Making something a deductible expense, over time, has the effect of making it almost free. (That may sound exaggerated, but we'll explain in a moment.) A college education at a private college -- but nothing fancy -- costs about $40,000.
If you're paying taxes -- including state, local, federal and social security levies -- at an effective marginal rate of 40%, which is what we've been assuming throughout this report, that means you have to earn about $66,000 to pay that $40,000 bill.
If you make it a deductible expense, however, you only have to earn $40,000 extra -- or to look at it another way -- if you still earn $66,000, you only have to pay tax on about $26,000. Your tax bill falls from $26,000 to 40% of that amount. Thus, you save $16,000 ($26,000 less 40%) -- or $4,000 per year over four years of college. If you invest that money at 10%, in about seven years you've got your $40,000. In effect, you've gotten a college education free. Let's look at a few ways to make college a deductible expense.
Thanks to the tax law, taxes on annuities and gifts of up to $10,000 a year are tax-deferred. Buy a variable annuity with a $10,000 premium (or give your child money to buy the annuity and take advantage of the lower tax rate) and invest it so it grows to $20,000 in 10 years. When your child is of college age, give the $20,000 to him or her as a gift. Under IRS rules, a gift of up to that amount is tax-free. The child then chooses a payout (monthly, semiannual, or annual), which is only partially taxable.
Of course, $20,000 is probably not going to be enough to cover the costs of a four-year college degree in 10 years. So, buy one $10,000 annuity per year over a four-year period, and give one annuity per year while your child is in school.
A more direct way to make the expense deductible is to have your business either pay your child enough to cover the expenses -- or pay the school directly. In the first instance, you put your child on the payroll at the earliest possible time. Even children 10 years of age can perform useful tasks and earn money. The money goes into the child's account and builds up. Payroll expenses are, of course, deductible to the business. But they are taxable to the recipient -- in this case, the child. However, the child is generally in such a low bracket that the taxes he must pay are low or negligible. Beginning at age 10, for example, you have to pay the child only about $2,000 per year to cover a $40,000 college expense -- assuming the money is properly invested and tax-sheltered.
This example shows not only the power of tax-deductibility of college expenses, but also the power of compound interest over time. The $2,000 per year you are paying begins collecting interest many years before the college expenses become payable. You are only putting about $22,000 into the fund. And even that amount is tax-deductible to your corporation. So the real, net cost is only 60% of $22,000 -- or $13,200. It's a good discount on top of a $40,000 expense.
Note: there are a lot of special rules on this. Please consult a qualified tax professional to get the maximum benefit.The other way your corporation can shoulder the burden is for the corporation itself to set up its own scholarship fund for employees and/or the children of employees.
About the Author Adam Starchild is the author of over 20 books, mostly on taxes, personal finance and business. He has also written hundreds of magazine articles. The above article is reprinted with permission from his book How to Save on Your Taxes Without Cheating.
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