Capital gains affect financial aid eligibility

Parents and students sitting on capital gains in taxable accounts from surging stock prices need to consider when, and if, selling their positions will affect potential college aid eligibility, how much tax will be due and if the market is poised for a decline from its highs that would erode the value of their investments.

After Jan. 1, college students will apply for financial aid for the academic year of 2014-15.

In completing the aid forms, they will need to report 2013 financial information for themselves and their parents. They do this every year they are in college.

Many mutual funds are set to make large taxable distributions to shareholders this year. Although many investors in recent years have seen their taxable-account values climb with few distributions on which they have had to pay taxes, this year will be a different story.

The unearned income (interest, dividends and capital gains) that shows up on the students’ or parents’ tax returns for this year, either from their selling investments or from distributions from mutual funds, therefore will be counted on the students’ financial aid forms for the 2014-15 academic year.

The asset value itself will be counted on the aid forms, too, while it is sitting in a brokerage account, or in cash or savings, after the sale. Depending on the aid formulas used by the colleges a student is considering or already enrolled at, the value of reportable assets in parents’ names will be assessed at up to 5% to 5.64%, and in students’ names at 20% (most public universities and some privates), 25% (at 300 private colleges and the University of North Carolina at Chapel Hill and the University of Michigan at Ann Arbor) and only 5% (same as parents, at 26 private colleges called the 568 Presidents’ Group).

For example, for financial advisers with clients who have an investment worth $50,000 that has an unrealized gain of $15,000, only the value of that investment gets reported on the aid forms. As soon as it is sold and the $15,000 gain is realized for tax purposes, then the capital gains income will be reported as part of the account owner’s adjusted gross income on the aid forms.

Assuming that the parents are in the 25% tax bracket or above — the capital gains rate in 10% and 15% brackets is 0% — they will pay capital gains tax at 15% to 20%, or as high as 23.8% for some taxpayers, or $2,250 to $3,000 on the $15,000 gain and raise the student’s expected family contribution by about half the after-tax income, or $6,500.

If the child owns the asset and has no other income, the child will be subject to the “kiddie tax” and pay $2,050 in capital gains tax. The student’s income protection allowance in the aid formulas would offset about $6,000 of the $15,000 in capital gains income.

So after taxes and the student’s income allowance, the income from the sale would increase the student’s expected family contribution by about $3,500.

If the child doesn’t qualify for need-based college aid, then sell the asset and focus on the most tax-efficient way to deal with the capital gains income.

If the student is a high school senior enrolling next year or a student already enrolled in college and qualifies for need-based aid, then selling the asset will affect the student’s aid eligibility for the upcoming year but not subsequent years.

If the student is a junior in college, you could wait until January and then sell because the resulting income would be in the 2014 tax year, and the student would be graduated before the 2015-16 academic year.

TAX CREDIT

If the parents have a modified annual adjusted gross income of less than $160,000, they can claim the full American Opportunity Tax Credit of up to $2,500 per year per child during the year in which qualified college expenses are paid. The credit helps offset the added capital gains income dollar-for-dollar.

If the parents’ modified annual AGI exceeds $180,000 jointly, then they can’t claim the credit and, if the child isn’t eligible for need-based aid, should explore the tax-saving strategy I described in a previous column “(How to make college costs less taxing,” InvestmentNews, June 3), eliminating $25,000 of capital gains in one year on the child’s tax return. If the child is a high school senior now, the parents could wait until January to sell, realizing the capital gains income in the year college expenses are paid, and use the American Opportunity Tax Credit to offset the gain.

Troy Onink (troy.onink@stratagee .com) is chief executive of Stratagee Corp., which provides college- planning approaches to families and their financial advisers, and licenses college-planning software to advisers.