While college tuition and expenses are rising, funding and tax strategies for middle-class families are becoming more limited. Part 1 examines the impact of stock compensation on financial aid. Part 2 reviews the rules of gift tax and the tax treatment of various types of stock grants. Part 3 focuses on methods to minimize capital gains at sale, planning for the "kiddie tax" and education credits, and strategies your children can use.
Minimizing Capital Gains Tax
Now that we have covered ways to shift to your children, through gifting, the capital gain from company stock you acquired through various types of stock grants, let's look at how to minimize or eliminate capital gains tax when they sell the stock.
The goal in shifting capital gains to your child is to pay tax on the capital gains at the child's typically lower tax rate. The current long-term (stock held over one year) capital gains tax rate is 15% for taxpayers in the 25% tax bracket and above, but the rate is 0% for taxpayers in the lower (10% and 15%) brackets for regular tax purposes. (This rate dropped from 5% to 0% in 2008, and the 0% rate was made permanent by the American Taxpayer Relief Act.) Since most children are in the lower tax brackets, it is easy to see the tax advantage in shifting income to them.
However, the so-called "kiddie tax", which applies to dependent children and college students, limits the ability of dependent children to take advantage of the lower capital gains tax rates. Understanding the kiddie tax and the few ways around it are essential to effectively using company stock to pay for college.
The Kiddie Tax (Ages 0–18, And Full-Time College Students Under Age 24)
The kiddie tax law was originally established to prevent well-off families from abusing the strategy of shifting unearned income to their children so that the income could be taxed at a lower rate than their own.
Under the kiddie tax, the following provisions apply in 2016. The first $1,050 of a dependent child's unearned income (dividends, interest, and capital gains) is tax-free, i.e. offset by the child's standard deduction. The second $1,050 of unearned income is taxed at the child's rate (the 0% capital gains rate that applies to people in the 10% income tax bracket). Any amount over $2,100 is taxed at the parents' rate, which is typically higher.
Alert: Gifts of company stock (or other securities) to your child that result in up to a $2,100 gain at sale generate tax-free proceeds to use for college tuition. This is a strategy to consider if it does not affect eligibility for financial aid.
The kiddie tax used to apply only to children under the age of 14, but in 2005 the Tax Increase Prevention and Reconciliation Act (TIPRA) moved the age up to apply to children under the age of 18. Legislation passed in 2007 expanded it further. Since January 1, 2008, the kiddie tax has applied to children under the age of 19 as well as college students under the age of 24 (unless a college student provides over half of his or her own financial support from earned income).
Tax Credits and Deductions For Education
There are two education-related tax credits: the American Opportunity Tax Credit (AOTC) and the Lifetime Learning Tax Credit. Only one education tax credit can be claimed on behalf of a student each year. The AOTC, created by the American Recovery and Reinvestment Act of 2009 and recently extended through 2017, is now by far the better of the two credits to claim. The AOTC is available for the first four years of undergraduate college education.
Under AOTC rules, the amount of the credit equals 100% of the first $2,000 of qualified tuition and expenses, now including books, that are paid, and 25% of the next $2,000 of paid expenses. Therefore, the maximum American Opportunity Tax Credit is $2,500 per year per eligible student (compared with just $2,000 under the Lifetime Learning Credit). Therefore, $10,000 in AOTC can be claimed for a child over four years, and the credit can be claimed for multiple children in the family in the same year. A family of four with two kids in college can receive as much as $5,000 in American Opportunity Tax Credit in a single year.
More families are eligible to claim the AOTC because the income limits are substantially higher. To be eligible, married couples filing jointly must have modified adjusted gross income (MAGI) of less than $160,000 per year, or less than $80,000 if filing as single or as head of household (HOH). Married couples with yearly MAGI of more than $160,000 ($80,000 for single and HOH) will be able to claim a partial credit up to $180,000 ($90,000), after which their eligibility is completely phased out.
Alert: Since stock compensation, such as income from exercising NQSOs or from restricted stock vesting, is part of your MAGI, you need to consider these events (and their timing) when evaluating your eligibility for the credit.
The rules also benefit lower-income families by making the American Opportunity Tax Credit 40% refundable for those families who don't have any federal tax liability. Under the previous rules, it didn't do low-income families much good to claim the credit because they didn't have any tax due anyway. By making the credit 40% refundable, the stimulus bill has put up to $1,000 more per student into the hands of lower-income families. However, no portion of the credit is refundable if the taxpayer claiming the credit is a child under the age of 19 or a college student under 24 who is providing less than half of his or her own support solely from earned income (i.e. the same rules that apply to the kiddie tax).
Combining Strategies to Fund Education
The American Opportunity Tax Credit, the standard deduction, and the personal exemption provide a useful mixture to minimize or eliminate the tax on capital gains, even when your child is still within the grasp of the kiddie tax.
2016 Example: Selling Stock
You have a daughter in college full-time between the ages of 18 and 23. If she is paying college tuition, she can use her standard deduction, her personal exemption, and the American Opportunity Tax Credit to reduce the federal tax on $27,000 of long-term capital gains to $0 in 2016. For example, if she has accumulated $150,000 in an UGMA/UTMA account with $54,000 of embedded long-term capital gains, she will have to pay tax on the $54,000 when she sells the investments in her account. She needs to sell to have money to pay for college. The key steps in eliminating the capital gains tax are the American Opportunity Tax Credit, the personal exemption, and the standard deduction.
As long as you (the parents) do not take the AOTC on your tax return, and do not claim the student as a personal exemption, she can claim the AOTC on her tax return. In this example, she would be using her own resources, specifically her UGMA/UTMA assets, to provide over half of her support, which includes the cost of college. Therefore, she would be able to pass the support test and claim the $4,000 personal exemption as well as the AOTC. IRS Publication 501 implies that, in general, if a person uses income and assets to provide over 50% of his or her own support (such as housing, food, education, and clothing), that person can claim himself or herself as a personal exemption on a tax return. Since in this example your daughter is able to claim herself as a personal exemption, she is also able to take the full standard deduction of $6,300 for herself.
Alert: While a student could still be subject to the kiddie tax, depending on how much of her own money is from earned income, she could "pass" the support test with investments to claim herself as a dependent and thus use the personal exemption on her own tax return.
In this example, your daughter would simply sell half ($75,000) of her $150,000 of appreciated stock, realizing long-term capital gains of $27,000. The $27,000 of taxable income from the capital gains would be reduced by your daughter's standard deduction of $6,300 and her personal exemption of $4,050, bringing her taxable income down to $16,650, which under the kiddie-tax rules would be taxed at your rate of 15%, resulting in a federal tax of $2,498. The AOTC (worth up to $2,500) would then reduce the tax on $27,000 of long-term capital gains to just $0.
|Long-term capital gains||$27,000|
|Student's personal exemption (support test)||–$4,050
|Student's standard deduction (single filers)||–$6,300|
|Net taxable income||$16,650|
|Capital gains rate (parents' rate of 15%)||x 0.15|
|Gross federal tax||= $2,498|
|American Opportunity Tax Credit||($2,500)|
|Federal tax due||$0|
The only way that college students under age 24 will be able to avoid the kiddie tax is if they are not enrolled full-time (i.e. taking 12 or more credits per semester) or if they provide over half of their own support from their earned income (e.g. wages and salaries, not income from selling stocks). This means that, in the example above, in 2016 your daughter would be subject to the kiddie tax on her $27,000 of capital gains instead of at her lower rate of 0%. This would cause her capital gains to be taxed at your capital gains rate (15% or 20%, but as high as 23.8% if you are subject to the Medicare surtax on net investment income).
Because the support test for the personal exemption is based on both income and assets, your daughter would pass the support test and be able to claim the personal exemption for herself, but she would still be subject to the kiddie tax because she isn't providing more than half of her own support exclusively from earned income. Oddly enough, she would qualify for the full standard deduction, the personal exemption, and the AOTC, but would still be subject to paying tax on her capital gains at your tax rate.
Summary of 2016 Strategy
Regardless of the kiddie tax, this strategy is still a highly effective way to fund college expenses in a tax-efficient manner by using company stock acquired from NQSOs, ISOs, ESPPs, and restricted stock. It can be repeated each year your child is enrolled in college.
The capital gains tax rate for the 25%–35% brackets is 15%, and it is 20% for those taxpayers in the 39.6% bracket. In the 15% bracket, if you did not implement this strategy you would pay a tax of $4,050 on the $27,000 of long-term capital gains ($8,100 on the full $54,000 of gains shifted on the total account value of $150,000).
The effectiveness of the strategy is enhanced for taxpayers subject to the 20% capital gains tax rate (AGI in 2016 of more than $466,950 per year for married joint filers and $415,050 for single filers), especially those also subject to the 3.8% Medicare surtax on net investment income. Using the example above, if you are subject to the 20% capital gains rate and the 3.8% Medicare surtax, your tax on the $27,000 of gains at the overall rate of 23.8% would be $6,426 ($12,852 on the full $54,000 of gains).
Furthermore, earnings in 529 College Savings Plans and 529 Pre-Paid Tuition Plans grow tax-deferred and are tax-free if used for qualified higher education expenses. These can be good accounts to use for minimizing future taxes on reinvested proceeds from the sale of company stock. These proceeds, if reinvested in bonds and/or certificates of deposit outside a 529 plan, will generate interest income on the student's tax return. If this income is over $7,400 a year, the student may be subject to the alternative minimum tax—ultimately raising the student's federal tax bill.
Content is provided under arrangement with myStockOptions.com, an independent source of online stock plan education and tools. Copyright © 2016 myStockPlan.com, Inc. Please do not copy or excerpt the myStockOptions.com content without express permission from myStockPlan.com, Inc.
Morgan Stanley Smith Barney LLC (“Morgan Stanley”), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. Clients should consult their personal tax advisor for tax related matters and their attorney for legal matters. This material does not provide individually tailored investment advice. It has been prepared without regard to the individual financial circumstances and objectives of persons who receive it. The strategies and/or investments discussed in this material may not be suitable for all investors. Morgan Stanley recommends that investors independently evaluate particular investments and strategies, and encourages investors to seek the advice of a Financial Advisor. The appropriateness of a particular investment or strategy will depend on an investor’s individual circumstances and objectives.
© 2016 Morgan Stanley Smith Barney LLC. Member SIPC.
CRC 1469481 05/2016