Category: Tax

November 14, 2024 | by RSM US LLP

Executive summary: Individuals’ and families’ approach to potential tax changes in 2025

Individuals and families should consider the following preparations for potential tax changes under the Trump administration and Republican Congress in 2025:

• Estate planning: The TCJA’s increased estate and gift tax exemptions are set to expire in 2025. Republicans may push to extend these exemptions. Taxpayers should consider utilizing higher exemptions now through gifts or trusts.
• Personal income tax: The TCJA lowered individual tax rates, which are scheduled to revert in 2025. Republicans may seek to extend these lower rates. Taxpayers can prepare for potential rate changes by considering accelerating income or deferring deductions.
• Pass-through business ownership: The 20% qualified business income deduction is set to expire in 2025. Republicans may extend this benefit. Business owners should evaluate their eligibility and consider restructuring to maximize benefits.
• Maximizing deductions: The SALT cap and other itemized deduction limits may expire in 2025. Taxpayers should review their deductions and consider strategies like bunching deductions or prepaying taxes.
• Transition readiness: Favorable tax parameters under a Republican Congress could create opportunities for business transitions. Owners should stay alert to valuations, interest rates, and legislative changes to optimize tax outcomes.

Now that Republicans have won the House of Representatives, individuals and families have more clarity about the direction in which the Trump administration and unified Republican Congress will steer tax policy in 2025.

Republicans are expected to quickly pursue legislation that continues policies they implemented in the Tax Cuts and Jobs Act of 2017 (TCJA), which sought to broaden the tax base and lower tax rates for both individuals and businesses. However, the estimated $4 trillion cost of extending TCJA provisions, plus interest costs of $600 billion, add uncertainty to tax policy outcomes. Even nonexpiring provisions and provisions outside of the TCJA are subject to change.

Below, we discuss five critical areas where potential tax changes could affect individuals and families, along with strategic planning considerations to help taxpayers make informed, timely decisions.

Estate planning

Potential tax changes: Estate and gift tax exemption

The TCJA doubled the 2017 estate and gift tax exemption and generation-skipping tax exemption for tax years 2018 through 2025, with inflation adjustments bringing it to $13.99 million per individual by 2025. This provision is set to expire at the end of 2025, potentially reducing the exemption to about $7 million in 2026.

Policy perspective

Expect Republicans to push for either making the increased exemptions permanent or extending them beyond 2025. Such an extension seems probable, considering Republicans’ substantial ongoing support for significant estate tax relief.

Notably, the nonpartisan Congressional Budget Office (CBO) in May estimated that extending the increased exemptions would cost the federal government $167 billion through 2034. That pales in comparison to the $6.13 trillion spent in fiscal year 2023.

Additionally, with a Republican-controlled Congress and presidency, any form of wealth tax is highly unlikely to pass. Concerns about the future of grantor trusts, may be less relevant, as Republicans are generally less likely to pursue restrictive changes to estate planning tools.

Planning considerations: Take advantage of higher estate tax exemptions

Consider utilizing the higher exemptions before they potentially revert to pre-TCJA levels. This could include making large gifts or setting up trusts to transfer wealth tax-efficiently. Ensure that any gifts align with your long-term financial goals and that you would not regret them if the exemptions do not decrease.

Estate planning remains beneficial even if the TCJA exemptions don’t decrease, as it allows you to transfer wealth out of your estate and provides numerous other advantages.

Personal income tax management

Potential tax changes: Income tax rates for individuals

The TCJA lowered individual income tax rates across most brackets, with the highest rate dropping from 39.6% to 37%. These rates are scheduled to revert to pre-TCJA levels after 2025.

Historically, Republicans have favored lower tax rates for both individuals and corporations. This is likely to continue with efforts to extend certain TCJA provisions affecting taxation of individuals as they approach their 2025 expiration.

Policy perspective

The Republican-controlled government might attempt to extend or make permanent the current lower tax rates. However, the CBO estimated that extending the lower individual income tax rates would cost the government $2.2 trillion, so budgetary considerations probably will influence the policy discussion.

Planning considerations: Financial planning

Consider how tax rate changes could affect your financial planning. Strategies such as accelerating income or deferring deductions could be beneficial if tax rates are expected to increase. Additionally, reviewing retirement contributions, charitable donations, and other tax-advantaged strategies can help optimize your tax situation under the current rates.

Pass-through business ownership

Potential tax changes: Qualified business income (QBI) deduction; individual income tax rates

The QBI deduction allows eligible business owners to deduct up to 20% of their QBI. It is set to expire at the end of 2025. The QBI deduction combines with individual income tax rates to significantly reduce the effective tax rate on QBI, which enhances after-tax cash flow for partners and incentivizes investments in pass-through entities.

Policy perspective

The Republican Congress may seek to extend or make permanent the 20% deduction, providing continued tax savings for business owners. However, the CBO has estimated it would cost the federal government $684 billion to extend it.

Planning considerations: Pass-through structuring

Evaluate your eligibility for the QBI deduction and consider strategies to maximize this benefit. This might include restructuring the business, managing income levels or making capital investments.

If the QBI deduction is allowed to sunset or is otherwise eliminated, the tax benefit for pass-through entities may be diminished. In any case, evaluating your options for tax classification (C corporation or pass-through) can help you align your business structure with your personal wealth goals.

Maximizing deductions

Potential tax changes: SALT cap

The TCJA introduced a cap of $10,000 on the deduction for state and local taxes (SALT), significantly impacting taxpayers in high-tax states. This cap, along with other changes to itemized deductions, is set to expire after 2025.

Policy perspective

The Republican-controlled government might aim to either extend the SALT cap or other itemized deduction limitations, or modify them in some way going forward. For example, the SALT cap could be increased but not eliminated. The CBO estimated that allowing the sunset of TCJA changes to itemized deductions, including the SALT cap, would cost $1.2 trillion.

Planning considerations: Itemized deductions

Review your itemized deductions and consider the impact on your overall tax liability. Strategies such as pass-through entity tax elections, bunching deductions, prepaying certain taxes, or making charitable contributions can help maximize deductions under the current rules.

Transition readiness

Potential tax changes: Estate and gift tax exemption; QBI deduction

Under a unified Republican Congress and Trump administration, the urgency to sell capital assets is diminished. For an owner planning to transition their business to family or other management, an extension of the gift tax exemption would keep the tax barrier to doing so relatively low.

Policy perspective

Republican control of Congress suggests a concerted effort to extend or make permanent the estate and gift tax exemption, current lower individual income tax rates and the QBI deduction. Also, capital gains tax rates seem less likely to increase.

With those favorable tax parameters, the interest rate environment and corresponding business valuations could create attractive opportunities for business transitions that preserve the respective companies.

Planning consideration: Transition planning

For owners seeking to transition their business, doing so before a surge in growth could help to ensure the successor’s estate realizes the gains instead of their own. With that in mind, stay alert about valuations, the interest rate environment and potential legislative changes—specifically tax rates, exemptions and depreciation provisions. If you are ready, be sure to provide time to execute a transition strategy to optimize tax outcomes before positioning assets for growth, acquisitions or sales.

The tax policy road ahead for individuals and families

With more than 30 provisions in the TCJA scheduled to expire at the end of 2025, Republican lawmakers have indicated a desire to act quickly on tax legislation after taking office in January. Under Republican majorities in both chambers, the budget reconciliation process would allow the Senate to pass legislation with a simple majority.

However, the cost of tax changes could complicate an agreement between Senate and House Republicans, given continued concerns about the size of the existing federal debt and the continuing annual federal deficits.

In other words, even under a unified Republican government, some complicating factors continue to shroud tax policy outcomes in uncertainty.

Proactive planning will be crucial to navigate tax changes and optimize tax positions. Individuals who work with their tax advisor to monitor legislative proposals and model the effects on cash flows and tax obligations will be best equipped to make smart, timely decisions based on policy outcomes.

We invite you to register to attend our tax policy webcast on Nov. 18. We will discuss:

• Aligning business structure with your current strategy and potential tax changes
• Income accelerations and deduction deferrals to enhance cash flow
• Preparing for potential adjustments in your business transition plans for either a family transfer or a sale

October 21, 2024 | by Atherton & Associates, LLP

We’re now in the last quarter of 2024, and taxpayers with multiple income streams, particularly gig economy workers and high-income earners, should take a moment to review their tax withholding. 

While the September 16th deadline for third-quarter estimated tax payments has passed, there’s still time to make adjustments before the year ends. Doing so can help you avoid an unexpected tax bill or penalties next spring. 

Who should be paying close attention?

Certain taxpayers are especially at risk of underpaying taxes, and year-end is the right time to correct course. 

Gig economy workers and side hustlers

Workers in the gig economy, such as freelancers, independent contractors, and those with side hustles, often receive income that isn’t subject to withholding. Since taxes aren’t automatically withheld, these taxpayers must make quarterly estimated tax payments to cover their income and self-employment tax liabilities. 

Failing to pay enough during the year could result in a substantial tax bill, penalties, and interest when filing a return. Even if you missed the estimated tax payment deadline for the third quarter, there’s still time to make a payment before the end of the year to reduce penalties and interest. 

High-income earners with investments or side income

High-income individuals with investment income, rental properties, or dividends may also have insufficient tax withholding throughout the year. If you’ve received significant income from these sources without adjusting your withholding, you could face a surprise tax bill. Individuals in this group should meet with their CPA before year-end to assess their total 2024 income and determine if an additional estimated payment is necessary to cover potential shortfalls.

The risks of ignoring withholding adjustments

Ignoring your withholding can have serious financial consequences. The IRS requires taxpayers to pay taxes as income is earned throughout the year. Failure to do so could lead to underpayment penalties in addition to the taxes owed. 

While the IRS offers safe harbor rules that can protect you from penalties if you pay at least 90% of your current year’s tax liability or 100% of last year’s tax liability (110% for those married filing jointly with AGI over $150,000), falling short of these thresholds could lead to penalties.

The IRS calculates penalties based on how much you underpaid and how long the amount has been outstanding. Even if you can’t pay your full tax bill by year-end, making a partial payment can reduce potential penalties and interest charges.

Actions to take now

The first step is to calculate your total annual income, including wages, bonuses, investment income, and any gig economy earnings. You’ll want to project your tax liability based on this income and compare it to the amount you’ve already paid through withholding or estimated payments. If there’s a shortfall, you’ll need to make an additional payment before year-end. You can do this through the IRS’s online payment system, where you can specify that the payment is for the 2024 tax year.

If you expect to continue earning additional income that isn’t subject to withholding, you may want to adjust your W-4 form with your employer to increase withholding. This can ensure that taxes are covered for future income. Additionally, any bonuses or other year-end compensation can create a tax burden, so updating your withholding now may prevent a larger tax bill next spring.

Meeting with your CPA: a smart year-end strategy

If you haven’t consulted with your CPA this year, now is the perfect time. A year-end meeting can help you evaluate your current withholding or estimated payments and determine if adjustments are needed. For gig workers and high-income earners alike, this consultation can make the difference between a smooth tax filing season and one filled with unexpected expenses.

If you’d like personalized advice on how much to pay before the end of the year based on your expected 2024 income, please contact our office.

October 08, 2024 | by Atherton & Associates, LLP

We’ve all seen those eye-catching pop-up ads while browsing the web: “Discover the One Major Tax Trick the IRS Hates!” Most of us recognize such blatant clickbait and either avoid clicking or take the content with skepticism. However, not all misleading tax advice is so obvious. 

Dubious claims often lurk in engaging videos on TikTok, YouTube, and other social media platforms, making them harder to detect and potentially more damaging. 

These videos can be particularly persuasive when the content creator mentions, “I worked in the financial industry for years,” leading you to believe they’re qualified to dispense tax advice. But how can you determine if the information they’re sharing is accurate or that they’re genuinely credentialed? 

This article will help you identify red flags in online tax advice and provide practical steps to verify a content creator’s credentials, enabling you to distinguish reliable information from misleading claims. 

The allure of engaging content

Social media platforms thrive on engagement. Creators often use sensational headlines and compelling narratives to capture attention. While some offer valuable insights, others may spread misinformation, either intentionally or due to a lack of expertise. Unfortunately, this issue isn’t exclusive to the financial industry – it’s pervasive across various fields. 

We are all susceptible to misinformation, regardless of our level of education or expertise. In fact, a study conducted by researchers at Stanford University found that over 80% of participating students could not distinguish between actual news articles and native advertisements. 

In the realm of health reporting, an analysis of the 20 most-shared articles on Facebook with the word “cancer” in the headline revealed that more than half contained claims discredited by doctors and health authorities. This indicates that a significant portion of what we consume online might not be accurate or vetted by seasoned experts – and it’s not always easy to distinguish misleading content from legitimate information. 

Six red flags to watch out for

Identifying certain red flags can help you spot misleading information. While noticing one doesn’t automatically mean the advice is false, the more red flags you observe, the higher the likelihood that the information is unreliable.

1. Vague or exaggerated credentials

Red flag: phrases intended to make the presenter appear credentialed without specific details.

Example: A video where the presenter says, “As someone who’s been in the financial world for years, I have insider tips the IRS doesn’t want you to know,” but provides no specifics about their background. 

What to look for: seek specific qualifications such as Certified Public Accountant (CPA) or Certified Financial Planner (CFP). Genuine professionals will clearly state their credentials and likely display them on their profiles. 

2. Sensational claims

Red flag: promises of “secret loopholes” or “tricks” that the IRS supposedly doesn’t want you to know. 

Example: an article titled, “Eliminate your tax bill entirely with this one hidden strategy!”

What to look for: be cautious of advice that sounds too good to be true or claims to offer easy solutions to complex problems. 

3. Lack of evidence or sources

Red flag: advice without reference to tax codes, regulations, or official guidelines. 

Example: a social media post saying you can deduct all personal meals as business expenses.

What to look for: reliable advice is usually backed by concrete references to the Internal Revenue Code, IRS publications, or well-known financial authorities. Don’t hesitate to ask for sources or clarification. 

4. Pressure tactics

Red flag: urgency cues like “You must do this now!” or “This secret won’t last long!”

Example: a message stating, “Claim this exclusive tax credit today before it’s gone forever!”

What to look for: good financial strategies are well-thought-out and don’t require hasty decisions. Take your time to research and consult professionals. 

5. Overgeneralization

Red flag: statements that ignore individual circumstances or local laws.

Example: a claim like, “Incorporate your side hustle immediately to save thousands in taxes!”

What to look for: quality advice acknowledges that tax strategies often depend on personal situations. 

6. Conflicts of interest

Red flag: content that pushes a product or service as the solution to your tax woes.

Example: a video that insists, “The only way to reduce your tax bill is by investing in this exclusive real estate program I offer.”

What to look for: be wary if the primary goal seems to be selling something rather than educating. 

How to verify a content creator’s credentials

Licensed professionals like CPAs adhere to strict ethical standards and are often very careful about the information they share online. However, these safeguards don’t prevent unlicensed individuals from disseminating misinformation.

When evaluating the credibility of online content, it’s important to verify a creator’s qualifications. While you may not find all of the following indicators for every legitimate professional – such as extensive publications or media features – the more evidence you can gather, the higher the likelihood that their advice is trustworthy. 

• Check professional licenses: search for their name on state licensing board websites or professional organization directories to confirm their credentials.

• Review their online presence: look up their LinkedIn profile or professional website. A legitimate expert will often have a consistent online presence detailing their experience and qualifications.

• Search for publications: see if they have contributed to reputable publications or have been cited in the media.

Assessing the quality of advice

While spotting red flags can alert you to potentially unreliable sources, assessing the quality of the advice itself goes a step further. This involves a deeper evaluation of the content to determine whether the information is accurate, applicable, and trustworthy. It’s not just about who is providing the advice, but also about the substance of what’s being said. 

Contextual misrepresentation

Videos or articles may present isolated cases as general rules or completely misrepresent legal precedent. For example, some influencers contend that taxpayers can refuse to pay taxes on religious grounds by invoking the First Amendment, but this is a serious misrepresentation of the law. The IRS has identified this as a frivolous argument that is consistently rejected by courts.

To assess the quality of such advice, consult a professional to verify whether the strategy is legitimate and applicable to your situation. Also, consult the IRS publication on frivolous tax arguments to see if the advice has already been deemed unreliable. 

Incorrect causality

Misleading advice often suggests that one action will directly cause a specific tax outcome without considering other factors. For instance, someone might claim, “People who donate to charity pay less in taxes.” This oversimplifies how charitable deductions work, ignoring factors like adjusted gross income limits and itemization requirements. 

Recognize that laws are complex, and outcomes often depend on multiple variables. Before acting on advice that promises direct results, understand the underlying rules and consult a tax professional to grasp the full picture. 

Risk misrepresentation

Some content downplays the risks or legal implications of a tax strategy. For example, sources may imply that by forming an S-corporation, you can avoid paying payroll taxes. They might neglect to clarify that you’re legally required to pay yourself a reasonable salary (subject to payroll taxes) if you’re actively working in your business. 

Ensure that potential downsides or the likelihood of IRS scrutiny are adequately discussed when evaluating such advice. 

Steps to protect yourself

Online misinformation is an evolving problem, and detecting it isn’t an exact science. While we’ve highlighted some common red flags, we haven’t covered every possible example of misleading tax advice. New misinformation appears constantly, and acting on bad advice can lead to serious consequences. 

The most effective way to protect yourself is to seek personalized advice from a qualified tax advisor who understands your unique circumstances. A CPA can provide tailored guidance, help you comply with tax laws, and ensure you’re making decisions that align with your financial goals. 

If you’re interested in developing a comprehensive tax strategy, we’re here to help. Please contact our office to speak with one of our experienced CPAs, and together, we can find solutions tailored to your needs. 

September 05, 2024 | by Atherton & Associates, LLP

Federal Reserve Chair Jerome Powell has signaled that rate cuts are on the horizon – it’s just a matter of time. As we prepare for this shift, it’s crucial to understand what these cuts might mean for your financial future. 

Currently, the Fed’s benchmark interest rate is at its highest in nearly 25 years, sitting between 5.25% and 5.50%. A potential cut of 0.25% to 0.50% is on the table, and while this might sound like good news, the move could impact everything from your mortgage to your savings. 

This article breaks down what you need to know about these potential changes and how to prepare so you can make informed decisions that align with your financial goals. 

Breaking down the rate cut

When the Fed talks about cutting rates, it means they’re making borrowing money cheaper. This is part of their strategy to keep the economy running smoothly. If you’re paying interest on credit cards or loans, a Fed rate cut means the interest you’re charged could go down, too. However, the impact on your finances might not be immediate or as big as you might hope, especially if the cut is small. 

While the first cut may not make a significant dent in your interest payments, it can signal the start of a trend leading to a more favorable borrowing environment over time. 

Historical trends

Historically, the Fed doesn’t slash rates all at once. Instead, they usually make small cuts over time, sometimes over several months or even years. This gradual approach allows them to carefully manage the economy without causing too much disruption. 

So, when might you start to see lower interest rates on your credit cards or loans? 

It usually doesn’t happen right away. Even if the Fed cuts rates in September, lenders might take a while to adjust their rates. When lenders adjust their rates, the timing varies depending on several factors, including market conditions, the lender’s business model, and competitive pressures. Generally, it can take anywhere from a few weeks to several months for lenders to pass on the benefits of a Fed rate cut to consumers. 

A study by the Federal Reserve Bank of San Francisco found that while some lending rates, such as those for adjustable-rate mortgages, tend to respond relatively quickly to changes in the Fed’s benchmark rate, others, like fixed mortgages, may lag by several months. 

The most recent major rate-cutting cycle occurred during the Great Recession from 2007-2008. The Federal Reserve cut the federal funds rate from a peak of 5.25% in September 2007 down to nearly 0% by December 2008. This series of cuts happened over approximately 15 months. During the early phase of these cuts, mortgage rates began to decline, but the most significant drops occurred about 6 to 12 months after the first rate cut. By mid-2009, mortgage rates had fallen to historic lows. 

Five financial moves to consider

Lock in high-yield savings ASAP

One of the most immediate and actionable steps you can take is to lock in the high interest rates currently available on savings accounts, CDs, and other safe investments. Currently, with the Fed’s benchmark interest rate at the highest level in nearly 25 years, savers have been enjoying some of the best returns in decades. But this window of opportunity may be closing soon, because the yields on savings accounts and CDs usually decrease when the Fed cuts rates. 

Given that CDs lock in a fixed interest rate for a specific term, they can be an excellent way to secure these higher rates before they potentially decline. If you’re worried about locking up all your money in a long-term CD, consider creating a CD ladder. This strategy involves spreading your investment across multiple CDs with different maturity dates. This way, you can benefit from higher rates now while also having some funds available to reinvest later. 

However, make sure your emergency fund is kept in a high-yield savings account. Not only will this help your money grow, but it will also be accessible when you need it. 

Work on your credit score to position yourself for lower rates

With a potential Fed rate cut on the horizon, now is the opportune time to focus on improving your credit score. Even if interest rates drop, a poor credit score could keep you from getting the best rates and terms. 

Start by reviewing your credit report for any errors or inaccuracies that might be dragging your score down. Make it a priority to pay all your bills on time and reduce any high balances, aiming to keep your credit utilization below 30% – ideally even lower. If your credit score is currently low, consider using a secured credit card to help rebuild it over time. These steps can position you to take full advantage of lower rates when they become available. 

Credit cards: take action as rates begin to fall

As the Fed raised rates, many credit card interest rates climbed as well. However, don’t expect your card’s interest rate to drop in line with the Fed’s rate cuts, especially if the reduction is modest – just 0.25%. Credit card companies are often slow to lower rates, if they do so at all. 

That said, falling rates could spark increased competition among credit card issuers. Some may start offering 0% balance transfers, lower rates, or other perks to entice you to switch. This puts the ball in your court: take the initiative to call your current provider and negotiate a better rate, or be prepared to shop around for more favorable terms. 

Plan ahead for major purchases

Major purchases, such as homes or cars, could also become more affordable as lower interest rates reduce the cost of financing. However, timing these purchases to align with rate cuts requires careful planning, as market conditions can be unpredictable, and increased demand might drive prices higher. 

Historically, mortgage rates tend to follow the trend of the Fed’s rate changes, but not always immediately. For instance, after rates were cut in the wake of the 2008 financial crisis, mortgage rates dropped significantly, hitting historic lows by mid-2009. But the process took time and not every rate cut led to an immediate decrease in mortgage rates. 

Auto loan rates can also be influenced by rate cuts, and the effect is often more immediate compared to mortgages. But factors like lender policies, borrower creditworthiness, and vehicle demand also play a role. 

That said, keep in mind that lower interest rates can lead to increased demand for homes and cars as financing becomes more accessible. This increased demand can drive prices higher, potentially offsetting the benefits of lower interest rates. For example, during 2020-2021, low mortgage rates contributed to a surge in housing demand, which pushed home prices to record highs in many areas. 

Refinance with caution

While refinancing can be a smart way to take advantage of lower interest rates, it’s not practical or cost-effective to refinance your mortgage after every rate cut. Instead, it’s important to assess when refinancing will truly benefit you financially, factoring in the costs associated with the process. The total costs of refinancing include closing costs, loan origination fees, and any prepayment penalties. Closing costs for refinancing typically range from 2-5% of the loan amount. 

Consider using a refinancing calculator to determine how much rates would need to fall to offset closing costs and other fees. Generally, if you can reduce your rate by 1% or more, refinancing might be worth considering, but this varies based on your specific situation. 

Personalized guidance for your financial strategy

As you consider the potential impact of a Federal rate cut, it’s essential to remember that every financial decision should be carefully tailored to your unique situation. This article provides an overview of what to keep in mind and how historical trends might guide your choices, but the specifics of your financial strategy might require a more nuanced approach. 

If you’re thinking about making any significant changes to your financial strategy, we strongly recommend seeking professional advice. Our office is here to provide personalized guidance and help you make informed choices. Contact us today to discuss how you can best position yourself to take advantage of upcoming changes and ensure your financial strategy remains strong.

September 03, 2024 | by Atherton & Associates, LLP

Smart financial planning for college: a parent’s guide

As parents, we all want the best for our children, including the opportunity for a higher education. But with the ever-rising costs of college, many families are concerned about how to afford it, especially those who are unlikely to qualify for need-based financial aid.

We all know that a college education is a significant investment. Even in 2024, the average cost of a four-year public in-state degree can easily exceed $100,000. And that doesn’t include textbooks, supplies, and other incidental expenses.

Our goal today is to explore how to effectively plan and save for your child’s education so they can pursue their dreams without being overwhelmed by debt. Whether your child is 5, 10, or 15 years away from starting college, it’s never too early or too late to start preparing. By developing a solid financial plan, you can ensure that when the time comes, your child has the opportunity to attend college without financial worry.

In this article, we’ll provide step-by-step instructions to help you maximize your financial resources and support your child’s educational journey.

Understand student aid and expected family contributions

Federal student aid eligibility is determined by various factors without a specific income cutoff. When you fill out the Free Application for Federal Student Aid (FAFSA), the information you provide determines the Student Aid Index (SAI). The SAI estimates how much your family is expected to contribute to your child’s college education based on your income, assets, family size, and the number of family members attending college.

Here’s a rough breakdown of how it works:

Family income: the SAI calculation considers your family’s AGI along with untaxed income and benefits like tax-exempt interest income and deductible retirement contributions.

Allowances against income: several allowances are subtracted from your income for necessary expenses like federal and state taxes, payroll taxes, essential living expenses, and an employment allowance.

Assets: the calculation also considers assets such as cash, savings, checking accounts, investments, business net worth, trusts, and education savings accounts. Child support received is also considered an asset. A nominal asset protection allowance is subtracted, which is based on the age of the older parent and whether the household has one or two parents.

The total expected contribution is then assessed, much like taxes, at rates ranging from 22% to 47%. Some students can qualify for zero expected family contribution if their parents’ combined income is $29,000 or less. However, for many families, there is little likelihood of qualifying for zero expected family contribution.

In a nutshell, most parents can expect to pay tens of thousands of dollars per year to send a child to college. Expected contributions are relatively high because non-liquid assets like business and investment net worth can affect your expected contribution. And the thresholds and requirements for need-based financial aid are particularly hard to meet.

Consider a college savings plan as early as possible

With the cost of education steadily increasing, starting a dedicated savings plan early can make a substantial difference. Early savings benefit from compound interest, easing the financial burden when college bills start arriving. Even if you save more than needed, there are some ways to use excess funds.

Types of college savings accounts

There are two main types of college savings accounts: Coverdell Education Savings Accounts (ESAs) and 529 plans. Both types of accounts allow your money to grow and be withdrawn tax-free, provided the funds are used for qualified educational expenses. If the funds are not needed for education, you can change the beneficiary to another family member.

Coverdell ESAs

ESAs have a lower annual contribution limit of $2,000 per year per beneficiary. Contributions are phased out for joint filers with an AGI between $190,000 and $220,000. You cannot contribute to an ESA if your income exceeds that threshold.

However, ESAs are versatile and can be used for a wide range of educational expenses, including K-12 schooling. Withdrawals are free from federal taxes if used for qualified expenses like tuition, books, tutoring, supplies, room and board,and  even computer equipment and internet service. If funds are used for non-qualified expenses, the earnings are taxable and subject to a 10% federal penalty.

If your child earns a scholarship, the amount of the scholarship is deducted from allowable expenses. For example, if they have $10,000 in qualified expenses and receive a $4,000 scholarship, $6,000 can be withdrawn tax and penalty-free to cover remaining expenses.

ESAs must be distributed by the time the beneficiary reaches age 30, but you can change the beneficiary to another family member under age 30 if excess funds remain.

529 plans

529 plans have much higher contribution limits, varying by state. Generally, parents can contribute up to $18,000 per year in 2024 without triggering the federal gift tax and can front-load up to five years’ worth of contributions.

Many states offer tax deductions or credits for contributions to their own 529 plans. Some states provide benefits for any plan, not just in-state plans. These states include Arizona, Arkansas, Kansas, Maine, Minnesota, Missouri, Montana, Ohio, and Pennsylvania.

529 savings can be used at any eligible college nationwide, and you can withdraw up to $10,000 per year for K-12 tuition.

If your child receives scholarships that cover their education costs, you can withdraw an equivalent amount without penalty, though taxes will apply to the earnings.

The good news is that your child can be the beneficiary of both a 529 plan and an ESA, allowing you to contribute to both accounts in the same year.

Set goals to increase the chances of receiving merit-based scholarships

It’s not just about how you’re going to pay for college; it’s also about finding ways to reduce expenses so less money has to come out of your pocket.

It’s important to get your child involved in the college planning process early. Their active participation is key to securing scholarships and managing future college expenses.

Strive for high grades

Encourage your child to aim for high academic performance. Merit-based scholarships often depend on GPA and standardized test scores. Emphasize that their efforts in middle and high school can greatly impact their college funding opportunities.

Participation in extracurricular activities

Participation in clubs, sports, and community service also enhances scholarship applications. Colleges look for well-rounded individuals who show leadership, commitment, and a willingness to give back to the community.

Parental support and motivation

As parents, your role is crucial in motivating and supporting your child. Work with your child to set achievable academic and extracurricular goals. Offer resources like tutoring, test prep courses, and access to extracurricular activities. And stay involved in your child’s academic life because faculty can often provide key information to ensure your child excels and has the best chance of receiving merit-based scholarships.

Start the scholarship search early

Start looking for scholarships early in high school. This can give your child a competitive advantage by allowing more time to find and apply for various opportunities.

For local scholarships, check with your child’s high school guidance counselor, community organizations, businesses, and civic groups. Local scholarships are often overlooked and have fewer applicants, increasing your child’s chances of winning.

You can also search for national scholarships using online databases like Fastweb, Scholarships.com, and the College Board’s Scholarship Search. These platforms allow you to search for scholarships based on your child’s qualifications and interests.

Junior year: consider a range of educational institutions

As your child reaches their junior year, it’s a good time to explore educational options and plan for college credits and costs. Encourage your child to take AP courses. These classes look good on scholarship applications and can earn your child college credits, saving time and money.

Also, look into the financial benefits of staying in-state for college. In-state schools typically offer lower tuition rates, and some offer scholarships or grants for in-state applicants.

Another cost-effective option is to have your child attend a community college for the first two years to complete general education requirements. Afterward, your child can transfer to a four-year institution to finish their degree. This pathway can offer significant savings on tuition and other expenses.

Senior year: application and financial aid process

When your child enters their senior year, it’s time to focus on college applications and securing financial aid. Be sure to complete the FAFSA, even if you think your child won’t qualify for need-based aid. Many schools require the FAFSA for scholarship eligibility, including merit-based scholarships. Submitting it ensures your child is considered for all possible aid.

At this point, your child should have identified several other scholarship opportunities. Keep them on track to ensure they finalize each application. It may help to create a checklist of all scholarships and their deadlines and gather necessary documents, like transcripts and letters of recommendation, in advance.

Post-acceptance: understand and utilize available tax benefits

Once your child is accepted to college, it’s time to explore tax benefits that can help reduce the cost. Two key tax credits are the Lifetime Learning Credit (LLC) and the American Opportunity Tax Credit (AOTC).

Lifetime Learning Credit

The LLC helps offset the cost of higher education for students in undergraduate, graduate, and professional degree programs, as well as courses to improve job skills. There is no limit on the number of years you can claim the credit.

It’s worth 20% of the first $10,000, up to $2,000. For 2024, the credit is reduced if your AGI is between $160,000 and $180,000 if filing jointly. It cannot be claimed if your income exceeds these limits.

American Opportunity Tax Credit

The AOTC offers more tax savings but can only be used by students in their first four years of higher education. You can get a maximum annual credit of $2,500 per eligible student. Up to $1,000 of the credit is refundable even if you owe no tax. Like the LLC, the credit is reduced if your AGI is between $160,000 and $180,000 if filing jointly.

Plan ahead to ensure your child’s education is financially manageable

This article provides an overview of strategies for paying for your child’s education. If you’d like more personalized information and advice, please contact our office. We’re here to help you plan effectively and ensure your child’s college journey is financially manageable.