August 15, 2021
What springs to mind when you think about saving for college (besides saving enough)?
529 plans.
529 plans are ubiquitous in the world of college planning, and for good reason—gains and qualified distributions are tax-free. Some states even provide tax deductions for regular contributions.
But 529s aren’t the only way to save for college, especially for business owners.
Business owners have several opportunities that W2 employees simply don’t—setting their own hours, unique tax deductions, plus additional savings options for their kid’s education.
On top of saving for your retirement and other goals, business owners also have to take the lead in saving for their kid’s education.
How can business owners save for college smarter?
Hire Your Child
It’s never too early to imbue your child into the family business. Not only will the experience make for an excellent resume builder, but it could also save you a pretty penny on your taxes.
By hiring your child, you can write off their earnings, saving you on your tax bill and leaving more margin to save for school. Wages for workers under 18 also aren’t subject to FICA or Medicare tax. You may have an opportunity to sidestep state and federal taxes, depending on what they earn.
Whether or not your child will have to pay taxes depends on if the salary exceeds the standard deduction. The Tax Cuts and Jobs Act of 2017 set the standard deductions through the roof, resting at $25,100 for Married Filing Joint and $12,550 for Single in 2021.
The key?
Ensure you’re paying your child a reasonable salary, so the IRS doesn’t flag you. To do that, give your child a healthy list of responsibilities like filing, cleaning, computer work, administration, etc., and put them on the payroll.
You must also comply with all legal requirements, such as filling out a W-4, Form I-9 and record your employee’s social security number.
Your child can also use some of their earnings to save for school!
Also, if you have fewer than 100 employees, you don’t have to count your business income on FAFSA.
Consider an Educational Assistance Plan
You’ve likely heard about larger companies that offer education assistance as a benefit. In 2014, Starbucks started offering full tuition reimbursement for bachelor’s degrees to qualifying full and part-time employees, for example.
But these benefits aren’t reserved for big names; your business could consider creating an educational assistance plan to sponsor your employees’ education. You can fund upwards of $5,000 per student per year, and the funds count as a business expense.
The catch? You need a written plan, and you must offer the plan to all employees. You can’t cherry-pick who you’ll allow to participate in the program. Since you must include all qualifying employees, it could end up costing you more than it helps.
There are some additional rules you should be aware of concerning qualifications:
- Employees must work more than 500 hours in a calendar year.
- According to Section 127 of the internal revenue code, a business can exclude $5,250 of the gross income of educational assistance to an individual in the calendar year.
- You need to be aware of the expenses deemed “qualified,” which are often tuition, fees, books, supplies, equipment, etc.
You must completely understand all the rules and intricacies before establishing a plan like this. Work with your financial team and tax professional to see if an education assistance plan could benefit you, your child, and your company long-term.
Establish Automatic 529 Contributions
It’s nearly impossible to talk about college savings without mentioning 529 plans. 529 plans are state-sponsored, tax-advantaged education investment vehicles. You fund the account with after-tax dollars, earnings grow tax-free, and qualified education expenses like tuition and books remain tax-free.
There are two general categories of 529s:
- Pre-paid tuition plans
- Education savings plans
Pre-paid tuition plans allow you to “pre-pay” future college costs for qualifying public and private schools at today’s tuition rates. But, the most popular is the education savings plan. An education savings plan operates like a traditional investment account, and you can use the balance for tuition, supplies, etc., at any qualifying institution.
How can you strategically fund a 529 account?
- Automate monthly contributions. Once you have a reasonable savings goal, you can automate regular savings month to month. Investing $500 a month with 18 years to compound could yield a healthy bounty.
- Contribute a lump sum. 529 plans offer the ability to front-load 5-years of gift tax contributions, averaging about $75,000 per beneficiary. A married couple filing jointly could double that number to $150,000!
Another benefit, thanks to the SECURE Act, is that beneficiaries can withdraw up to $10,000 tax-free for student loan repayment. Parents can also withdraw up to $10,000 for K-12 expenses. Any earnings not used for qualified education expenses are subject to a 10% penalty.
What if the current beneficiary doesn’t use all the funds in the account? You can change the beneficiary without incurring any income tax consequences. But, doing so could trigger the Generation-Skipping Transfer Tax (GST) if the new beneficiary is 37.5 years younger than the donor.
Gifts made to a “skipped” person, typically a grandchild, are subject to a flat 40% in additional gift taxes. The GST can get complicated, so be sure to check with your advisor and tax professional.
Consider a Roth IRA
You can use Roth IRAs for more than just retirement. You can take out funds without penalty for qualified education expenses. There are a few ways you could take advantage of Roth IRAs.
First, your child could open a Roth IRA and contribute some of their earnings into it to save for school.
Second, you could withdraw contributions (not earnings) from your account to cover some of the bills. Watch out because Roth distributions count as income on FAFSA, which could jeopardize future eligibility for scholarships.
While most business owners exceed the income limits to directly contribute to a Roth IRA (and make deductible contributions to a traditional IRA), backdoor Roth conversions could be an option. But going down this route opens up its own can of worms, namely the pro-rata rule, the IRS system to determine how much of the conversion will be taxable.
The pro-rata rule comes into play when you have deductible and non-deductible dollars in a traditional IRA that you want to convert to a Roth. The formula is relatively straightforward.
First, take the total amount of after-tax money in all IRAs and divide it by the total value of all IRAs. Then, multiply by the amount you’re converting. Voila!
Look Into A Custodial Account
A custodial account is an investment vehicle that is established and controlled on behalf of a minor. There are two types of custodial accounts,
- Uniform Gift to Minors Act (UGMA)
- Uniform Transfer to Minors Act (UTMA)
Both allow diverse investment options like stocks, bonds, property, and more. A UTMA also permits investing in art, collectibles, and other property. These accounts are flexible, as you can contribute $15,000 tax-free per year (per the current gift tax exclusion limit), and there is no distribution schedule.
Custodial accounts come with tax benefits. The first $1,050 in earnings is tax-free, and the next $1,050 in earnings is subject to kiddie tax rates. Any earnings over $2,100 are subject to the parent’s tax rate.
The tricky part? The funds technically belong to the child, so once they reach a certain age (as flexible as 21 in Delaware), they can use the money on anything—school or otherwise.
Create A Unique Strategy for You
Business owners have a wealth of financial opportunities. It’s all about matching your financial strategy with your goals and vision for the future.
If saving for your child’s education is a critical goal for you, our team will work with you to create a savings plan that works for you and your business. Unlike W-2 employees, business owners have several more tax opportunities like deductions and credits, which can get confusing.
With such a momentous savings goal as education, it’s paramount to work with a trusted team who can help ensure you’re taking the proper steps to reach your goals.
While juggling business and personal finances can be tricky, our team is positioned to help you effectively prioritize your goals and keep your money working for you.
Set up a call to learn more today!