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Helping to fund a child's education with equity awards and company stock

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The rising costs of tuition and other expenses associated with a college education can be startling, and are a concern for many parents. Your stock compensation may be a source of college funding that you might not have considered.

The cost of a college education

In its publication Trends In College Pricing 2014, the College Board reported the following from its survey data of college expenses for the 2014–2015 academic year:

  • Average total cost for in-state students at four-year public colleges: about $19,000 per year.
  • Average total cost for out-of-state students at four-year public colleges: about $32,000 per year.
  • Average total cost for students at four-year private colleges: about $42,000 per year.

You may find it challenging to prepare financially for college while also juggling mortgage payments, retirement preparation and other financial responsibilities. But, thoughtful planning can help make potential gains from your equity awards go as far as possible. This article includes the basics of college funding and financial aid, the role that stock compensation can play, the related tax facts, and a sample approach.

College funding and financial aid basics

Student aid, in the form of work-study, student loans, grants, and scholarships, may be awarded on the basis of financial need. To apply for federal financial aid, students must complete the Free Application For Federal Student Aid (FAFSA). The information is then used to calculate the expected family contribution (EFC) and determine the financial need:

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Example: Your child has enrolled in a college that costs $35,000 per year. Your expected family contribution is $21,000. Your child therefore demonstrates an annual need for aid in the amount of the difference, or $14,000. The financial-aid officer at the college will try to fill that need with a package of work-study, student loans, grants, and scholarships. If the EFC exceeds the cost of attendance, the student is not eligible for need-based aid.

Income counts against eligibility
According to the 2015–2016 Federal Methodology Formula, a family of four that has one college student and no assets, makes no contributions to a qualified retirement plan, and files a joint tax return with $140,000 of adjusted gross income typically will not qualify for need-based student aid at the average four-year public college. A family with $210,000 of adjusted gross income typically will not qualify for aid at either a public college or a private college.

In general, all non-retirement savings and investments, including vested stock options and other in-the-money equity awards, count against the parents at a maximum rate of 5.64%, reducing eligibility for need-based student aid.

Assets count, too
Your income is only part of the picture. In general, all non-retirement savings and investments, including vested stock options and other in-the-money equity awards, count against the parents at a maximum rate of 5.64%, reducing eligibility for need-based student aid. Fortunately, parents receive what is referred to as an Asset Protection Allowance, which is an amount of “reportable” assets that do not count against you when you complete the FAFSA. The amount of the Asset Protection Allowance depends on your age and other factors (see Table A5 on page 19 of the 2015–2016 Expected Family Contribution (EFC) Formula Guide).

According to informal discussions between financial aid experts and the U.S. Department of Education, the value that should be reported is the net value (after fees, commissions, taxes, etc.) of all types of vested stock options as if they were being exercised and sold at market value on the day of the form’s completion. (For stock options, the value is just the spread, not the face value of the grant before exercise costs.) Similar rules apply for restricted stock, restricted stock units, stock appreciation rights, and employee stock purchase plans.

Today’s assets, last year’s income
Although FAFSA requires information on your current assets, the income questions are based on your prior year’s income tax return. This can work against you because income from equity compensation last year is reflected in your most recently filed tax return, which is the source of income information on the FAFSA.

Example: You hold $200,000 worth of vested but unexercised stock options. They count against you as an asset this year. As reported on your most recent tax return, last year you also received income from options that you exercised and restricted stock units that vested. That income will have to be reported on the FAFSA and will count against you in the income portion of your expected family contribution.

In addition, equity compensation income reported two tax returns ago will also count as an asset in the FAFSA if you still have the cash proceeds as savings or continue to hold the shares that you acquired. Some ways to prevent cash proceeds from being counted against your expected family contribution include putting them into an annuity or a life-insurance policy. Proceeds invested in a 529 college-savings plan or prepaid plan are considered an asset of the parents and will count against aid eligibility. However, if the assets are invested in an annuity or a life-insurance policy they may not be considered as an asset for purposes of the FAFSA.

...the tax status of the shares after you acquire them is a primary factor in determining whether they can be used efficiently to pay for college.

Using stock compensation for college funding

Whether you have stock options, restricted stock, restricted stock units, stock appreciation rights, or an employee stock purchase plan, the tax status of the shares after you acquire them is a primary factor in determining whether they can be used efficiently to pay for college. Also important are the special rules under the Internal Revenue Code on stock sold by dependent children and on the funding of education.

Capital gains tax and the benefits of income shifting
Since most dependent children are in the 10% and 15% tax brackets, which carry a capital gains rate of 0% for U.S. taxpayers, gifting appreciated shares (and the embedded capital gains on those shares) to a child may let you take advantage of the child’s typically lower tax rate. This is called income-shifting. These are the essential facts:

  • In 2015, you can make individual gifts, including gifts of stock, to your child of up to $14,000 per year (and joint gifts with your spouse of up to $28,000 per year) without incurring any gift-tax consequences.
  • Gifts to children aged 18 and older can be made outright to them, but children under the age of 18 can own such assets only through custodial accounts (UGMA/UTMA) or trusts.
  • Gifts of stock are based on the value of the shares at the time of the gift and not on your tax basis. Your tax basis and the length of time you have held the shares carry over to the recipient.
  • Capital gains on future sales of the gifted shares may be taxed at the child’s tax rate, subject to the kiddie tax.
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The Kiddie Tax
Keep in mind that the strategy of shifting capital gains to your children is limited by the so-called “kiddie” tax, which may place a ceiling on the amount that can be subject to the 0% rate. The kiddie tax applies to:

  • All children under the age of 18.
  • Children that are age 18 and do not have earned income that is more than half of their financial support.
  • Full-time students that are at least age 19 and under the age of 24 who do not have earned income that is more than half of their financial support.

Under the kiddie tax provisions in effect for 2015, a gift of company stock (or other securities) may be made to your child with the sale of that company stock (or other securities) by your child generating tax-free proceeds to use towards college tuition to the extent that the capital gain (coupled with all other unearned income of the child) does not exceed $2,100. This is a strategy to consider if it doesn’t affect eligibility for financial aid.

The American Opportunity Tax Credit
There are two education-related tax credits: the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Credit. Only one education tax credit can be claimed on behalf of a student each year. The AOTC was recently extended through 2017, and is by far the better of the two credits to claim. (See IRS Form 8863 on educational credits and IRS Publication 970 at irs.gov for details on tax-related education-funding topics.)

The AOTC is available for the first four years of post-secondary education. The credit covers the first $2,000 of qualified tuition and expenses, including books, and 25% of the next $2,000 in expenses. Therefore the maximum AOTC is $2,500 per year for each eligible student, so $10,000 can be claimed over four years.

...the maximum AOTC is $2,500 per year for each eligible student, so $10,000 can be claimed over four years.

To be eligible for the AOTC in 2015, married couples filing jointly must have modified adjusted gross income (MAGI) of less than $160,000 per year (less than $80,000 if filing as single or as head of household). Married couples with greater yearly MAGI will be able to claim a partial credit up to the MAGI limit of $180,000 (single/HOH $90,000). Couples with MAGI of $180,000 (single/HOH $90,000) or more are ineligible for the AOTC. Since stock compensation income, e.g. from option exercise or restricted stock vesting, is part of your MAGI, you should consider the timing of that income when evaluating your eligibility for the AOTC.

Putting it all together — a sample approach

  • Assume you have a daughter between the ages of 18 and 23 who is enrolled in college full time and is paying for her tuition.
  • Her UGMA/UTMA (custodial) account has accumulated $150,000, with $54,000 of embedded long-term capital gains.
  • She will have to pay capital gains tax on the $54,000 when she sells the investments in her account to pay for tuition.
  • Her standard deduction, her personal exemption, and her AOTC can reduce the federal tax on $27,000 of her long-term capital gains (if she sells half of her assets) to just $5 in 2015, as described below.

As long as you (the parents) do not take the AOTC on your tax return and do not claim the student as a dependent, she should be entitled to claim the AOTC on her tax return. Because she is using her own resources, her UGMA/UTMA assets, to provide over half of her support, she should be able to pass the support test and claim the $4,000 personal exemption as well as the AOTC. (For further information, see IRS Publication 501). Since in this example your daughter is able to claim a personal exemption for herself, she also should be able to take the full standard deduction of $6,300 for herself.

Assume your daughter simply sells half ($75,000) of her $150,000 of appreciated stock, realizing long-term capital gains of $27,000. After the subtraction of her standard deduction ($6,300) and her personal exemption ($4,000), the $27,000 is reduced to $16,700. Under the kiddie tax rules, this amount is taxed at her parent’s capital gains rate. If her parent’s capital gains rate is 15%, the sale of half of her appreciated stock results in federal tax of $2,505. The AOTC ($2,500) reduces that amount of tax to just $5.

Long-Term Capital Gains

$27,000

Student's Personal Exemption
(Support Test)

($4,000)

Student's Standard Deduction
(Single Filer)

($6,300)

Net Taxable Income

$16,700

Capital Gains Rate
(Parent's Rate of 15%)

x 0.15

Gross Federal Tax

= $2,505

American Opportunity Tax Credit

($2,500)

Federal Tax Due

$5

As college tuition and expenses rise, funding and tax strategies for middle-class families have become more important than ever. The approach outlined in this article can be an effective way to pay for college in a tax-efficient manner by using shares acquired from your stock compensation. It can be repeated each year during which your child is enrolled in college.

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Neither Merrill Lynch nor any of its affiliates or financial advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

This article is adapted from a three-part series by Troy Onink at myStockOptions.com.

This content is adapted from content provided under arrangement with myStockOptions.com, an independent source of online stock plan education and tools. Copyright © 2015. myStockPlan.com Inc. is not responsible for any errors in the article, or any actions taken in reliance on it. Please do not copy or excerpt the myStockOptions.com content without express permission from myStockPlan.com Inc.

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