taxable. Also, IRS rulings require scholarships that are awarded to students who have teaching, research, or other responsibilities associated with the grant to be allocated between the "service" portion and the scholarship portion. The portion of a grant or scholarship allocated to service is considered taxable income to the student. Non-degree candidates receive no exclusion.

Income-shifting and Parents' Support Obligation

Advisers should not recommend the use of income shifting techniques to help fund a child's education without some consideration of the tax impact such techniques may have as a result of a parent's support obligations. As a general rule, if resources are used to satisfy the parent's legal obligation to support a child, the parent, not the child, is subject to tax on the income. While the basic concept is easily understood, this issue has long been a subject with unknown boundaries. The principal question is whether or not a parent's legal obligation to support a child includes the obligation to pay for a child's college education.

The implication of the applicable case law is generally that in states where a college education is considered a normal support obligation of the parents, funds that parents have transferred to a child are the child's money. Therefore, the child does not have to use those assets to pay college expenses even though the parents gave the child the money with the express purpose of having the child use it to fund the child's college education! In other words, using non-parental funds to pay the normal support obligations of the parents (including paying college education expenses) in states that extend the support obligation to college education is a breach of a parents' fiduciary duty. Such breaches could result in fines and penalties and would normally require that the parents make complete restitution. In addition, custodial funds used to pay college expenses would be taxable to the parents in a state where the parents have an obligation of support that extends to college education.

In general, the courts have considered a number of factors (e.g., the parents' means, ability to pay, and station in life) in determining whether a college education is a normal support obligation. If, after assessing a client's financial status, college financing needs, and their parental support obligation in their state, it appears that income and asset shifting may serve their purposes, advisers and parents should consider the tools and techniques that are still available in light of the expanded kiddie tax rules described in this chapter.

Gifts to Minors

The most direct method of giving funds to children is making gifts under the Uniform Gifts to Minors Act (UGMA) or under the Uniform Transfers to Minors Act (UTMA).

A gift to an UGMA or UTMA account (generally called a "custodial account") usually qualifies for the gift tax annual exclusion. The gift is completed by opening an account and transferring property to a custodian for the benefit of the minor child. Specially drafted legal documents are usually not required. The types of assets that can be transferred to a custodial account are defined by state law. In some states, the asset categories are limited to money, securities, and insurance policies. Other states have expanded the list to include real estate, partnership interests, and other investment properties. The trend has been toward a broader definition of eligible investments for custodial accounts.

The custodian of the custodial account has general investment powers over the account and has discretion to apply the principal and income in the account for the benefit of the minor. The property placed in a custodial account vests immediately and irrevocably in the minor at the time of transfer. Also, the entire principal and income of the custodial account must be delivered to the minor when the custodianship ends (typically at age 18 or 21). If the minor dies during the custodianship, the balance in the account must be delivered to the minor's estate.

The income from a custodial account is taxed to the minor unless, and to the extent that, the income is used to discharge a legal obligation of another person, in which case the income is taxed to that other person. If, for example, the funds are used to meet the parent's legal obligation to support the minor, the income will be taxed to the parent.

The major advantages of the custodial account are its

1. simplicity;

2. low cost; and

3. ease of administration.

The possible disadvantages include

1. loss of parental control over assets;

2. inflexible distribution requirements at termination of custodianship;

3. questions about education as a "support" item;

4. the prospect of the child receiving more money than he is capable of managing (or willing to apply toward the intended purposes); and

5. the revised "kiddie tax" rules, which reduce or eliminate tax savings.

In light of the kiddie tax rules being expanded to include full-time students under age 24, the benefits of this asset and income-shifting technique for education funding purposes are now significantly reduced. The parents can shelter from their higher tax rates only the first $1,900 (in 2009) of unearned income per year transferred to each child through the gifting of income-producing assets. Assuming the assets can earn 5% interest, this means that parents could transfer up to about $38,000 worth of assets to each child before the earnings would become subject to tax at the parents' rather than the child's rates.

However, for the families that might consider shifting assets to children for education funding--that is, those who are well-enough off that they would not expect to qualify for financial aid--the effort hardly seems worth the trouble. The maximum tax savings the family would enjoy by shifting the assets to a child is only $665 per year if the parents are in the 35% bracket and the child is effectively in the 0% percent bracket. Furthermore, once money is given to an UGMA or UTMA account, the money technically belongs to the child and so parents have no assurance that these monies will, in fact, be used for education funding.

However, if parents decide it is still advisable to use a custodial account, the types of assets that are placed in a custodial account can have a significant effect on the tax benefits. If a child is a full-time student under age 24 and, therefore, subject to the kiddie-tax rules, the parents could at least partially fund the custodial account with tax-free, tax-deferred, or low-income/high-appreciation investments in order to postpone realization of excess taxable income until the child attains age 24. Such investments include;

* Series EE savings bonds;

* zero-coupon municipal bonds;

* tax-deferred annuities;

* single-premium life insurance;

* growth stocks;

* stocks in a closely held business;

* land; and

* other growth-oriented assets that do not produce significant current income.

Gifts of Appreciated Assets to Minors

Gifts of appreciated assets to minor children have limited use for tax-favored college education funding because of the expanded kiddie tax rules.

However, in some circumstances such gifts might be a means to provide tax savings on the recognition of gains, but only if the (dependent) children recognize the gains after they become age 19, or, if students, the earlier of when they are no longer students or they become age 24. The one planning opportunity still available for such gifts in the college funding context is as a means to pay off debt incurred to pay college expenses. For example, assume that the parents, instead of liquidating appreciated assets to pay a child's college expenses, transfer appreciated assets to the child which the child then uses, in part, as collateral for loans to pay the college expenses. Assume the student incurs secured and unsecured debt of $20,000 for college expenses by the time the child graduates from college. Assume, for illustration, that the value of the gifted assets is $20,745 after the child finishes school and that the transferred assets had a basis of $5,000 when transferred. Under current (2009) tax rules, the gain would be taxed at a 15% rate if owned by the parents but, at most, at a 5% rate if owned by the child (assuming the child is in the 10% or 15% federal income tax bracket). The tax savings is computed as follows:
Taxable Gain Transferred from Parent to Child

Market Value                     $20,745
  Less Cost                      (5,000)
Gain                             $15,745
Parents' capital gain tax rate    x 0.15
Parents tax                       $2,362

Child's tax cost

Taxable gain                     $15,745
Less dependent's deduction        ( 950)
Taxable income                   $14,795
Child's tax rate                  x 0.00
Child's tax                           $0
Family Tax Savings                $2,362


So the tax savings in this case is about $2,362 and the actual economic savings are these tax savings less whatever interest was paid to carry the loans until the assets were liquidated to pay off the debt. The gift of appreciated property qualifies for the $13,000 (in 2009, $26,000 for split-gifts) gift tax annual exclusion and the parent's holding period and basis carries over to the child.

Interest-Free loans and Below-Market Interest loans

Below-market loans, interest-free or low-interest "demand" loans (i.e., loans that may be called at any time by the lender) are treated as follows: the lender (parent) is deemed to have made a loan to the borrower (child) at the "applicable federal rate" (a rate that is established and published monthly by the IRS). At the end of the calendar year, the child is deemed to have paid the parent interest at a rate equal to the applicable federal rate; therefore, the parent has interest income as if the imputed interest had been paid. The parent is then deemed to have made a gift to the child in the amount of that interest. The interest deemed to have been paid by the child will be subject to the general limitations on deductions of interest.

The imputed interest rules were devised to prevent income-splitting, but there are certain limited exceptions. The first exception to the general rule applies if the total amount of outstanding loans to a child does not exceed $10,000. However, if the loan is directly attributable to the purchase or carrying of income-producing assets, the rules do apply. What this means is that if the loan proceeds are invested in income-producing assets or placed in a savings account, the $10,000 exception will not apply.

The second exception allows a loan of up to $100,000 to escape the rules as long as the child's net investment income (from all sources) for the year does not exceed $1,000. If the child's net investment income does exceed $1,000, the amount of interest treated as being transferred is limited to the amount of the child's net investment income.

The application of the $10,000 exception depends on how the specific funds are spent; in contrast, the application of the $100,000 exception depends on how much investment income the child has. The following examples illustrate these rules:

Example 1: Assume that a father makes a loan of $10,000 to his son who has net investment income of $2,000. The son uses the loan to pay tuition. Assuming the principal purpose of the loan is not tax avoidance, the imputed interest rules do not apply because the loan qualifies under the $10,000 de minimis exception. However, if the son had placed the $10,000 in a savings account, the interest would have to be imputed.

Example 2: Assume that a mother makes a $100,000 loan to her son who has no investment income. The son uses the money to buy a house. The imputed interest rules do not apply and the loan qualifies under the $100,000 exception. But, if the son had $5,000 of investment income that year, the imputed interest rules would apply. However, the imputed interest would be limited to the amount of net investment income, $5,000.

The Family Partnership

A gift to children of an interest in a family partnership can also be an income-splitting device. The tax savings are limited, however, by the kiddie tax rules for children under age 19, or age 24, if they are students. If the child is age 19 or older and not a student, or age 24 or older, the income will be taxed at the child's tax rate.

In addition to the limitations imposed by the kiddie tax rules, several other potential pitfalls may arise when using family partnerships for family income shifting:

1. In most cases, children will not be recognized as partners unless it can be shown that the children are competent to manage their own affairs. Consequently, partnership interests owned by minors should generally be held in trust or in an UGMA account with an independent custodian.

2. Many states recognize a trust as a legal partner, but there are some that do not.

3. If the partnership interest is given to the trust by the parent, an independent trustee relationship should be established.

4. Control by the parent in any form can jeopardize recognition of the partnership interest.

5. 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 in order for the Internal Revenue Service to recognize the children's partnership interest.

6. 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. This is because the partnership would be unable to satisfy the IRS requirement that capital be a significant income-producing factor.

S Corporations

A family-owned S corporation can be used to shift income to children in much the same way that a family partnership can. In contrast with the family partnership, S corporation stock can be owned even if capital is not a significant income-producing factor. However, this is not true in the case of a professional corporation electing S corporation treatment; shares cannot be transferred to a family member who is not licensed if the shareholders must be professionally licensed under state law to hold shares. For example, a doctor's stock in her medical S corporation cannot be transferred to her minor daughter or to a trust for her benefit, even if it were a trust that could otherwise hold S corporation stock.

Income-shifting and income-splitting may be accomplished by transferring S corporation shares to children because the tax treatment of S corporations resembles that of a partnership. Income, losses, deductions, and credits are passed through to the shareholders and are reported on the shareholder's individual returns. However, note that the "kiddie tax" rules apply to S corporation income. Therefore, the benefits of income-splitting will be limited unless the child has attained age 19 (24 if a student). (But planners should keep in mind estate tax and other advantages).

In most cases, children will not be providing significant services to the corporation. However, children may be employed by the corporation to perform services commensurate with their age and abilities. Consequently, an S corporation can be used to shift income in two ways: (1) through payment for services performed for the corporation; and (2) through distributions of profits to children who are shareholders. Given the limitations imposed by the kiddie tax on unearned income, payments for services provide the best income shifting opportunity by far.

In some cases it may be wise to use a custodial account or trust to hold the minor's stock. The use of a custodial account may be less complicated and less expensive, but does not provide for as much flexibility as a trust. In most states, the custodial arrangement ends at age 18 or age 21, at which time the children take possession of the stock. At that point, the children may use the proceeds for any purpose they desire (which may or may not include paying for their college education).

If a trust is used to hold minor children's stock, the trust must be a Qualified Subchapter S Trust (QSST) or an Electing Small Business Trust (ESBT). What constitutes a QSST or ESBT is beyond this discussion. Generally, however, there are complex restrictions (e.g., how the trust can be structured, who can be a beneficiary, and how income can be distributed).

A QSST or ESBT is indicated when:

1. A parent does not want to give stock to a child outright.

2. A parent does not want the child to have ownership of the stock until he or she reaches a certain age.

3. Parents wish to distribute income on the stock to one beneficiary and later distribute the income and stock outright to another beneficiary when the trust terminates. (For example, the trust instrument could state that the income from the trust would go to the parent's child throughout his or her lifetime, and the remainder of the trust would go to a grandchild upon the child's death.)

Using the S corporation form for a family business, and transferring shares to children is especially suitable when the family may desire to transfer ownership of the business outright to the children at some later date, as well as providing income for a college education.

Employing Children

One of the best methods for shifting income to children is to employ them in a family-owned business. Employing children has a double tax benefit. First, income is shifted to the lower tax-bracket children and, second, the parent-employer receives a deduction for the amount paid in wages. The salary paid must be reasonable in relation to the services rendered, but the work performed need not be either significant or regular. For example, a child may be employed to clean the office, cut the grass, clear sidewalks of snow, perform maintenance or janitorial services, open the mail, make deliveries, or other similar tasks.

If the business is not incorporated, the services performed by a child under the age of 18 are excluded from Social Security coverage. The business may deduct the salary or wage payment, but avoid the added expense of Social Security taxes that would be required if the compensation were paid to unrelated employees.

A parent/business owner employing a child in the business may generally claim a dependency exemption for the child if (1) the parent/business owner furnishes more than one-half the child's support, and (2) the child is under 19 years of age, or is a full-time student under age 24. If the child is 24 years of age or older and a fulltime student, the parent is not entitled to the dependency exemption unless the child earns less than the exemption amount ($3,650 in 2009).

A child who is a dependent may not claim any personal exemption, but is allowed to claim a standard deduction equal to the greater of (1) $950 (in 2009, as indexed) or (2) the sum of $300 and the dependent's earned income (up to the appropriate standard deduction limit, e.g., $5,700 for single taxpayers for 2009; thereafter, indexed for inflation). In other words, in 2009, a child with earned income pays zero tax on the first $5,700 of earned income. Therefore, by employing a child, the business owner in the 25% bracket (in 2009) will save $1,425 in taxes for the first $5,700 in wages paid to each child. On any compensation in excess of $5,700 paid, the business owner will save the difference in taxes between the child's low bracket amount and the parent's 25% bracket amount.

Children over 17 years of age can work any job, whether hazardous or not, for an unlimited number of hours. Under the Federal Fair Labor Standards Act, children aged 16 and 17 are restricted to nonhazardous jobs. They may work any type of nonhazardous job for an unlimited number of hours. If children are age 14 or 15, they may work no more than 3 hours on a school day and 18 hours in a school week, and are restricted to nonhazardous jobs. Fourteen is the minimum age for most non-farm work unless the child works for the parent in a nonhazardous job in a non-manufacturing business owned by the parent. In that situation there is no minimum age. Planners must also check state and city laws regarding employment of minors.

The Gift-leaseback Technique

The Tax Court has approved the gift-leaseback technique as a legitimate means of reducing tax liability and shifting income. In the typical situation, the taxpayer, such as a professional or perhaps a shareholder in a closely held corporation, establishes a trust for the children. Business property, such as office buildings, furniture, equipment, autos, trucks, or machinery, is transferred to the trust, which agrees to lease it back to the taxpayer. The lease payments are then deductible by the high-bracket taxpayer and reported as income to the low-bracket trust beneficiaries (or to the trust if the income is accumulated).

If the children (the trust beneficiaries) have no other income, the first $950 (in 2009, as indexed) of the shifted income to each child is exempt from tax (because of the dependent's exemption). The next $950, regardless of age, is taxed at the child's tax rates. If the child is under age 19 (age 24 if the child is a full-time student), distributed income in excess of $1,700 is taxed at the parent's rates. This can be avoided by having the trust retain the income (but trust income tax brackets are very compressed). If the child is 19 or over and not a student, the distributed income is taxed at the child's rate. When the property is ultimately transferred to the income beneficiary (or the residual beneficiary, if different), gains on sales of assets are taxable to the beneficiary, not the grantor. The parent taxpayer will also continue to be entitled to a personal exemption for each dependent child who is at least 50% supported, so long as the dependency tests are met.

Investment Vehicles

The selection of an appropriate investment vehicle for college education funds depends on many factors, including the time until the funds are needed, whether the parent or child will be the owner of the asset, the client's attitudes towards risk and return, tax rates, and the like. Many clients are especially interested in investments that are particularly suitable for their children who are under age 19, or under age 24 and full-time students (and thus subject to the kiddie tax rules), and that provide tax advantages or certainty of value when college costs must be paid. The following sections briefly describe some of the investments that can meet these objectives.

Investments for Children subject to the Kiddie Tax Rules; Investments for Tax Deferral

If funds are being transferred to a child subject to the kiddie tax rules, investments that minimize taxable income while providing relatively certain growth potential would be most suitable, since they will minimize the effect of the kiddie tax. Among those that the financial planner should consider are

1. Variable and universal life insurance--Inside buildup is tax-deferred or tax-free; a child may borrow cash value without paying tax on gains to pay college costs; secure.

2. Zero coupon bonds--Prior to JGTRRA 2003, some financial advisors favored zero coupon bonds (or "deep discount bonds") as a college savings vehicle because of their low cost, simplicity, and relative safety, despite the fact that taxes on the phantom income thrown off by these bonds is due and payable annually as the deemed interest accrues. Before JGTRRA was enacted, the rates on long-term capital gains (28%) were generally higher than the generally applicable ordinary income tax rate for children (15%) so bonds were viewed as being preferable to stocks.

Under JGTRRA, "qualified" dividends and most long-term capital gains are generally taxed at 0% for children through the end of 2010. On the other hand, ordinary interest income (including the "phantom" income thrown off by zero coupon bonds) is taxable at higher rates (i.e., 10% or 15% for most children). Because the tax rates "flip-flopped" when JGTRRA 2003 was enacted, zero coupon bonds are now generally less attractive as a college savings vehicle than they were prior to JGTRRA.

In another JGTRRA-related development, some advisors now recommend shifting appreciated assets to children to take advantage of the existing capital gain rate differential between children (0%) and their parents (15%).

3. Municipal bonds--Interest is free of federal income tax and, in many cases, state income tax.

4. High-growth, low-dividend stocks--Tax on gain is deferred until recognized upon disposition. If leveraged, interest expense offsets dividend income (note that dividend income may be subject to lower income tax rates) and increases growth potential. In this way, leveraged growth stocks are similar to deep-discount bonds, except that there is much less certainty of value when the funds are needed for college. However, if there is at least 10 years until college begins, the risk/ return potential is favorable as compared with bonds.

5. High-growth, low-dividend stock mutual funds--These funds are similar to high-growth, lowdividend stocks except that the leveraging possibilities are more limited and some capital gains must be recognized. The gains are subject to tax when the fund declares capital gains dividends each year.

6. Series EE savings bonds--Tax on accruing interest is deferred on savings bonds; high certainty of value. Some taxpayers may be able to exclude income used for college expenses, as described below.

Special Income Exclusion for Series EE and Series I Bonds

For Series EE bonds purchased after 1989 (and Series I bonds purchased after 1998), a parent who redeems these bonds--and pays certain education expenses of his child in the same year--may be entitled to exclude the accrued interest on the bonds. This exclusion is subject to the following limitations:

1. Bond ownership requirement--In order to qualify for the exclusion, the owner must have purchased the bonds after having attained the age of 24, and must be the sole owner of the bonds or own the bonds jointly with a spouse. The exclusion is not available to an individual who is the owner of a Series EE bond that was purchased by another individual, other than a spouse. For example, the exclusion is not available if a parent purchases a Series EE bond and puts the bond in the name of a child or another dependent. Also, the exclusion is not available for married taxpayers who do not file jointly. Furthermore, the exclusion is not available for any bonds that might be obtained as part of a tax-free rollover of matured Series E savings bonds into Series EE savings bonds.

2. Qualified educational expenses--Qualifying educational expenses include tuition and required fees for a taxpayer, or the taxpayer's spouse or dependents, net of scholarships, fellowships, employer provided educational assistance, and other tuition reduction amounts at an eligible educational institution. Such expenses do not include expenses with respect to any course or other education involving sports, games, hobbies, other than as part of a degree or certificate granting program.

3. Limitation where redemption amount exceeds qualified expenses--If the aggregate redemption amount (i.e., principal plus interest) of all Series EE and Series I bonds redeemed by the taxpayer during the taxable year does not exceed the amount of the student's qualified educational expenses, all interest for the year on the bonds is potentially excludable. For example, if the redemption amount is $10,000 ($5,000 each of principal and interest), and qualified educational expenses are $12,000, the entire $5,000 of interest may be excluded from income (subject to the phaseout described below). However, where the redemption amount exceeds the qualified educational expenses, the amount of excludable interest is reduced on a pro rata basis. For example, if the redemption amount is $10,000 ($5,000 each of principal and interest), and qualified educational expenses are $8,000, then the ratio of expenses to redemption amount is 80% ($8,000/$10,000) and $4,000 (5,000 x 0.80) of the interest may thus be excluded from income.

4. Phaseout of exclusion where income exceeds certain amounts--The exclusion is phased out for taxpayers with modified adjusted gross income (MAGI) of $69,950 (in 2009; $104,900 for joint filers) or more for the taxable year. No amount is excludable for taxpayers whose MAGI exceeds $84,950 (in 2009; $134,900 for joint filers). (12)

Modified adjusted gross income (MAGI) is defined as the taxpayer's adjusted gross income for the taxable year including what would otherwise be excluded foreign earned income (or certain income of residents of Puerto Rico, Guam, American Samoa, or the Northern Mariana Islands), the partial inclusion of Social Security and Tier

1 Railroad Retirement benefits, the adjustments for contributions of retirement savings, and the adjustments with respect to limitations of passive activity losses and credits.

The amount that may be excluded when a taxpayer's MAGI falls within the phaseout range may be determined using the following formulas.

For singles and heads of households whose MAGI exceeds $69,950:

Adjusted Exclusion = Unadjusted Exclusion x [1 - (MAGI - $69,950) / $15,000]

For married taxpayers whose MAGI exceeds $104,900:

Adjusted Exclusion = Unadjusted Exclusion x [1 - (MAGI - $104,900) / $30,000]

Example 1: Assume a married taxpayer filing jointly who has a MAGI of $114,900 redeems bonds worth $12,000 ($6,000 principal and $6,000 interest) and pays qualified educational expenses of $13,000. The unadjusted exclusion is $6,000 because the qualified expenses exceed the redemption amount. Therefore, the adjusted exclusion computed using the formula shown above for married taxpayers is $4,000 [$6,000 x (1 - ($114,900 - $104,900) / $30,000)].

Example 2: Assume a single taxpayer who has a MAGI of $79,950 redeems bonds worth $12,000 ($6,000 each of principal and interest) and pays qualified educational expenses of $9,000. The unadjusted exclusion is 75% ($9,000 / $12,000) of $6,000, or $4,500. (Remember, if the redemption amount exceeds the qualified expenses, the amount of interest that is excludable is determined by multiplying the interest by the ratio of the total expenses to the total redemption amount.) Therefore, the adjusted exclusion using the formula shown above for single taxpayers is $1,500 [$4,500 x (1 - ($79,950 - $69,950) / $15,000)].

The phaseout levels are indexed annually for inflation; consequently, the phaseout will begin at higher nominal (but essentially the same real) level of income in future years.

Investments with Certainty in Reinvestment Rate or Return

One problem facing any accumulation program is the uncertainty regarding the rate that can be earned on reinvested income and, consequently, the uncertainty regarding the amount that will ultimately be accumulated by the target date. If your client wants certainty of value when the funds are needed to pay college expenses, the following investments should be considered:

1. Zero-coupon bonds--Zeros sell at a discount from face value and pay no cash interest. At maturity zeros pay their face value. Consequently, investors who hold the bonds to maturity are guaranteed that they will receive a rate of return equal to the original yield to maturity regardless of what happens to reinvestment rates over the term until the bond matures. However, most zero-coupon bonds are callable. Therefore, investors bear some risk. If the bonds are called before maturity, investors will not be able to reinvest the proceeds at a rate comparable to their original yield on the bonds.

2. "Stripped "bonds--"Stripped" bonds are artificially created zero-coupon bonds. These bonds are created by investment bankers who "strip" the coupons from the bond and sell the principal portion at a discount from face value. Strips are sometimes issued with "call protection," a guarantee against early redemption of the bonds that would force investors to reinvest the proceeds at potentially lower yields. The call protection feature is especially attractive on municipal bond strips since municipal bonds are generally much more likely to be called than taxable bonds.

3. "Bunny" bonds--These are bonds issued with rights to purchase additional bonds with the same coupon and terms as the original bond. Bunny bondholders may direct their coupon payments on the bonds to be used to purchase additional bonds, thus guaranteeing their reinvestment rate of return.

WHERE CAN I FIND OUT MORE?

1. Leider and Leider, Don't Miss Out: the Ambitious Student's Guide to Financial Aid (Alexandria, VA: Octameron Associates, updated annually).

2. Leider, A's and B's of Academic Scholarships: 100,000 Scholarships for Top Students (Alexandria, VA: Octameron Associates, 2007).

3. Leider, Loans and Grants from Uncle Sam: Am I Eligible and for How Much? (Alexandria, VA: Octameron Associates, updated annually).

4. Funding Education Beyond High School: The Guide to Federal Student Aid--The guide is published by the United States Department of Education and provides definitive information about federal aid programs, including Pell Grants, Federal Direct Loans, Federal Family Education Loans (FFEL), Federal Supplemental Educational Opportunity Grants (FSEOG), Federal Work-Study (FWS), and Federal Perkins Loans. This publication can be viewed online at: www.studentaid.ed.gov.

5. Cash for College and Financial Aid: You Can Afford It--The public page of the National Association of Student Financial Aid Administrators (NASFAA) includes the complete text of two publications for students and their families at www.nasfaa.org. The Cash for College (2008) pamphlet summarizes basic information about getting financial aid for college. Financial Aid: You Can Afford It (2004) provides an overview of student financial aid.

6. Preparing Your Child for College: A Resource Book for Parents: This is an online version of the publication by the United States Department of Education (www. ed.gov/pubs/Prepare). The publication talks about the benefits of a college education and how to prepare children for college educationally and financially. The topics include choosing a college, how much college will cost, how the parent will be able to afford it, the most common sources of financial aid, some ways to keep college costs down, setting up a long-range plan, and sources of further information. In addition, this booklet is available as a ZIP file for anonymous FTP, and also from the Consumer Information Center on their gopher. A paper copy may be ordered by calling 1-800-USA-LEARN.

7. Websites--A helpful list of websites that can assist in college planning can be found on The Vanguard Group website at: www.vanguard.com. An excellent website devoted to Section 529 plans may be found at www.savingforcollege.com.

CHAPTER ENDNOTEs

(1.) Notice 97-60, 1997-2 CB 310, Sec. 3 Q&A-1.

(2.) Notice 97-60, 1997-2 CB 310, Sec. 6.

(3.) IRC Sec. 529.

(4.) This program of study includes four years of English, three years of mathematics (including Algebra I and higher-level courses such as Algebra II, Geometry, or Data Analysis and Statistics), three years of science (including at least one year each of two of the following: biology, chemistry or physics), three years of social studies, and one year of a foreign language other than English.

(5.) The federal methodology computes the student's contribution from income by starting with the student's taxable income; then (1) adding most other untaxed income and benefits received by the student; and (2) further adding to that any education credits claimed by the student, any child support paid, and any taxable earnings from need based employment programs, such as Federal Work-Study and need based employment portions of fellowships and assistantships received by the student to derive the student's "Total Income" for aid purposes. Next, the federal methodology subtracts certain adjustments against income including any federal income tax the student paid on income, a state and other tax allowance, a Social Security tax allowance, an income protection allowance of $3,750 (for the2009-2010 academic year, $4,500 for 2010-2011), and an allowance if the parents' have a negative adjusted available income from the computation of their expected contribution under the federal methodology. The student's contribution from income is then equal to 50% of the difference between the student's total income and the student's total allowances.

The federal methodology computes the student's contribution from assets by starting with the student's cash, savings, and checking account balances and adding the net worth of the student's investments and the net worth of the student's business and/or investment farm, if any, and then multiplying this total net worth by 20%.

(6.) IRC Sec. 1(g).

(7.) IRC Sec. 1(g)(7).

(8.) IRC Sec. 1(g)(2)(A).

(9.) As described in IRC Sec. 170(b)(1)(A)(ii).

(10.) IRC Sec. 1(g)(2)(A)(ii)(II).

(11.) IRC Sec. Rev. Proc. 2008-66, 2008-45 IRB 1107.

(12.) Rev. Proc. 2008-66, 2008-45 IRB 1107.
Figure 10.1
AVERAGE UNDERGRADUATE TUITION, FEES,
AND ROOM AND BOARD (R+B)

                                      2006-2007 *   2009-2010 **

2-Year Institution (no R+B)              $2,511        $3,076
2-Year Institution (w/ R+B)              $7,497        $9,184
4-Year Public Institution (no R+B)       $5,685        $6,964
4-Year Public Institution (w/ R+B)      $12,805       $15,687
4-Year Private Institution (w/ R+B)     $28,896       $35,399
4-Year All Institutions (w/ R+B)        $18,445       $22,596

* Source: U.S. Department of Education, National Center for Educ
for in-state.

** Projected at 7% college inflation rate.

Figure 10.2
HOW EDUCATION PAYS OFF

Full and Part Time Workers

Full Time Workers Only

                              Median    % of     Mean       % of
Level of education *          Income    HSG      Income     HSG

Less than ninth grade         $17,422    65.7%   $20,308    64.1%
High school dropout            20,321    76.7%    23,612    74.6%
High school graduate           26,505   100.0%    31,664   100.0%
Some college                   31,054   117.2%    37,089   117.1%
All education levels           32,140   121.3%    43,362   136.9%
Associate's degree             35,009   132.1%    39,662   125.3%
Bachelor's degree              43,143   162.8%    56,740   179.2%
Bachelor's degree or higher    49,303   186.0%    65,042   205.4%
Master's degree                52,390   197.7%    68,302   215.7%
Doctorate degree               70,853   267.3%    93,593   295.6%
Professional degree            82,473   311.2%   119,343   376.9%

                              Median    % of      Mean      % of
Level of education *           Income    HSG      Income    HSG

Less than ninth grade         $20,826    66.0%   $24,078    65.0%
High school dropout            25,039    79.4%    28,663    77.4%
High school graduate           31,539   100.0%    37,030   100.0%
Some college                   37,135   117.7%    44,634   120.5%
All education levels           39,336   124.7%    51,203   138.3%
Associate's degree             40,588   128.7%    46,146   124.6%
Bachelor's degree              50,944   161.5%    65,281   176.3%
Bachelor's degree or higher    56,078   177.8%    75,116   202.9%
Master's degree                61,273   194.3%    79,423   214.5%
Doctorate degree               79,401   251.8%   107,386   290.0%
Professional degree           100,000   317.1%   135,674   366.4%

More years of school correlate with higher incomes, according to U.S.
Census Bureau data.

Source: U.S. Census Bureau, Current Population Survey, 2006 Annual
Social and Economic Supplement. People 25 years old and over as of
March of the following year. Last revised: August 29, 2006. Educational
Attainment--All people (all races and both sexes) 25 years old and over
by total money earnings in 2005, work experience in 2005.
(http://pubdb3.census.gov/macro/032006/perinc/new03_000.htm)

Figure 10.3

COLLEGE COSTS PROJECTED

Yearly Tuition, Fees, Supplies, Room & Board

                                                    Assuming Increases
                                                    of 5% Per Year

NAME OF INSTITUTION          LOCATION               2009     2014

Auburn University            Auburn, Ala.           15,812   20,181
Bowdoin College              Brunswick, Maine       48,570   61,989
Brigham Young University     Provo, Utah            11,470   14,639
Bucknell University          Lewisburg, Pa.         48,380   61,747
The Citadel                  Charleston, S.C.       20,420   26,062
Colorado State University    Ft. Collins, Colo.     15,461   19,733
Columbia College             New York, N.Y.         49,218   62,816
Dartmouth College            Hanover, N.H.          47,694   60,871
De Paul University           Chicago, Ill.          36,934   47,138
Drake University             Des Moines, Iowa       32,392   41,341
Duke University              Durham, N.C.           47,810   61,019
Emory University             Atlanta, Ga.           47,908   61,144
Florida State University     Tallahassee, Fla.      13,185   16,828
George Washington Univ.      Washington, D.C.       51,607   65,865
Hamline University           St. Paul, Minn.        37,264   47,559
Harvard College              Cambridge, Mass.       47,215   60,260
Jackson State University     Jackson, Miss.         10,514   13,419
Kansas State University      Manhattan, Kans.       12,678   16,181
Loyola University Chicago    Chicago, Ill.          44,195   56,405
Marquette University         Milwaukee, Wis.        37,862   48,323
Michigan State University    E. Lansing, Mich.      18,760   23,943
Middlebury College           Middlebury, Vt.        50,210   64,082
Ohio State University        Columbus, Ohio         16,752   21,380
Oral Roberts University      Tulsa, Okla.           25,996   33,178
Purdue University            W. Lafayette, Ind.     16,546   21,117
Rutgers College              New Brunswick, N.J.    21,504   27,445
St. Lawrence University      Canton, N.Y.           47,550   60,687
Salem International Univ.    Salem, W.Va.           21,360   27,261
Seattle University           Seattle, Washington    37,080   47,325
Southern Methodist Univ.     Dallas, Tex.           43,295   55,257
Stanford University          Stanford, Calif.       49,105   62,672
Texas A & M University       College Sta., Tex.     17,044   21,753
Tulane University            New Orleans, La.       49,094   62,658
University of Arkansas       Fayetteville, Ark.     13,822   17,641
University of California     Berkley, Calif.        24,694   31,516
University of Louisville     Louisville, Ky.        14,622   18,662
University of New Mexico     Albuquerque, N.Mex.    12,834   16,380
University of Rhode Island   Kingston, R.I.         18,310   23,369
University of Virginia       Charlottesville, Va.   18,349   23,418
Vanderbilt University        Nashville, Tenn.       50,241   64,122
Yale University              New Haven, Conn.       46,000   58,709
Yeshiva University           New York, N.Y.         41,974   53,571
Average Cost                                        31,708   40,468

                             Assuming Increases of 5% Per Year
NAME OF INSTITUTION          2019     2024

Auburn University            25,756    32,872
Bowdoin College              79,115   100,974
Brigham Young University     18,683    23,845
Bucknell University          78,806   100,579
The Citadel                  33,262    42,452
Colorado State University    25,184    32,142
Columbia College             80,171   102,321
Dartmouth College            77,689    99,152
De Paul University           60,162    76,783
Drake University             52,763    67,341
Duke University              77,877    99,394
Emory University             78,037    99,597
Florida State University     21,477    27,411
George Washington Univ.      84,062   107,287
Hamline University           60,699    77,469
Harvard College              76,908    98,157
Jackson State University     17,126    21,858
Kansas State University      20,651    26,357
Loyola University Chicago    71,989    91,878
Marquette University         61,673    78,712
Michigan State University    30,558    39,001
Middlebury College           81,787   104,383
Ohio State University        27,287    34,826
Oral Roberts University      42,345    54,044
Purdue University            26,952    34,398
Rutgers College              35,028    44,705
St. Lawrence University      77,454    98,853
Salem International Univ.    34,793    44,406
Seattle University           60,399    77,087
Southern Methodist Univ.     70,523    90,007
Stanford University          79,987   102,086
Texas A & M University       27,763    35,433
Tulane University            79,969   102,063
University of Arkansas       22,515    28,735
University of California     40,224    51,337
University of Louisville     23,818    30,398
University of New Mexico     20,905    26,681
University of Rhode Island   29,825    38,065
University of Virginia       29,889    38,146
Vanderbilt University        81,837   104,447
Yale University              74,929    95,631
Yeshiva University           68,371    87,261
Average Cost                 51,649    65,918

Explanation of Table. Costs for public schools assume the student is a
resident of the state. Costs (i.e., tuition) for out-of-state students
are generally substantially more then shown. Costs for supplies are
included when available. Costs for transportation are not included.
Since over the past decade college costs have more than kept pace with
the rate of inflation, it seems highly likely that costs will continue
to escalate in the years to come. In this regard, see the Consumer
Price Index on page 330. Source of 2008-2009 college education costs:
Author research of college internet sites during the month of November,
2008, supplemented by direct inquiry when required.

Source: Cady, 2009 Field Guide to Estate Planning, Business Planning, &
Employee Benefits, page 112 (Cincinnati, OH: The Na-tional Underwriter
Company, 2009).

Figure 10.5

SIMPLIFIED COLLEGE COST WORKSHEET

1. Enter child's AGE                                  __
2. YEARS to College (18--child's AGE)                 __
3. Annual College COSTS (current dollars)             __
4. Assumed College INFLATION Rate (%)                 __%
5. College INFLATION FACTOR                           __
(Factor from Compound Interest Table,
Appendix D, for Years In Step 2
and INFLATION Rate in Step 4.)
6. Estimated FUTURE ANNUAL COSTS                      __
(Step 3 x Step 5)
7. Estimated TOTAL Future Costs                       __
(Step 6 x number of years of college)

FUNDING REQUIREMENTS

8. Assumed After-tax RATE OF RETURN (%)               __%
9. Present Value of Future LUMP-SUM Factor            __
(Factor from Present Value Table, Appendix A,
for YEARS in Step 2 and RATE OF RETURN in Step 8.)
10. Total LUMP-SUM INVESTMENT Currently Required      __
(Step 7 x Step 9)
11. AMOUNT ALREADY EARMARKED for Education            __
12. Additional LUMP-SUM Funding Required              __
(Step 10-Step 11)
13. YEARS OF FUNDING                                  __
14. Present Value of an Annuity Due Factor            __
(Factor from Present Value of an
Annuity Due Table, Appendix B,
for YEARS in Step 13 and RATE OF RETURN in Step 8.)
15. ANNUAL TARGET AMOUNT to Invest                    __
(Step 12-f Step 14)
16. Approximate MONTHLY TARGET AMOUNT to Invest       __
(Step 15 f 12)

Figure 10.6

COMPLETED COLLEGE COST WORKSHEET

1. Enter child's AGE                                     4 years
2. YEARS to College (18--child's AGE)                    14 yrs.
3. Annual College COSTS (current dollars)                 21,420
4. Assumed College INFLATION Rate (%)                         7%
5. College INFLATION FACTOR
(Factor from Compound Interest Table, Appendix D, for
Years in Step 2 and INFLATION Rate in Step 4.)            2.5785
6. Estimated TOTAL Future Cost
(Step 3 x Step 5)                                         55,231
7. Estimated TOTAL Future Cost                               x 4
(Step 6 x number of years of college)                   $220,924

FUNDING REQUIREMENTS

8. Assumed After-tax RATE OF RETURN (%)                       6%
9. Present Value of Future LUMP-SUM Factor
(Factor from Present Value Table, Appendix A,
for YEARS in Step 2 and RATE OF RETURN in Step 8.)        0.4423
10. Total LUMP-SUM INVESTMENT Currently Required
(Step 7 x Step 9)                                         97.715
11. AMOUNT ALREADY EARMARKED for Education               $22,500
12. Additional LUMP-SUM Funding Required
(Step 10--Step 11)                                        75,215
13. YEARS OF FUNDING                                          14
14. Present Value of an Annuity Due Factor
(Factor from Present Value of an Annuity
Due Table, Appendix B,
for YEARS in Step 13 and RATE OF RETURN in Step 8.)       9.8527
15. ANNUAL TARGET AMOUNT to Invest
(Step f Step 14)                                          $7,634
16. Approximate MONTHLY TARGET AMOUNT to Invest
(Step 15 f 12)                                             $ 636

Figure 10.7

COLLEGE COST ANALYSIS ASSUMING 6 PERCENT RETURN

                                             4-yr. Old   6-yr. Old

1. Enter child's AGE                                 4           6
2. YEARS to College (18--child's AGE)               14          12
3. Annual College COSTS (current dollars)     16,065 *    16,065 *
4. Assumed College INFLATION Rate (%)               7%          7%
5. College INFLATION FACTOR
(Factor from Compound Interest Table,
Appendix D, for Years in Step 2 and
INFLATION Rate in Step 4.)                      2.5785      2.2522
6. Estimated FUTURE ANNUAL COSTS
(Step 3 x Step 5)                              $41,424     $36,182
7. Estimated TOTAL Future cost
(Step 6 x number of years of college)         $165,696    $144,728

FUNDING REQUIREMENTS

8. Assumed After-tax RATE OF RETURN (%)             6%          6%
9. Present Value of Future
LUMP-SUM Factor
(Factor from present
Value Table, Appendix A,
for YEARS in Step 2 and                         0.4423      0.4970
RATE OF RETURN in Step 8.)
10. Total LUMP-SUM INVESTMENT                  $73,287     $71,930
Currently Required
10a. SUM of Line 10, all columns                          $214,489
11. AMOUNT ALREADY EARMARKED for Education                 $30,000
12. Additional LUMP-SUM Funding Required
(Step 10a--Step 11)                                       $184,489
13. YEARS OF FUNDING                                         14 **
14. Present Value of an Annuity Due
Factor (Factor from
Present Value of an Annuity Due
Table, Appendix B, for YEARS in                             9.8527
Step 13 and the RATE OF
RETURN in Step 8.)
15. ANNUAL TARGET AMOUNT to Invest
(Step 12 f Step 14)                                        $18,725
16. Approximate MONTHLY TARGET
AMOUNT to Invest (Step 15 f 12)                             $1,560

                                             10-yr. Old

1. Enter child's AGE                                 10
2. YEARS to College (18--child's AGE)                 8
3. Annual College COSTS (current dollars)      16,065 *
4. Assumed College INFLATION Rate (%)                7%
5. College INFLATION FACTOR
(Factor from Compound Interest Table,
Appendix D, for Years in Step 2 and
INFLATION Rate in Step 4.)                       1.7182
6. Estimated FUTURE ANNUAL COSTS
(Step 3 x Step 5)                               $27,603
7. Estimated TOTAL Future cost
(Step 6 x number of years of college)          $110,412

FUNDING REQUIREMENTS

8. Assumed After-tax RATE OF RETURN (%)              6%
9. Present Value of Future
LUMP-SUM Factor
(Factor from present
Value Table, Appendix A,
for YEARS in Step 2 and                          0.6274
RATE OF RETURN in Step 8.)
10. Total LUMP-SUM INVESTMENT                   $69,272
Currently Required
10a. SUM of Line 10, all columns
11. AMOUNT ALREADY EARMARKED for Education
12. Additional LUMP-SUM Funding Required
(Step 10a--Step 11)
13. YEARS OF FUNDING
14. Present Value of an Annuity Due
Factor (Factor from
Present Value of an Annuity Due
Table, Appendix B, for YEARS in
Step 13 and the RATE OF
RETURN in Step 8.)
15. ANNUAL TARGET AMOUNT to Invest
(Step 12 f Step 14)
16. Approximate MONTHLY TARGET
AMOUNT to Invest (Step 15 f 12)

* 21,420 total current cost x 75 percent that parent plans to fund

** Years until youngest child starts first year of college

Figure 10.8

COLLEGE COST ANALYSIS ASSUMING 8 PERCENT RETURN

                                           4-yr. Old   6-yr. Old

1. Enter child's age                               4           6
2. YEARS to College (18--child's AGE)             14          12
3. Annual College COSTS (current dollar)   $16,065 *   $16,065 *
4. Assumed College INFLATION Rate (%)             7%          7%
5. College INFLATION FACTOR
(Factor from Compound Interest Table,
Appendix D, for Years in Step 2 and
INFLATION Rate in Step 4.)                    2.5785      2.2522
6. Estimated FUTURE ANNUAL COSTS
(Step 3 x Step 5)                            $41,424     $36,182
7. Estimated TOTAL Future Cost
(Step 6 x number of years of college)       $165,696    $144,728

FUNDING REQUIREMENTs

8. Assumed After-tax RATE OF RETURN (%)           8%          8%
9. Present Value of Future
LUMP-SUM Factor
(Factor from Present Value
Table, Appendix A, for                        0.3405      0.3971
YEARS in Step 2 and
RATE OF RETURN in Step 8.)
10. Total LUMP-SUM INVESTMENT
Currently Required (Step 7 x Step 9)         $56,419     $57,471
10a. SUM of Line 10, all columns                        $173,546
11. AMOUNT ALREADY EARMARKED                            $ 30,000
for Education
12. Additional LUMP-SUM
Funding Required
(Step 10a--Step 11)                                     $143,546
13. YEARS OF FUNDING                                       14 **
14. Present Value of an Annuity
Due Factor (Factor from
Present Value of an Annuity
Due Table, Appendix B,
for YEARS in Step 13 and                                  8.9038
RATE OF RETURN in Step 8.)
15. ANNUAL TARGET AMOUNT to                              $16,122
Invest (Step 12 f Step 14)
16. Approximate MONTHLY
TARGET AMOUNT to Invest
(Step 15 f 12)                                            $1,343

                                           10-yr. Old

1. Enter child's age                              10
2. YEARS to College (18--child's AGE)              8
3. Annual College COSTS (current dollar)   $16,065 *
4. Assumed College INFLATION Rate (%)             7%
5. College INFLATION FACTOR
(Factor from Compound Interest Table,
Appendix D, for Years in Step 2 and
INFLATION Rate in Step 4.)                    1.7182
6. Estimated FUTURE ANNUAL COSTS
(Step 3 x Step 5)                            $27,603
7. Estimated TOTAL Future Cost
(Step 6 x number of years of college)       $110,412

FUNDING REQUIREMENTs

8. Assumed After-tax RATE OF RETURN (%)           8%
9. Present Value of Future
LUMP-SUM Factor
(Factor from Present Value
Table, Appendix A, for                        0.5403
YEARS in Step 2 and
RATE OF RETURN in Step 8.)
10. Total LUMP-SUM INVESTMENT
Currently Required (Step 7 x Step 9)         $59,656
10a. SUM of Line 10, all columns
11. AMOUNT ALREADY EARMARKED
for Education
12. Additional LUMP-SUM
Funding Required
(Step 10a--Step 11)
13. YEARS OF FUNDING
14. Present Value of an Annuity
Due Factor (Factor from
Present Value of an Annuity
Due Table, Appendix B,
for YEARS in Step 13 and
RATE OF RETURN in Step 8.)
15. ANNUAL TARGET AMOUNT to
Invest (Step 12 f Step 14)
16. Approximate MONTHLY
TARGET AMOUNT to Invest
(Step 15 f 12)

* 21,420 total current cost x 75 percent that parent plans to fund

** Years until youngest child starts first year of college

Figure 10.9

HOPE SCHOLARSHIP CREDIT AND LIFETIME LEARNING CREDIT
SUMMARY AND COMPARISON

                 HOPE Scholarship       Lifetime Learning
                 Credit                 Credit

Credit amount    Up to $2,500 per       Up to $2,000 per
                 student per year       taxpayer per year.
                 (for 2009 and 2010).

Concurrent use   Same taxpayer may
                 elect both credits
                 in the same year
                 provided credits are
                 not used for the
                 same student's
                 expenses.

Application of   Per-student basis      Per-taxpayer basis
expense limit
Phaseout         Married filing         Married filing
                 jointly: phase-out     jointly: phase-out
                 range between          range between
                 $160,000 and           $100,000 and
                 $180,000. Single:      $120,000. Single:
                 phase-out range is     phase-out range is
                 between $80,000 and    between $50,000 and
                 $90,000. (for 2009     $60,000. (for 2009,
                 and 2010).             indexed for
                                        inflation each
                                        year).

Qualified        Qualified tuition      Qualified tuition
expenses         and related expenses   and related expenses
                 (including required    (but not required
                 course materials for   course materials)
                 2009 and 2010) for     for the attendance.
                 the attendance by
                 the taxpayer,          Also includes
                 taxpayer's spouse,     qualified tuition
                 or taxpayer's          and related expenses
                 dependents at a        for course that is
                 post-secondary         part of a nondegree
                 educational            program that is
                 institution offering   taken by the student
                 credit toward a        to acquire or
                 degree or other        improve job skills.
                 recognized post-
                 secondary
                 educational
                 credential.

Eligibility      First two years        All years of post-
limitations      (four years for 2009   secondary education,
                 and 2010) of post-     graduate, and
                 secondary education    professional school.
                 for any one student.   No degree
                 Degree requirement     requirement No
                 Felony drug            felony drug
                 conviction             conviction
                 restriction At least   restriction No
                 half-time              workload
                 attendance.            requirement.

Credit           For payments covering an academic period
available        beginning in the same calendar year as
                 the payment is made.

                 Exception: for payments made during the
                 calendar year to cover academic period
                 that begins in January, February, or
                 March of the following taxable year.

Coordination     Expenses excluded from gross income
with other tax   under employer-provided educational
provisions       assistance plan cannot be used in credit
                 base.

                 Expenses claimed for the credits will
                 reduce the amount of expenses eligible
                 for Section 135 exclusion (U.S. savings
                 bond interest used to pay for higher
                 education). No credit if tax-free
                 distribution from Education Savings
                 Account (ESA) or Qualified Tuition Plan
                 (QTP) in tax year unless student waives
                 the tax-free treatment of the ESA or QTP
                 and pays tax on ESA or QTP distribution.

Payments         Includes payments made with student's
included         earnings, loan, gift, inheritance,
                 savings (including savings from
                 qualified tuition program (QTP).

                 Does not include payments made with Pell
                 Grant or other tax-free scholarship,
                 tax-free distribution from an ESA, or
                 tax-free employer-provided educational
                 assistance.

Figure 10.10

FEDERAL LOAN PROGRAMs (As OF SUMMER 2009)

                Subsidized/
                unsubsidized   Eligibility

Direct          Subsidized     Financially
and FFEL                       needy student
Stafford Loan

Direct          Unsubsidized   Student--
and FFEL                       Not awarded on
Stafford                       basis of financial
Loan                           need

Direct          Unsubsidized   Creditwor-
and FFEL                       thy parent,
PLUS                           co-signed, or
Loan                           extenuating
                               circumstances

Federal         Subsidized     Undergraduate
Perkins                        and graduate
Loan                           students--with
                               financial need

                                      Interest
                Limits                rate

Direct          * Dependent:          * New loans:
and FFEL        Frsh: $5,500          fixed 5.6%
Stafford Loan   Soph: $6,500          (2009-2010)
                Jr/Sr: $7,500         4.5% (2010-
                * Independent:        2011)
                Frsh: $9,500 (max     3.4% (2011-
                $3,500 subsidized)    2012)
                Soph: $10,500         * Earlier loans:
                (max $4,500           variable,
                subsidized)           91-day
                Jr/Sr: $12,500        T-bill +
                (max $5,500           2.3 points;
                subsidized)           Cap: 8.25%
                * Grad student:
                $20,500/year (only
                $8,500 subsidized)

Direct                                * New loans:
and FFEL                              fixed 6.8%
Stafford                              * Earlier loans:
Loan                                  Same as
                                      subsidized
                                      Stafford Loan

Direct          Up to the full cost   * New loans:
and FFEL        of attendance less    Direct-
PLUS            other financial aid   fixed 7.9%
Loan                                  FFEL-
                                      fixed 8.5%
                                      * Earlier loans:
                                      variable,
                                      91-day
                                      T-bill +
                                      3.1 points;
                                      Cap: 9%

Federal         Undergrads: up        5%
Perkins         to $4,000/yr.;
Loan            $20,000 total
                Grads: up to
                $6,000/yr.;
                $40,000 total

                Payback

Direct          Six mos. after
and FFEL        graduation, leaving
Stafford Loan   school, or dropping
                below half-time
                enrollment

Direct          Same as
and FFEL        subsidized
Stafford        Stafford loan
Loan

Direct          * New loans:
and FFEL        deferral option
PLUS            * Earlier loans:
Loan            Repayment begins 60
                days after payment to
                college; interest-only
                option during college
                years

Federal         Nine months after
Perkins         graduation, leaving
Loan            school, or dropping
                below half-time status
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Title Annotation:FINANCIAL PLANNING
Publication:Tools & Techniques of Financial Planning, 9th ed.
Date:Jan 1, 2009
Words:28837
Previous Article:Chapter 9: Financial goals--current lifestyle.
Next Article:Chapter 11: Retirement issues.

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