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Woulda, Coulda, Shoulda
Financial Planning for your Child

Preparing for your child’s educational needs should not be put off for more than a few months after your baby’s birth. Those of us who have now entered the college paying years can testify to the need for early planning.

College costs keep sky rocketing. Those of us who paid $2,000 to $3,000 per year for tuition, room and board in private colleges in the 60’s are now paying $35,000 to $40,000 for our children. In 18 years the cost of four years in a public college is expected to cost $100,000.00; a private school, over $200,000.00. What’s a parent to do?

I. What You Can Do

In order to qualify for government loan programs and many private scholarship awards you must have a combination of need, poverty and sharp planning. Families who acquire wealth will be severely affected if they are not mindful of the traps for individuals with some means beyond Federal FAF poverty definitions.

Here’s what you can do to prevent you and your children from being disqualified for these programs:

1. You can usually increase the financial aid your child gets by filing an advantageous application. Like an honest tax return, using the application to your advantage violates no law or ethical principle.

2. Be careful about putting savings or investments for college expenses in your children’s names. Your child is in a lower tax bracket than you are, so you can save taxes by investing in your child’s name instead of your own. But consider this: under the federally legislated aid formula, the required family contribution to the child’s education must include only 2.6 percent to 5.6 percent of the parents’ assets per year. That means the bulk of most families’ wealth is never counted against them. But students are expected to spend up to 35 percent of their assets each year. Conduct a family accounting and estimate what you stand to save on taxes by investing in your child’s name, compared with what you would lose in college aid.

3. Adjust and reposition your assets to minimize your wealth as measured by the aid system. In surveying your net worth, the system recognizes some forms of wealth as assets but not others. Bank accounts, stocks, bonds and mutual funds count against you, but the cash you accumulate in most retirement funds, insurance, and annuities does not. Some financial planners, therefore, advise clients to move part of their investments into universal life or deferred annuities a few years before a child is ready for college. But be careful. If you later need to take this money out to help pay for tuition, you’ll owe taxes and possibly penalties on the withdrawals. That situation may change in the future. The FAF and institutional forms now ask how much you’ve contributed to your 40l(k) plan in the most recent year. However, you might be able to borrow from those funds for college.

4. One sure fire way to set aside family wealth and prevent negative treatment is by setting up family assets within limited partnerships and family limited partnerships, with or without the use of a new vehicle called the Limited Liability Company.

Because you have the inability to liquidate and sell your shares in a partnership at will, the minority ownership rule severely reduces their value. A family partnership is not excluded from this treatment generally.

If you are going to set aside assets and look for long term growth to fund your children’s education, you should be investing time and money with your tax and legal advisors to set up vehicles which will give you the maximum benefit when addressing college grants and loans. The object for your family college plan should be to have the most assets stored away with the least amount of personal value attributed to any one individual in your family.

II. What The Government Thinks Will Help You or The "We’re Here To Help You" People

The much-touted Taxpayer Relief Act of 1997 made it easier to put your kids through school. Or did it? Look closely at changes to the tax law and some of the benefits start looking less beneficial. You need to understand the changes to use them to your advantage. The act has three primary components:

· New education IRAs;

· Penalty-free withdrawals from IRAs for education; and

· Tax credits.

Education IRAs (EIRAs)

Good side: Of all the reforms, EIRAs offer the most help to middle-class parents. They allow families to contribute up to $500 per year per child to an IRA earmarked for higher education. Although contributions aren’t deductible, the distributions, including earnings, are tax-free if used to pay for qualified educational expenses.

Eligibility requirements are relatively loose. A married couple filing jointly must have an adjusted gross income (AGI) of less than $150,000 and an individual an AGI of less than $95,000. However, a married couple filing jointly still qualifies for a reduced contribution if their income is between $150,000 and $160,000; and an individual qualifies for a reduced contribution if his or her income is between $95,000 and $110,000. Although distributions not used for higher education are subject to a 10 percent penalty, any unused money in the account may be rolled over tax-free to another Education IRA benefiting another child or grandchild.

Bad side: Let’s say you open up an Education IRA as soon as junior is born and put in the maximum $500 per year until day one of college. Assuming an eight percent annual return, you’ll only have accumulated about $20,000 when college begins. In 18 years, assuming five percent inflation, that will cover about half a year at the average private school.

Penalty-Free Withdrawals From IRAs for Education

Good side: You can now make penalty-free withdrawals from both traditional IRAs and Roth IRAs as long as the money is used to pay for education expenses. Eligible expenses include college or graduate-level courses for yourself, your spouse, your children, or your grandchildren. Regular income taxes, however, still apply.

Bad side: First, it boosts your income, which reduces the amount of financial aid you’ll receive. Second, you have to pay taxes on the investment earnings. That’s a tax you would have avoided if you’d waited until retirement to withdraw the money from a Roth.

Tax Credits

Good side: At first blush, the following credits seem like a boon to parents. The HOPE credit is designed to make community college as accessible as the first twelve years of school; it offers a $1500 tax credit per student per year for the first two years of post-secondary school. Specifically, it refunds 100 percent of the first $1,000 of tuition and fees and 50 percent of the next $1,000.

The Lifetime credit picks up where the HOPE leaves off. It covers both the final years of undergraduate and all the years of graduate education. It gives you a nonrefundable tax credit of up to $1,000 per year (20 percent of college expenses, up to $5,000). In 2003, the maximum credit will be bumped to $2,000 (20 percent of college expenses, up to $10,000). Nevertheless, a family can take only one Lifetime credit per year regardless of how many children are in college.

Bad side: You can’t take advantage of these credits in any year you withdraw from an EIRA. Also, qualifications are more stringent than those for the EIRA. The credits start phasing out at $80,000 for couples filing jointly and $40,000 for singles.

Ugly side: Most families won’t benefit from the credits. Schools will simply take the credits into account when calculating financial aid and assume families can afford to pay more. If you receive a credit of $2,000, your financial aid will likely shrink by the same amount.

If you take the time to plan now and seek competent legal and accounting advice, you will be rewarded with maximum benefits for each of your children at the college steps.

Note: All advice contained herein should be reviewed with your independent accountants and attorneys to determine how it affects your family’s individual situation.

Roy De Barbieri is an attorney at the Law Firm of De Barbieri & Associates, New Haven, where he specializes in family asset planning and the transition of family businesses.

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