How High-Income Families can Combine College Funding and Retirement Planning
Today, more and more high-income parents are having children later in life. The reason for this decision is often to pursue a career and first become financially sound; however, this decision can come back to haunt these late-bloomers when they eventually face a double-whammy: college and retirement.
The decision to delay starting their families has left many couples with only six to twelve years to save for retirement after their youngest child graduates from college. When you consider that today’s college costs can range anywhere from $30,000 to $60,000 per year, per child; it is clearly evident that the high costs of college can place a tremendous burden on a high-income family’s ability to fund both college and retirement.
Furthermore, the actual “true cost” of college for a high-income family is considerably more than the “advertised price.” Because college costs are paid using after-tax dollars, the amount that must be “earned” to cover these costs is much more. A high-income family in the highest tax bracket can pay almost 50% in income taxes, which means that the family must earn twice the amount of money that they pay to the college.
The colleges do not help much, either. While colleges do offer financial aid subsidies to some families, high-income families are usually expected to absorb the entire college-cost burden. But that’s the bad news; the good news is that college is big business and colleges would much rather market to high-income families. Statistics show that students from high-income families are more apt to successfully earn a college degree, which equates to charitable donations to the college’s endowment coffers. Colleges have also begun hiring “enrollment management specialists” who market heavily in high-income zip codes in order to maximize the college’s tuition cash inflow and minimize the financial aid outflow.
Although there are few financial aid benefits available to the high-income family, there are some little-known tax strategies related directly to education which can provide additional cash flow for college expenses. While many of the new tax credits like the “American Opportunity Tax Credit,” “Lifetime Learning Tax Credit,” and the “Student Interest Deduction” have middle-income phase-outs, there are also overlooked strategies in the present tax code which can benefit education.
Here are two examples of simple techniques to increase cash flow for college expenses:
CASE #1 – For the highly-compensated executive, companies can provide a source of college funds for their key executives through a special deferred-compensation plan, which can be done without the business providing any additional funds.
Companies with deferred-pay plans can simply amend their payment timing rules. The amendment allows executives to tap their deferred pay account not only at retirement or separation from service, but also to pay for a child’s college costs. Under the amended plan, the company defers a percentage of each executive’s pay into a “rabbi trust” (subject to the claims of the company’s general creditors). A plan participant gets enough, and no more, of his deferred pay to meet the child’s college costs.
The amendment in the company’s plan allows the executive to avoid all penalties for early withdrawal from the deferred account to pay college costs. The executive receives a firm commitment from his company to pay all of his child’s college costs (up to the amount in his account), and yet he owes tax only as he actually withdraws the money from the trust to pay the college expenses. The company can also take a tax deduction for the payments.
There is a potential problem if the executive does not need to withdraw funds from the plan to pay for college costs. Although he has not taken any money from his account, he could have taken the money. Therefore, he may be in constructive receipt of (and owe tax on) the amount he could have withdrawn but did not. This is very similar to zero coupon bonds. In this case, there is a simple solution to this potential problem: the company could simply amend its deferred payment plans so that the executive can take pay out of college costs only by showing financial need. An executive that needs the money for college can get it, while another executive that does not need the money can leave it in the plan until separation or retirement and avoid current taxation.
CASE #2 – For the self-employed businessperson, there’s the Educational Assistance Program. This program will allow the employer a tax-free fringe benefit of up to $5,250 for each qualifying employee by establishing an Educational Assistance Program (IRC 127). The courses need not be job-related and benefits cannot exceed $5,250 per employee for a calendar year. The advantages of these programs can be substantial for both the employer and employee and are as follows:
- The employer and employee are not responsible for any payroll taxes on this type of employee compensation.
- The employee does not need to report the amount of educational assistance as income on his/her tax return.
- The employer does not have to fund this program, as is the case in other types of employee benefits.
- The employer receives a current tax deduction for the education assistance paid.
Business owners may be able to provide this fringe benefit to their children if they employ them in their business. In order to qualify for this fringe benefit, the following tests must be met: (1) The child must be age 21 or older; (2) The child must be a legitimate employee of the business; (3) The child must not own more than 5% of the business; and (4) The child must not be a tax dependent of the parental owner.
If the self-employed business owner meets these stipulations, he may be able to write off one or two years of college costs, or $5,250 to $10,500. These are significant savings!
However, there are some specific IRS regulations which must be followed in order to qualify for this benefit. Therefore, the financial advisor should thoroughly understand these regulations or the family must engage the services of a financial professional who does understand these regulations.
These are just two of the many education-oriented tax strategies that high-income families can use to reduce taxes and increase cash flow to help pay college expenses. It requires only advanced planning with a dedicated financial advisor who is knowledgeable of college financial planning.
There are also unique academic strategies which can lower the cost of college. Many grants, scholarships, and tuition-discounts are available to high-income families through proper positioning and negotiation. The following is a list of the “Top 10 Things to Do” to maximize the student’s college success while helping to lower costs:
- Apply for admissions early to properly position the student for possible grant money.
- Apply to 6 to 8 colleges to maximize your financial opportunity through negotiation.
- Apply to private colleges, as many offer tuition-discounts in order to compete.
- Apply for financial aid, as some colleges require this for scholarships and student loans.
- Prepare for ACT/SAT tests, as top scores can increase grant and scholarship opportunities.
- Investigate a career path, as lack of planning often forces students into a 5- or 6-year degree.
- Diligently investigate each college to ensure that it fits with the personality of the student.
- Do not be afraid to negotiate the price, as private colleges must compete for good students.
- Discuss cost-limitations as a family before differences occur between college choice and cost.
- Consult with a Certified College Funding Specialist (CCFS®) who can help you link your college funding and retirement planning.
College costs can place significant burdens on high-income families’ retirement plans regardless of how much money they earn. And, regardless of income, there are many opportunities for families to reduce the high costs of college if they do not put off the inevitable. Plan ahead!
If you need a college funding gameplan for your family, give me a call at 404-477-1772 or schedule a 20-Minute chat.
We may be able to save your family considerable money on your college expenses.