College planning: shake hands with the taxman.

• Author: Samson, William D.
• Position: Personal Financial Planning

One of the greatest financial planning challenges you'll ever face is funding your children's college education. Even high-income parents are frequently astounded by the astronomical costs. After you recover from the sticker shock, you might want to know that tax planning is an often-overlooked technique for funding your children's college education. For instance, before the 1986 Tax Reform Act, many high-income parents shifted some of their income to their children to maximize the family's after-tax income. TRA '86 dramatically reduced the top individual tax rate and introduced the "kiddie tax rules," which discouraged income-shifting.

But 1993 tax increases have brought us full circle. The current top federal tax rate has increased from 28 percent to 31 percent, and some states have increased their top state income tax rates, too. Also, the federal phaseout of exemptions and itemized deductions for high-income taxpayers insidiously increase the marginal tax rates. And Congress recently increased the top individual tax rates to 36 percent and 39.6 percent.

That's why it's a good idea to reexamine income-shifting as a valuable college-funding technique, even though the kiddie tax rules are still around. The family benefits from the lower tax rates, and the tax system encourages parents to shift income to a child by letting them retain their dependents' exemption, as long as they provide 50 percent of the child's support.

Before you race over to your accountant's office, however, take a moment to understand the basics of the income-tax and kiddie-tax rules. If you have children under 14 with "unearned" income, such as dividends, interest, royalties, rent or income from property, your tax situation will figure into your child's tax. Your top tax rate applies to your child's unearned income above $1,200. Children age 14 and older and young children with "earned income" are considered separate taxpayers, totally independent of the parents. Children with income get a standard deduction amount, above which they're taxed at 15 percent, 28 percent and so on, regardless of your tax situation.

While a dependent child can't take an exemption on his or her own tax returns, a standard deduction of up to $600 of taxable income or up to $3,600 of earned income is allowed in computing the taxable income. Thus, even for an under-14 child, the tax system encourages parents to transfer income-producing property, because the first $600 isn't taxed.

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