A tax-saving approach once used mainly by the wealthy is emerging as a college-funding tool for the upper middle class, spurred by the recent reduction in capital gains taxes.

Parents, or grandparents, who own appreciated stock can give it to college-bound children in the form of a gift to reduce potential capital gains and tap into a nearly tax-free source of college funding.

For tax years 2004 through 2007, the long-term capital gains rate for those in the upper-most income tax brackets, 25% and above, is 15%, vs. 20% prior to the 2003 tax law change.

However, most teens and college students are in the lower income brackets of 10% and 15%, where the long-term capital gains rate is 5% through year 2007, and zero for tax year 2008, compared to 10% prior to 2003. (See charts.)

Many families hold stocks with a low tax basis, due to the widespread ownership of stock among the upper middle class, distribution of stock options and the receipt of inheritances.

That fact, combined with the ever-soaring cost of college, can make the gift of securities a better choice than the widely touted 529 college savings plans for some families. (See related story.) These state-run plans offer substantial tax breaks to families of all income levels who set aside money for college to be invested by professional money managers.

"With 529s, to get that appreciation built up, you need to start reasonably early," says Mark Luscombe, a tax analyst for CCH of a Riverwoods, Ill., a tax and legal information company.

"You have so much flexibility with appreciated securities." Unlike a 529 plan, for example, there is no tax penalty if the child decides not to go to college.

Deborah Fox is the founder of Fox College Funding, a San Diego company that is training financial advisers nationwide to offer college financial planning to families too well off to qualify for financial aid or income tax credits that have income caps. She says one key strategy is shifting appreciated stocks from one generation to another.

Window of Opportunity
Income Tax Rate Reductions
2002 2003 - 2010 2011
Top Bracket 38.6% 35% 38.6%
Fifth Bracket 35 33 35
Fourth Bracket 30 28 30
Third Bracket 27 25 27
Second Bracket 15 15 15
Initial Bracket 10 10 Eliminated
Source: CCH Inc.

"It's financial aid planning for the affluent," says Fox. "One of the best ways to do that is to use the tax capacity of the child. We call it 'tax scholarships.'"

However, just because parents inherited shares of IBM ( IBM) or have a fistful of valuable company stock options doesn't mean the securities should go to ensure Junior a place in the Ivy Leagues. Before giving their children significant amounts of stock, Fox cautions that parents should make certain their own retirement is covered first.

A four-year education at a prestigious college can run $300,000 after tax, says Fox, which can decimate a retirement plan. "The baby boomers," she says, "have a relatively few number of years left to save for retirement."

Bob D. Scharin, editor of Warren, Gorham & Lamont/RIA's Practical Tax Strategies, says while the strategy is time-honored, with more individuals owning stock, "It's become something a lot more people are focusing on. It makes sense to start gifting those assets right away."

Each individual can give another as much as $11,000 per year without any tax consequences.

Thus, two parents can give each child a total of $22,000 a year. Grandparents or other relatives can also contribute $11,000 each per child, per year.

If the money is needed soon, or in large amounts, more than $11,000 annually can be contributed if the giver is willing to reduce his or her lifetime estate tax exemption. Currently, every individual can give away up to $1 million while alive, free of estate taxes, which start at 48%.

That amount, however, will be deducted from the $1.5 million currently excluded from federal estate taxes at the time of death. (Individuals who exceed the $11,000 gift limit must file Gift Tax Form 709 with their annual returns, even though no tax is due.)

Window of Opportunity
Capital Gains Tax Rate Reductions
2002 2003 -2007 2008 2009-2011
Top four brackets 20% 15% 15% 20
Bottom two brackets 10 5 0 10
Source:CCH Inc.

To qualify for the long-term capital gains rate, the security must be held at least one year by the giver or the recipient, or by the two combined.

Dennis Stein, a CPA and head of the personal tax practice at DeJoy, Knauf & Blood in Rochester, N.Y., says that transferring stock to children for college can be a palatable way for parents to diversify concentrated stock positions. "We recommend it all the time," he says.

For example, one client whose father left her a large holding in Philip Morris, now Altria ( MO), has a tax basis of only pennies per share, Stein says, which would result in capital gains on the majority of any sale proceeds.

If a parent owns a stock acquired years ago, but now 30 years later, due growth and splits, those shares are worth $80 each, her tax basis, or cost for tax purposes, is just $2.

Her gain is $78 a share. If she sold now, she would owe 15% or $11.70 in capital gains tax on each share, compared to 5 %, or $3.90 per share for the child. That's a big savings.

Her gain is $118 a share. If she sold now, she would owe 15%, or $17.70, in capital gains tax on each $120 share, compared to $5.90 per share for the child. That's a big savings.

Stein says his client has been transferring shares of stock to her two daughters, one in college and one in high school, for years. They've essentially created their own college funds, by selling off the shares and gradually converting to fixed income assets. (This kind of intergenerational asset shifting need not be confined to college funding. It can be used to help children start a business or buy a house, preferably while they are in the 10% or 15% income tax brackets.)

On the downside, once the asset is given to the child, at age 18 or 21 it belongs to that child, who is free to spend it. Parents who wait until their kids are in middle or high school before giving them the assets are more likely to know how and trust how their children will use that money.

But parents shouldn't wait too long to take advantage of the current low capital gains rates. The 5% rate is to stay in effect until 2007, then drop to zero in 2008.

In 2009, unless Congress acts, capital gains rates will return to their pre-2003 rates, 20% for higher income earners and 10% for lower income earners on assets held for more than one year.

Of course, a change in presidential administration next year could mean an increase in capital gains and other taxes before then.

For a free report, "How to Have the IRS Pay a Big Piece of Your College Expenses," write to info@FoxCollegeFunding.com.

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