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School
is soon out and many parents and students are beginning to make summer
plans. Whether the child works for his or her parent's business, spends a
semester overseas or gets a head start on college classes, there are tax
benefits from these activities in addition to the life-experiences that they
provide.
Withholding
break
Young
adults are often in a position to claim a complete or a partial exemption
from federal tax withholding. A student or a child under age 19 may claim a
withholding exemption even though a dependency exemption is claimed by his
or her parent. Generally, an individual who may be claimed as a dependent by
another person is exempt from withholding unless (1) income exceeds $800 and
includes more than $250 in unearned income such as interest or dividends or
(2) the taxpayer has no tax liability for 2004 and 2005 because total income
was not more than $4,850 for 2004 or projected to be not more than $5,000 in
2005. A claim for this exemption is made on Form W-4.
Family
business
If
the teenager works in a family business, everyone could benefit. Business
expenses are deductible from gross income, and include expenses for labor.
That includes wages for bona fide labor of children of the proprietor. Since
many teenagers do not meet the threshold minimum income for having income
taxes withheld, it is likely the teenager will not have to pay taxes on his
or her salary, while giving the family business a deduction against income.
Additionally,
if a teenager works in his or her parent's sole proprietorship, or in a
partnership where each partner is the teenager's parent, the young adult may
not be liable for FICA or FUTA taxes, as employment for Social Security
generally does not include services performed by an employee under 18
working for a parent. In the case of unemployment taxes, an employee under
21 is not liable when working for a parent. Again, this means that the
teenager will see more of his or her paycheck.
IRAs
Another
benefit not to be overlooked when a teenager works for the summer and
recognizes earned income is the opportunity to open an individual retirement
account (IRA). To contribute to an IRA, regardless of the type, an
individual must have earned income, so a summer job is a great time to open
one. While saving for retirement is probably not the first use that the
teenager has in mind for his or her summer earnings, it's never too soon to
start saving.
Short
term, the funds are available for withdrawal should they be needed to cover
college expenses, without triggering a 10 percent early distribution
penalty. If it is a Roth IRA, withdrawal of after-tax contributions also
avoid income tax on those withdrawals. The maximum amount that can be
deposited in either a Roth or traditional IRA is the lesser of earned income
or $4,000 in 2005.
Since
retirement seems so far off to many young people, parent-employers may have
better luck getting their teenagers to think long-term with an IRA if they
matches the child's pay with a gift. The origin of the IRA contribution is
not restricted beyond the amount of income the owner has and it does not
exceed the annual cap.
Studying
abroad
For
many students summer brings trips abroad to take classes immersed in another
culture. For their parents, tax planning may help lessen the financial
impact the trip can have. While they're unlikely to cover the entire cost,
the tax benefits are often worth examining.
Educational
savings accounts, also known as Coverdell Education Savings Accounts, may be
used for tuition, accommodation and various other expenses related to
education. The accounts may be funded with up to $2,000 annually, and any
distribution used for qualifying expenses is tax-free. The definition of
qualifying expenses is broad, and includes tuition, fees, books, supplies,
equipment, computer equipment, tutoring and room and board. Travel, however,
even to the selected educational institution overseas, is not a qualifying
expense.
The
rules on qualifying uses also are quite liberal as they apply to enrollment
and school eligibility. With a Coverdell ESA, the student need not be
enrolled half-time to utilize the funds, unless the funding is for room and
board. A degree need not be sought to use the funds. Virtually all
accredited U.S. schools are eligible, and many overseas schools are as well.
If the student chooses to study at an institution abroad that does not
qualify during the academic year, the student should check to see if the
summer program qualifies independently.
If
the student's parent does not have an ESA set up, his or her parents may be
able to use other tax incentives to offset some educational expenses. The
HOPE Scholarship and Lifetime Learning credit may be available for
college-level tuition costs. The HOPE credit allows for a 100 percent credit
for the first $1,000 in tuition and 50 percent for the second $1,000.
Alternatively, the Lifetime Learning credit is available for 20 percent of
the first $10,000 in tuition but is only available if the HOPE Scholarship
is not used. These credits are generally only available for tuition,
however. Books and supplies may qualify if those expenses are part of a
mandatory enrollment fee but, ordinarily, books, supplies, computer
equipment, and other items eligible under ESAs are not available under the
HOPE or Lifetime Learning credits.
Head
start on college
A
Coverdell ESA may be used for expenses of students attending summer classes
and study programs at colleges and universities. Distributions may be used
for the costs associated with those classes, including room and board,
tuition, fees, and supplies. Other tax credits like HOPE and Lifetime
Learning will not be available in this case, however, because the student
will not be enrolled half-time, as is necessary to utilize those tax breaks.
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