What are tax-advantaged strategies?

In saving for a child’s college education, parents may want to consider certain tax-advantaged strategies. These strategies all share the common trait of reducing the amount of taxes owed. These tax-advantaged strategies can be based on either the use of investments that generate long-term capital gains instead of ordinary income (e.g., stocks, stock mutual funds, or real estate) or the use of investments that produce tax-exempt interest income (e.g., individual municipal bonds or municipal bond mutual funds).

Capital gain investments

As an investor, you would rather have your investments produce long-term capital gains than ordinary income (e.g., interest). The reason is that the federal income tax rate for long-term capital gains (assets held over 12 months) is generally lower than the federal income tax rate for ordinary income.

There are numerous investments that can produce capital gain income. They include:

Stocks

Stocks are one investment that can produce capital gains. Dividends (distributions) are taxed at long-term capital gains tax rates in the year you receive them. Income from the sale of stock is subject to capital gains tax when you actually sell the stock.

Caution:  Picking individual stocks successfully requires an investment of time and knowledge, as well as money. Unless you are prepared to spend the time needed to learn about particular stocks and the stock market, using professional guidance for selecting individual stocks is recommended.

Caution:  There is no guarantee that stocks will produce capital gains; you can lose money as well.

Mutual funds

Many parents find themselves investing in mutual funds for their child’s college education. Mutual funds are another example of an investment that can produce capital gains. With mutual funds, you may be subject to tax (at long-term capital gains tax rates) on mutual fund distributions attributable to any net long-term capital gains that the fund recognizes by selling stock or, for stock mutual funds, qualifying dividends. In addition, when you sell shares of the mutual fund, you also recognize capital gain or loss.

Real estate

Real estate is another example of an investment that can produce capital gains. When you sell a piece of real estate that you have held for more than one year that has appreciated in value, you recognize a gain that will be subject to tax at long-term capital gains tax rates.

Investments producing tax-exempt income

Investments that produce tax-exempt interest income are advantageous for an obvious reason: They produce income that is not subject to federal (and in some instances, state and local) income tax.

Municipal bonds

Municipal bonds are bonds issued by a particular state or local government. The interest you earn on municipal bonds is free from federal income tax and, if you live in the jurisdiction that issues the bonds, the interest is usually free from state and local tax as well. This is beneficial if you face high income tax brackets at the federal level and at the state level. However, the interest paid on municipal bonds is usually lower than the interest paid on taxable bonds.

Trip: Some states offer special bonds for college savers known as baccalaureate bonds. These bonds are general-obligation zero-coupon municipal bonds. For more information about purchasing these securities, contact a stockbroker.

Caution:  Municipal bond investments may increase your exposure to the alternative minimum tax.

Municipal bond mutual funds

These are mutual funds that invest in municipal bonds, often from a single state. Like their individual counterparts, municipal bond mutual fund dividends are usually free from federal income tax and, if the fund holds only bonds issued by the jurisdiction in which you reside, free from state income tax as well.

Strengths

Tax advantages

Investments that can produce capital gains are generally preferable to investments that produce ordinary income if such investments are held longer than 12 months because long-term capital gains tax rates are lower than ordinary income tax rates. In addition, investments that produce interest income that is specifically exempt from federal income taxation are advantageous for obvious reasons (although such investments may provide a pretax rate of return that is lower than similar taxable investments).

Tradeoffs

Wide range of investment choices requires research

There is a wide variation in the world of investments that produce capital gains. Knowing which investments to choose requires research. For example, successfully picking individual stocks requires time and knowledge that the average parent may not possess. Similarly, it may be difficult to invest successfully in real estate without the assistance of a local real estate professional who keeps abreast of trends in the area. You may need the help of a financial planner.

Investments may be risky

Different investments carry different levels of risk.

Trip: Whether you select a highly volatile investment will depend on your risk tolerance and how many years your child has until college. The volatility of individual stocks can be lessened somewhat through diversification in a stock mutual fund.

How do capital gains affect financial aid eligibility?

The federal government looks at parental income in the year before your child enters college to determine financial aid for your child’s freshman year (and, thereafter, looks at parental income in the year before each year your child applies for aid). The income calculation that the government uses includes any capital gains that you recognize during the year of the application.

Example(s): Your child is scheduled to attend college in the fall. In the previous year, you sold a large chunk of ABC stock and realized $5,000 in capital gains. This $5,000 is included in your income for financial aid calculations.

Trip:  If you have large unrealized capital gains in your investment portfolio and your family plans to apply for financial aid, you should try to realize the gains in any year before the year your child applies for aid. If your child is already only a year or two from college, you might consider taking out a loan and using your investment portfolio as collateral for the loan, rather than recognizing gains that could reduce your child’s financial aid eligibility.