How One Family Cut the Cost of College by $30,000 – A Capstone Case Study
By Joe Messinger, CFP®
April 1, 2016
At Capstone, our advisors sit with families every day to discuss their unique situations. One of the things we love about good financial planning is there is no one size fits all cookie cutter solutions. Solutions are highly personalized based on your goals and your resources. Sometimes we have a client whose situation may be similar to yours, and who we can learn from in the form of a case study.
A recent family came to us with a good problem; they had resources at their disposal and could afford basically all the schools that are out there. They’ve done well financially and were able to save. They also have parents who want to help pay for their grandchildren’s college educations. Their situation brings up many facets you can learn from including tax considerations, loan payments, and grandparent’s estate planning.
We frequently caution families not to run out and implement everything they read, even if it comes from us. Why? An effective strategy for one family may be catastrophic for another depending on their circumstances. Consult your financial and tax professionals to see how these strategies may impact your situation.
The Smithers (alias to protect the innocent) family has two children, and they make about $170,000 in salary per year. Lucky for them, Grandma has committed to paying $15,000 per year towards the cost of college for each child. They can afford to simply write the check to pay for college, but maybe there is a better way. Maybe bringing a little more strategy to the process will give you opportunities that you may be missing.
In this case, the eldest student, Bart, had already started college at a state university. After scholarships, his net cost to attend was right around $15,000 per year. So the funds from Grandma were enough to pay for all the tuition, room & board. In addition, the parents used some 529 plan assets to fund some additional costs for supplies, books, and things like that.
Fast forward to their meeting with Capstone, Bart is in his sophomore year. We reviewed two years of tax returns and discovered the family had not taken advantage of the American Opportunity Tax Credit, an IRS tax credit for qualified expenses up to $2,500 per year paid during the first four years of undergrad for college. With an adjusted gross income of about $150,000, they should have qualified based on that income for the full $2,500 amount. Here’s how it works:
- The amount of the credit is 100 percent of the first $2,000 of qualified education expenses you paid for each eligible student and 25 percent of the next $2,000 of qualified education expenses you paid for that student. So, if you spend $4,000 on qualified education expenses, you will receive a $2,500 tax credit.
- To claim the full credit, your MAGI, Modified Adjusted Gross Income, must be $80,000 or less ($160,000 or less for married filing jointly).
- You receive a reduced amount of the credit if your MAGI is over $80,000 but less than $90,000 (over $160,000 but less than $180,000 for married filing jointly).
- You cannot claim the credit if your MAGI is over $90,000 ($180,000 for joint filers).
So why didn’t they qualify for that credit on their taxes? Because college was paid for with Grandma’s money supplemented by the parent’s 529 money. (BEWARE!!! 529 dollars cannot be used to qualify for the American Opportunity Tax Credit. Doing so would be considered double dipping because you’ve gotten tax-free growth with the 529 plan.) For the past two years, Grandma has sent money directly to the college, and the parents have missed out on the $2,500 tax credit each year.
They are certainly lucky to have the resources to pay for college, but the reality is if they had coordinated with Grandma and used $4,000 of the parent’s own money from their checking and savings or other investment accounts, they would have qualified for the $2,500 tax credit. Think in terms of return on investment. If you were to invest $4,000 and a year from now you would have earned $2,500, that equates to a 62.5% return on investment! You have to agree that is a pretty good return on investment. If you take that strategy even further, four years from now, they would have given up $10,000 in tax credits following their prior plan.
Going forward they are going to have two students in school. Bart will be a junior next fall, and their youngest, Lisa, will be a freshman. Continuing with their previous plan of Grandma paying for most of the bill and 529 plan assets paying for the rest, they would have missed out on potentially eight years of tax credits totaling $20,000!
Often families think that their tax professional will make them aware of potential tax savings. There is a big difference between tax planning and tax filing. In most cases, CPAs do their job—you give them information, they report it accurately, they give you your tax returns and tell you where to sign. Many are simply tax filers, and they are not doing any tax planning. Don’t take for granted that someone doing your taxes is doing anything above and beyond what you tell them. Don’t be afraid to look a little bit deeper. Don’t be afraid to have your taxes audited because in this case we are talking $10,000 per student, or $20,000 for both, that they would have been giving up. A little more careful coordination of what resources to use can lead to a huge windfall–money that they wouldn’t have had. This $10,000 can be sitting in an account for your kids when they graduate.
Another aspect of this family’s situation that we often see deals with gifting from affluent grandparents. Over the years, grandparents have gifted money, and maybe their grandchildren have what is called UTMA accounts (Uniform Transfers to Minors Act). Money in these accounts can be invested in a variety of instruments including stocks, bonds, and mutual funds and may have appreciated quite a bit. Maybe they were started with $5,000 when the child was born, and now 17 years later the account is worth $25,000. The appreciated amount is a huge gain of $20,000. You will want to be sure you are utilizing the student’s tax capacity each year to withdraw funds from the account.
The tax code contains a kiddie tax provision. In 2016, a student is allowed $1,050 gains without tax. The second $1,050 is going to be taxed at the student’s tax rate. Anything above $2,100 is going to be taxed at the parent’s tax rate. Essentially, your student can have $2,100 in unearned earnings per year and pay no capital gains at the parent’s tax rate on that amount.
A well-staged plan will have you taking out money from the account slowly each year. You don’t have to wait for them to be in college to begin this process. This is a tax strategy. If you do wait for college and you liquidate the account slowly over a four-year period, you can avoid paying capital gains on $8,400—multiply that by multiple children. Our case study family paid capital gains tax at the parents rate on $10,000 of gain they liquidated all at once. ($10,000 x 15% Tax = $1500) If you think about what you are doing a little more surgically, you can evaluate how to better coordinate all your resources to work together.
The last piece of the puzzle and an overlooked resource for affluent families is the utilization of Stafford loans in the student’s name. Our case study family didn’t see the need to take out student loans. And yes, they do not NEED them because they have the resources to pay, but maybe they WANT them. What do we mean? Everyone qualifies for Stafford loans. In our family’s case, at some of the schools they were looking at, they even qualified for the subsidized version of the Stafford loan. With a subsidized loan, a student can borrow up to $19,000 over the four years of college and pay zero interest on that money while they are in college. By taking out the subsidized Stafford loan, you can continue to keep your money invested for four years and simply pay off the loan either at the end of each year or at graduation. (Be aware that there is a small origination fee of 1.058% when you apply for the Stafford loan.)
Before we leave this topic, we want to focus on an aspect of estate planning for grandparents that we don’t want to gloss over. One of the big benefits grandparents receive by paying for college directly to the university is that their payment does not count into their annual gifting exclusion (in 2016, the gifting cap was $14,000). Often grandparents are working on estate planning, and their advisers suggest they give $14,000 outright to their grandchildren. In addition, they can pay additional dollars directly to the university, and those dollars do not even hit the annual gifting exclusion.
This aspect of grandma’s estate planning certainly needs to be considered. However, when we talk about the coordination of all these things—taxes, loans, estate planning–we have to consider what is in the best interest of everyone. We are dealing with tri-generational planning. We’ve got 5 different tax capacities—grandma, mom, dad, and 2 kids. Five tax situations that can be utilized to create a comprehensive plan to ultimately pay less for college.
Very little of all this has to do with financial aid. High EFC families should focus on coordinating things for the most personal benefit. Take advantage of tax and loan strategies available to you. Ultimately put more money in your pocket by utilizing all the tools and don’t just write the check. Think about all the levers you can pull to create a good plan.
When you are talking about two children with eight years of college ahead, you can realize a tremendous benefit to being a little more strategic. In our family’s case, they will save somewhere between $30,000 and $40,000 in taxes by using a coordinated plan. Many good advisers with good intentions are not doing this work because they simply do not know how all the triggers and levers can work for you. Bottom line, pay as little for college as possible and leave no stone unturned.
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