Tax breaks to get your youngster through Yale

By Jeff Schnepper

Think you can find another use for the more than $200,000 it's going to cost you to put your newborn through college, or the $120,000 you're about to spend on your smiling freshman? How'd you like to have the IRS foot a good part of your college bills? Welcome to Schnepper's School of Scholarly Solutions for Education Problems.

Let's start with the ethics lesson. Our tax code is designed for more than just raising revenue. It's structured to achieve desired social goals. We want to encourage charity. So, the tax code lets you deduct your donations from your income taxes. It's also meant to help the economy. The home-mortgage interest deduction most assuredly stimulates the housing industry, and I don't hear you saying you won't take the interest deduction.

So don't be reticent about enjoying the benefits offered by our tax system.

Now, to the solutions:

If you have a young child

If you have a very young child, start now on saving for education expenses, but do it the tax-smart way. The simplest way is to invest in your kid's name. You can open a Uniform Gifts to Minors Act (UGMA) account in the child's name and have the income taxed at the child's marginal tax bracket, rather than yours.

Kids under age 18 are taxed under the kiddie-tax rules. Starting in 2008, the kiddie tax was expanded to include dependents under age 19 and dependent full-time students under age 24. But if the child’s unearned income is less than $1,800, the kiddie tax doesn't apply. Only unearned income in excess of that amount is subject to your higher rates. Their standard deduction, which is $5,450 for 2008 ($5,700 for 2009), is limited to the greater of either $900 or the child's earned income plus $300. Earned income is money generated from work -- things like wages, fees, salary and commissions. Unearned income includes interest, dividends and rents.

So, if your 2-year-old son has interest income of $900, the tax on that is zero. The next $900 is taxed at his 10% rate. If he had income of $1,800, and you're in the 28% bracket in 2008, the tax on the $1,800 total would be $504. Your son is paying only $90, so you've just saved $414 more for his college education. Over 16 years at a 10% rate of return (assuming there aren't many tax law changes), that's more than $18,250 added to the college fund.

Once your kid hits 24, the kiddie tax goes away. For 2009, each of your kids can earn as much as $8,350 that's taxed at 10%. Another $25,600 is taxed at 15%. (Above $33,950 in taxable income, your child jumps to the 25% bracket.)

Owning your business has its rewards

If you're self-employed, there are more avenues of tax savings available. Hire your kids! You can pay a child as much as $10,700 in 2009 with the child paying zero tax on those dollars. His standard deduction shelters the first $5,700, and a traditional IRA shelters the rest -- the contribution limit is $5,000 this year. (I should note that a non-deductible Roth probably would be better in the long term). You deduct the wage you pay in your bracket, and the kid pays no tax. If you're paying your own child, and you're not incorporated, you don't need to pay Social Security, Medicare or other payroll taxes.

The courts have validated hiring a child as young as age 7. If you're in the 28% bracket and subject to self-employment taxes totaling 15.3%, the wages paid to your kids yield a 43.3% tax savings -- not counting any state or local taxes.

If you pay your 7-year-old deductible wages of $10,700, you save $4,633. Start at age 7 and by the time he's 18, if the money's been invested at 10%, you've accumulated more than $107,600 from tax savings alone, not to mention the $10,700 earned each year.

Don't forget the education IRAs and credits

We're not done yet. Have you considered a Coverdell account? They let you set aside up to $2,000 per year per child. You get no deduction, but, as long as the dollars are used for qualified education expenses, before your kid reaches age 30, withdrawals from the account can be made tax- and penalty-free. Coverdell dollars can be used for primary and secondary school expenses, as well as for college costs. (After 2010, however, the contribution limit is scheduled to fall to $500, with K-12 costs excluded.)

Continued: Use Section 529 plans

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