5 Ways the New Tax Law Affects Paying for College

The final version of the GOP tax bill that passed last month rewrites the tax code in many ways, eliminating deductions and adding new benefits. Some of these new provisions affect those paying for college.

After public outcry on several provisions proposed in the House's tax bill, the Senate version that passed last month left many tax credits related to higher education untouched.

The new tax bill keeps the deduction for student loan interest. Additionally, the tuition waivers that graduate students receive will stay tax free, and other tax credits – such as the Lifetime Learning Credit and the American Opportunity Tax Credit – remain unscathed.

"A lot of things didn’t change that we were worried about changing – the taxation of the tuition waiver, the taxation of employer tuition assistance. We worried about that happening, but it didn’t end up happening," says Shannon Vasconcelos, director of college finance at College Coach, an admissions consulting firm.

But a few key changes will affect families and students who are financing higher education. Here are five new tax codes that may change a family's finances.

1. Deductions for interest on home equity loans and lines of credit are eliminated. Under the new tax legislation, the ability to deduct interest on home equity loans is suspended from 2018 to 2025.

"This one is a real big one that is a bummer for families," says Vasconcelos. "For a lot of families, it's the best interest rate – it's better than a lot of the education loan rates. A lot of families do tap their home equity to pay for college, so losing the deduction is going to cost them fairly significant money."

The new restrictive mortgage rules that cap interest on new loans to $750,000 will also "prevent many middle-income taxpayers from using home-equity loans in the future to fund college tuition, while generating tax-deductible interest," says Blake Christian, a CPA at Holthouse, Carlin, Van Trigt, a Southern California accounting firm.

2. Families can use 529 plans to pay for K-12 education. Families can now use qualified education expenses in a tax-advantaged 529 savings account to pay for elementary or secondary school tuition. The new tax code allows taxpayers to pay up to $10,000 per student per year in K-12 tuition.

But college experts caution some families against using this new flexibility with 529 accounts. Sean Moore, founder of SMART College Funding, worries that parents who redirect these funds to cover private school education may use the money too quickly and come up short for college.

Christian from HCVT says this benefit will largely help families with a high net worth.

3. Colleges and universities will pay a new excise tax on endowments. A new excise tax levies a 1.4 percent on a private educational institution's endowments that amount to more than $500,000 per student.

The new provision affects scores of private universities with large endowments, such as Harvard University in Massachusetts, the University of Notre Dame in Indiana and Stanford University in California, to name a few.

"It's going to cost these colleges money. How much is going to be passed on to students and parents – we don't know yet. The colleges are just now figuring out how to deal with this new tax," says Vasconcelos from College Coach.

4. Student loans discharged for death or disability are now tax-exempt. The new tax code makes death and disability discharges of federal and private education loans tax-free.

Previously, the debt cancellation would be added as income on to the taxpayer's bill. Now the cancellation of the student debt is tax-free. But the new tax code only applies to discharges that occur during 2018 to 2025.

"It's great for those families who suffer from those devastating effects. But the reality is the people that it helps are hopefully very small," says Moore from SMART College Funding.

5. Alimony for recipients is no longer taxable. College consulting experts say this provision should make it easier for custodial parents to qualify for need-based aid when filling out the Free Application for Federal Student Aid, commonly known as the FAFSA. For the most part, the FAFSA for college-bound students relies on parental information, such as tax records.

"Without alimony showing up on their tax returns, divorced custodial parents should be eligible for financial aid," says Joe Orsolini, president of College Aid Planners, a consulting organization in Illinois that helps families navigate paying for college. "This change will make is easier for them to qualify."

Even with this provision, the FAFSA uses tax records from the prior prior year – so there is a time gap to when this new tax code would benefit a custodial parent. But Orsolini says this should benefit these parents "unless the Department of Education catches on to this and changes the FAFSA."

Source: https://www.usnews.com/education

When an HSA-First Strategy Makes Sense

Many--perhaps most--articles about health savings accounts suggest that employees with an HSA who participate in a 401(k) plan should first contribute to the 401(k) plan the percentage of their compensation that enables them to obtain the maximum plan sponsor match, such as 3% on the employee's first 6% of compensation. Employees should then max out their HSA account contributions through payroll deductions. Once that's done, they should go back to contributing any additional dollars to their 401(k) plans.

While this strategy is indeed attractive, an even better one would be to change the sequence of the contributions. That is, employees should first max out contributions to their HSAs no matter their tax bracket, and once that's done, contribute to their 401(k) plans.

Break out that trusty old HP 12C and calculate any contribution, time horizon, and interest-rate combination. Then reduce that number by, say, 25% for tax to come up with the 401(k) balance. (An HSA demonstrates even greater superiority over an employer match in a 401(k) plan when withdrawals are made at a tax bracket higher than 28%, thereby illustrating the power of tax-free withdrawals in retirement. That is, the higher an employee's tax bracket, the larger the employer's 401(k) match must be to in order beat contributing to an HSA first.) 

A 401(k) plan will beat an HSA if left to retirement. However, reality intrudes when withdrawals are made from the 401(k) to pay for things like medical expenses and a participant in a 401(k) is slammed with taxes and penalties. This is why it makes the most sense to first max out HSA contributions and thereafter get the maximum company match from the 401(k).

Do the same for an HSA but then factor in a 7.65% (FICA) discount up-front and no tax deduction at the back end. In most calculations, the HSA-first strategy is ahead by one third. Then, add in a typical employer match of 3% on the first 6% in employee compensation and take the balance out at a 35% tax bracket. The result: HSA tax savings even beat the employer's match. And don't forget, 80% of employers that offer an HSA contribute $500-1,500 to an employee's HSA.

Once these two no-brainers are accomplished--max out HSA contributions first and then obtain a full company match for the 401(k) plan--only at that point should employees begin their retirement needs planning for the year and so on into the future.

For those who are uncomfortable with this strategy for whatever reason, perhaps they would prefer contributing simultaneously to both the HSA and the 401(k) account on a regular periodic basis throughout the year.

Apart from the issue of the sequence of contributions to an HSA and a 401(k) plan is the issue of the difference in the amount of contributions. For example, Employee A saves and invests $5,000 (a nice round number used even though it slightly exceeds what an individual 55 or older can currently contribute annually to an HSA) annually for 30 years in an HSA. Employee B also saves and invests $5,000 annually for 30 years in a 401(k) account. Employee A in the HSA will amass $611,729 while Employee B in the 401(k) plan will amass $423,699.

The differential in favor of the HSA of nearly $200,000 is due to avoiding payment of the (up-front) 7.65% FICA tax (or more in certain other states and localities) for 30 years of contributions. (Assumptions for the foregoing terminal amounts include a 25% income tax bracket, an 8% return, an HSA that's in the payroll deduction scenario to avoid paying 7.65% in FICA taxes and HSA assets are used for qualified medical expenses. Also, a 25% income tax bracket was applied for withdrawal of 401(k) money.)

Tax-Deferred Accumulation of Earnings and Interest on Contributions
Any earnings and interest generated on contributions to an HSA accumulate tax-deferred over time. When these accumulations are used to pay for qualified medical expenses or to reimburse an HSA holder for previous qualified medical expenses, they become tax-free distributions.

Tax-Free Distributions to Pay for Qualified Medical Expenses
In essence, HSA assets can be used to pay for anything tax-free. Suppose that HSA holders are able to max out contributions to their HSAs and pay for qualified medical expenses out-of-pocket through some or all of their careers. If the holders have kept their medical expense receipts over time, they can get reimbursed later for those expenses from their HSAs.

There's not even a need to have a current qualified medical expense; the HSA holder merely needs to have a receipt from any time in the past to get reimbursed. Qualified medical expenses, then, can arise from any year--not just the current one. This proactive strategy allows an HSA holder to augment retirement income tax-free rather than first pulling money from, say, its taxable 401(k) plan account. This could be helpful in cases where withdrawals from a 401(k) account could bump the holder into a higher tax bracket which could also result in higher Medicare premiums

Other instances of the versatility and flexibility of the HSA abound. For example, the fact that an HSA holder can contribute to an HSA until April 15 for the previous tax year (like an IRA) allows for a post-calendar year tax avoidance strategy. Suppose that a 56-year old self-employed worker had $4,000 in medical expenses and paid for them with (after-tax) out-of-pocket money because the worker didn't know that he or she was eligible for an HSA. A savvy investment advisor informed the worker about eligibility.

So before tax-time in April, the worker establishes an HSA and contributes $4,000, thereby avoiding payment of federal and state income taxes. (But not FICA taxes because the self-employed cannot establish an IRS section 125 cafeteria plan. However, LLC or LLP members might be able to establish a 125 plan if they have elected to be taxed as a Subchapter C Corporation; competent professional counsel should be consulted in such cases.) The worker then took out $4,000 from his or her HSA to reimburse himself/herself.

The result: a wash that saves a lot in taxes. This post-calendar year tax avoidance strategy demonstrates again that having a receipt for qualified medical expenses that were paid even far in the past allows an HSA holder to get reimbursed--assuming, of course, that the holder has been able to pay for its medical expenses out-of-pocket along the way.

Additional Advantages of HSAs
The Tax Cuts and Jobs Act passed by Congress last year failed to further expand the advantages of HSAs. However, it's thought that there will be a Medicaid/Medicare HSA provision as well as one to increase HSA contribution limits included in the 2018 Budget Reconciliation Act. In the meantime, here are some additional advantages of an HSA.

Full Vesting. Any contributions made to an employee's HSA by either the employee or its employer are immediately vested in the employee.

Portability. An HSA can be opened by a worker anywhere. For example, if employees don't like their employer-sponsored HSAs, say, because it's pricey and/or the investments are suboptimal (which is often the case), they can pull the assets from it and invest them elsewhere in an optimal HSA (within 60 days but without the rigmarole of a rollover). The downside to this non-payroll deduction scenario, of course, is that employees cannot take the 7.65% (or more) deduction for FICA taxes. Even if employees are currently ineligible to make contributions to their HSAs, the HSA always stays with them not their employers.

Flexibility. HSA holders can withdraw HSA assets or change them at any time while letting the HSA accounts accumulate, regardless of their current employer or current eligibility. In addition, there are no required minimum distribution rules or requirements to begin taking withdrawals at a certain age.

Sources of Contributions. Those other than HSA holders can contribute to a holder's HSA including a family member and, as noted, their employers.

Coverage for Family. HSA holders can use assets from their own HSAs to pay for qualified medical expenses incurred by spouses and their tax dependents even if they aren't eligible to establish their own HSAs or even if they have health insurance different than the holder.

At Death. At an employee's death, the HSA can be rolled over to a spouse tax-free, plus that spouse can continue to save and invest in the HSA. But if the HSA is rolled over to a nonspouse, the HSA balance is fully taxable like the balance in a 401(k) plan.

Medicare/Retirement. The Medicare Part B monthly premium (for visits to the doctor) is deducted from a recipient's monthly Social Security check. In such cases, however, an HSA holder can get reimbursed from HSA assets for these premiums as well as Part D monthly premiums (for drug prescriptions).

Source: http://news.morningstar.com/articlenet/article.aspx?id=842764

Phantom stock: Termination of right to buy or sell, treatment of asset and basis

In Hurford Investments No. 2, Ltd., No. 23017-11 (Tax Ct. 4/17/17) (order), the Tax Court considered whether the redemption of phantom stock was treated as a sale of a capital asset and what the tax basis in the redeemed phantom stock was.

Background

Gary Hurford owned "phantom stock" in Hunt Oil Co. The phantom stock was a form of deferred compensation that Hunt Oil paid to its employees; a share of phantom stock was valued at approximately the share price of Hunt Oil's common stock and would be adjusted for its increase or decrease in value at the end of each calendar year.

Under the terms of the phantom stock agreement, after Hurford's death, which was considered a "qualified termination of service," a five-yearcountdown was started. During this time Hunt Oil would continue to pay out dividends and adjust the stock for any growth or decline in value. At the end of the fifth year Hunt Oil would automatically redeem the stock; both parties had the right to liquidate the account at any time.

When Gary Hurford died in 1999, Thelma Hurford, his wife, inherited the phantom stock. Thelma decided to transfer the phantom stock into Hurford Investments No. 2 Ltd. (HI-2) in 2000, one of three limited partnerships Thelma's attorney formed as part of her estate plan after Thelma was diagnosed with cancer. On March 22, 2000, Hunt Oil formally recognized HI-2 as the holder of this stock. At the time of the transfer, the value of the stock was $6,411,000, and the receipt was reported on HI-2's Form 1065, U.S. Return of Partnership Income, as a short-term gain.

Thelma died in 2001, and the value of the stock on the date of her death was $9,639,588. In 2004, the five-year period that began on Gary's death was up, and Hunt Oil exercised its right to terminate the phantom stock. In 2006, Hunt Oil distributed $12,985,603 to HI-2. The IRS argued that the difference between the $12,985,603 distribution and $6,411,000 should be treated as ordinary income (deferred compensation) and argued that HI-2 should be considered an invalid partnership for federal income tax purposes since there was no transfer of phantom stock until after Thelma died. HI-2 and the estate argued the phantom stock should be treated as a long-term capital asset in HI-2's hands, which would also establish HI-2'svalidity as a holder and recognize it for income tax purposes.

Is phantom stock a capital asset?

In Thelma Hurford's hands, the termination of phantom stock generated ordinary income (deferred compensation), but it is pertinent to note that the character of property may change depending on who holds it, e.g., a laptop is inventory for a retailer but a capital asset for most buyers. "Capital asset" has a broad definition under Sec. 1221, which defines the term as all property that is not specifically excluded in a list of exceptions. The types of property excepted from Sec. 1221 are (1) stock in trade; (2) depreciable property used in a trade or business; (3) a copyright or other similar item; (4) an account or note receivable acquired in the ordinary course of business; (5) a U.S. government publication; (6) a commodities derivative financial instrument; (7) a hedging transaction; or (8) supplies used or consumed in the ordinary course of business.

Because HI-2's interest in the phantom stock does not fit into one of the exceptions listed in Sec. 1221, the Tax Court found that it was a capital asset. This designation makes more sense when one thinks about the nature of the asset. HI-2acquired an asset that had its value linked to the stock value of Hunt Oil, and HI-2 had no influence over the underlying Hunt Oil common stock, holding it in the hope that it would appreciate. According to the Tax Court, this distinguishing characteristic is enough to conclude that the phantom stock was a capital asset.

Does Hunt Oil's redeeming the phantom stock constitute a sale?

Under Sec. 1234A(1), the gain or loss attributable to the cancellation, lapse, expiration, or other termination of a right or obligation for property that is a capital asset in the taxpayer's hands is treated as a gain or loss from the sale of a capital asset. HI-2 argued and the Tax Court agreed that when Hunt Oil liquidated the phantom stock and distributed the proceeds to HI-2, it ended HI-2's right to sell the phantom stock. Thus, under Sec. 1234A, there was a termination of a right to buy or sell a capital asset, and HI-2 was entitled to capital gain treatment.

What is the basis of the stock?

The IRS argued the basis of the stock should be $6,411,000, which was HI-2's original interest in the phantom stock upon Gary Hurford's death; the difference between the value at termination of $12,986,603 and $6,411,000 would be the long-term gain. HI-2 argued that the basis in stock should be stepped-up to the value of $9,639,588 as of Thelma's death. Because the phantom stock was included in Thelma's estate, the Tax Court found that HI-2 was entitled to a step-up in basis under Secs. 1014(a) and 1014(b)(9). The court noted that Sec. 1014(c) specifically excludes from step-up in basis "property which constitutes a right to receive an item of income in respect of a decedent under section 691." However, it concluded that Sec. 1014(c) did not apply because the phantom stock had been converted into a capital asset in HI-2'shands and as such was no longer an item of income in respect of a decedent.

'Appreciation' is a hallmark of a capital asset

According to the Tax Court, the phantom stock was a capital asset in HI-2's hands as determined by Sec. 1221; it was treated as long-term capital gain when Hunt Oil terminated the program and liquidated the phantom stock account. The partnership could not affect the value of the stock in any way and could only hope for the phantom stock value to appreciate; this characteristic was enough to classify the stock as a capital asset. Per Sec. 1234(A), it was also determined that Hunt Oil's liquidation of the stock was a termination of HI-2's right to sell the phantom stock and constituted a sale of an asset. Lastly, the partnership had basis in the phantom stock equal to its fair market value as of Thelma's death. The fair market value of $9,639,588 was included in Thelma's estate, and under Sec. 1014(b)(9), that was the partnership's basis in the stock.

Source: https://www.thetaxadviser.com/