YOUR TAXES : PART THREE: INVESTING, SAVING, SPENDING : Couples get a jump on plans for their children’s college : New rules on taxing parental gifts income call for a different course
Kate Kosco is only 3 months old, but already her parents are starting to plan for her college education.
“If this was last year, I would be looking at income stocks,” said Kate’s mother, Sarah Stack, a securities analyst with the Los Angeles investment house of Bateman Eichler, Hill Richards. The new tax legislation has changed her thinking. “Since she’s now taxed at our rate, we’re putting money into tax-free municipal bonds,” she said.
Stack isn’t alone among parents who are looking for new ways to save for college. A revision in the tax code that changes the way children are taxed is forcing many parents to examine their financial plans for college, experts say.
Children used to be ideal tax shelters. Parents in high tax brackets could shift income to their children, where it was taxed at the children’s low rate. But the tax revisions have eliminated most of the advantages of shifting income to children who are under age 14.
Now investment income in excess of $1,000 is taxed at the parent’s rate. Under the new rules, the first $500 in investment income isn’t taxed and the second $500 is taxed at the child’s rate, normally 15%.
For example, for a child who receives $2,000 in investment income, the first $500 isn’t taxed, the second $500 is taxed at the child’s rate and the rest, or $1,000, is taxed at the parent’s rate.
This means upper-income families are looking for investments that defer taxes until the child reaches age 14, when the income will be taxed at the child’s lower rate. Gregory P. Kushman, director of executive financial services at Price Waterhouse & Co., says the new tax law means that parents with younger children should consider different investments from those of parents with older children.
Kushman says that parents with children age 14 or older should look to taxable securities with high yields, such as corporate bonds. These securities should also have a certain degree of security, since the children will be ready for college in just a few years.
Parents with children under 14 might want to consider investments that aren’t fully taxable, such as U.S. government securities and municipal bonds, he says.
Colin B. Coombs, a financial planner with Petra Financial Group in Woodland Hills, says he is advising parents to “shift to tax-deferred or low-tax instruments when a child’s portfolio is producing income over $1,000. When a child reaches 14, you can shift back to taxable instruments.”
This year, for example, Coombs says he is telling clients who have set aside investments for their children to sell income-producing securities, such as corporate bonds, and reinvest the proceeds in growth stocks that pay no dividends, since these stocks aren’t taxable until they’re sold.
Some tax advisers suggest U.S. savings bonds for children under 14. Federal tax isn’t paid on the accrued interest until the bonds are sold, and the bonds are completely exempt from state and local taxes. Bonds normally mature in 10 years. David S. Rhine, a tax partner with the accounting firm Seidman & Seidman/BDO, says the bonds are also attractive because their interest rate is automatically adjusted to keep pace with market rates, yet they can’t fall below 6%.
Coombs, who is chairman of the Institute of Financial Planners, recommends an investment in growth stocks because they can be sold after the child reaches age 14, when the gain is taxed at the child’s lower rate.
But some financial advisers caution that a portfolio of growth stocks requires close attention since a drop in stock prices can erode or even wipe out an investment. Coombs suggests that parents select a mutual fund with a good track record rather than try to pick the stocks themselves.
Rhine says that municipal bonds, which are tax-exempt, are also a good investment for children under age 14 if the parents are in a high tax bracket. “If it makes sense for the parents, it makes sense for the child,” he said.
Stack says she and her husband, Keith Kosco, a lawyer with Morgan, Lewis & Bockius, are in the top income tax bracket, and so municipal bonds make sense for them and for their daughter. But she is also investing college funds in growth stocks and blue chip corporate stocks. She says she expects gains in growth stocks to keep pace with inflation, while the blue chips offer a fairly secure investment and the promise of a higher return than municipal bonds.
“We’re choosing a balance of investments for her,” she said. “The municipals provide an element of certainty; the growth stocks are a hedge against inflation, and the blue chips are in the middle.”
The pitfall of her investment strategy is that it requires a good deal of attention. If the stock market slides, the investments could rapidly lose their value. “There is a lot of housekeeping involved,” she said.
The tax revision has dealt a death blow to Clifford trusts and other vehicles used by upper-income families to save for a child’s education. The Clifford trusts were popular because a parent in a high tax bracket could put securities in a trust for a child and have the income produced by the securities taxed at the child’s lower rate. After 10 years, the parent could take the securities back, so there was no danger of the child using the money to buy a Porsche instead of going to college.
Congress removed the advantages of these trusts by making the income taxable at the parent’s rate. Trusts that were established before March 1, 1986, are exempt from the new rule, although income produced by assets put into the trust after that date are now taxed at the parent’s rate.
The new tax code requires parents to get Social Security numbers for children age 5 or older to claim them as dependents on their income tax returns. Congress adopted this rule to cut down on the number of people who claimed deductions for non-existent children. The rule is also intended to prevent a divorced couple from claiming the same child on their individual returns.
Not everything has changed, however. A child’s earned income is taxed at the child’s rate, regardless of age. This means that if a child under age 14 earns more than $1,000 from working at the family business, that income is taxed at the child’s rate. “Parents don’t have to worry about getting their kids a job,” Rhine said.
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