College Savings with Pre-tax Dollars for Junior

Saturday afternoon and I am content that Army gave #5 Stanford a game at home. I plan to write a longer article on this topic but here is a summary of an idea that I have been thinking that of a concept to provide for a college savings plan for Junior on a pre-tax basis.

I believe that everyone should own a business of some sort for personal tax planning purposes. Even if you work for “The Man” and make most of your money from W-2 wages as an employee, you should set up a business to manage any business activities that you operate on the side or any investment management for your own personal investments. There are a significant number of benefits in terms of personal tax planning that can result from setting up a business. I will write a series of articles on these advantages.

One benefit to operating your own business is that you can put Junior and his siblings on the family company’s payroll. The salary payments are tax deductible to the business. Children under age 18 in a family business are not subject to FICA and FUTA withholding taxation. The business must be a sole proprietorship or partnership (LLC).

Generally a child is not taxable on their income up to the standard deduction threshold which is $6,100 in 2013. The contribution level cap for a traditional or Roth IRA is $5,500 in 2013. Junior can still be claimed as a dependent on the parent’s tax return. Junior’s income can contribute to the IRA up the limit. The funds can be invested on a tax deferred basis. In the Roth IRA, they can be withdrawn for college without an early withdrawal penalty under one of the exceptions for early withdrawals for qualified tuition expenses.

If you want to step it up a little, and you can justify Junior’s compensation as reasonable, you can increase his earned income up to the 2013 401(k) threshold of $17,500. Recall from my earlier comment that there is no FICA or FUTA withholding on Junior’s income. The full amount can be deferred on a pre-tax basis into a 401(k) plan in the family business. My vote is for a self-directed plan. Alternatively, you can contribute in a Roth 401(k), and the income can be taxed on a after-tax basis. The amount in excess of the standard deduction will be taxed in the 15 percent bracket but future distributions for college expenses will be tax-free. The distributions qualify under one of the exemption for early withdrawal under IRC Sec 72 and avoid the early withdrawal penalty.

So among the many benefits of operating your own business, you can convert some of the passive investment income from your family LLC which manages your investments and other sideline ventures and convert some of this money into pre-tax contributions into a IRA or 401(k) for Junior and his siblings. You can enjoy the tax-deferred growth and then take distributions to pay Junior’s college tuition or hope that he gets a scholarship. The strategy is further energized by the absence of FICA and FUTA withholding.

If you have any questions on this, or would like to set this strategy up, give me a call.



About gerrynowotny

I am a tax and estate planning attorney with a JD and LL.M in estate planning from the Univesity of Miami School of Law. I have worked in the life insurance industry for twenty three years and the last eleven in private placement life insurance.
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