Today, we take a look at one of the most misunderstood and underutilized accounts in your tax-planning aresenal.
The Coverdell Education Savings Account can be incredibly useful as a tool for you to pay for:
- elementary school expenses
- secondary school expenses
- homeschool expenses (in some states)
- college expenses
- vocational school expenses
- and more!
Perhaps more importantly, there are very few things you can’t use as an investment in the account. You can choose to invest in:
- real estate
- notes
- tax liens
- companies
- precious metals
- etc.
But what about the income limitations? Meaningless. You can circumvent them so easily they’re utterly meaningless.
This account is constantly criticized as being useless. Check out my discussion of the details and see if it deserves the criticism.
Enjoy!
Joshua
Links:
- IRS Publication 970: Tax Benefits for Education
- Estate and Gift Tax Treatment of a Coverdell Account
listening to the podcast now, so you may have figured it out later in the episode, but the word you were looking for is Ward. A Guardian looks out for the interests of the Guardian’s Ward.
Thanks, Brandon! I never did come up with it. 🙂
Hi Joshua,
On the show you asked about nondeductible expenses and distributions with an S corporation. Both basically do the same thing on the tax return. Neither count as a deduction on the return and both reduce the basis of the shareholder’s stock.
Also, neither are subject to self employment tax. WIth an S corporation, the only thing subject to SE tax is the W-2 of the shareholder. For S corporation, shareholders that participate in the business are required to pay themselves a wage and the rest of the income from the S corporation is not subject to SE tax. There’s a lot of controversy on where that wage should actually be set for the owners of the business (for an extreme example… pay yourself a W-2 of $100,000 and the business generations $100M of income), but that’s an entirely different conversation!
Ryan
Ryan, Thanks for helping keep me on track. That’s what I thought!
On the S-corp salary issue, my understanding is that the wage you set should be a market wage. Therefore, I’ve advised people to research comparable wages of some kind and keep those records of research. Is that a safe recommendation?
Hi Joshua,
That is a safe recommendation… and the one I give as well.
A lot of the litigation with S corporations takes place around a reasonable wage for the owner(s). As you can probably guess, this is the case because the incentive for the S corporation owner is to keep the wage low so that they don’t pay self employment tax while the incentive for the IRS is the opposite.
Paying a market wage is what you’re supposed to do, which can be hard if the business is new and not really cash flowing. For established businesses I have a lot of people that set their wage at the social security wage limit and be done with it, which for 2015 is going to be $118,500. They want to reduce the risk of being audited and having to pay the social security tax, which for “larger” small business isn’t that much so they just want the risk to not be there. In addition, for what it’s worth, they get larger social security benefits (arguments for what this will look like or how much one will actually get is another topic).
The bigger tax one can end up paying is the medicare tax because there’s no income ceiling on that. For “smaller” small businesses where you wouldn’t pay a salary at the social security wage limit then there’s a little more work to do with, like you said, documenting and retaining a market wage.
Ryan
Thanks, Ryan. That seems like prudent, conservative advice.
Do you know of any planning tricks for the medicare tax other than wages vs. dividends?
Hi Joshua,
That’s a tough question because there’s not much planning to do around the SE tax for earned income. A possibility would be to try and make the income “passive”, but then that opens up the door to being subject to a different tax, the Net Investment Income Tax.
Another thing one might consider is to try and accelerate income once they are over the social security wage base. Assuming they’re making money right around the wage base each year (so the income is being subject to the full social security and medicare taxes each year), this could be beneficial as the income is not being subject to the social security taxes (only the medicare taxes) when it otherwise would have been.
One could also operate the business inside of a C corporation, but for most small businesses that’s probably not the best structure.
Ryan
Hello Joshua, great podcast as always. As a father of a two year old and another on the way, I really appreciate all the work you have put into your educational series of podcasts. I’m having trouble finding documentation about the use of Coverdell funds to invest in real estate. Did you read a particular story about it online? Could you post a link? Thanks and keep up the good work!
Thanks, Joel. I actually purposely didn’t include a link because I can’t vouch for any specific custodian you can work with. There’s no reason in the IRS rules why you can’t do it but I’m not ready to endorse any of these custodians.
Start with this search and educate yourself: https://duckduckgo.com/?q=self+directed+coverdell+esa+real+estate
Be very careful of who you work with and do your own due diligence.
Listen to this show for more information: http://radicalpersonalfinance.com/143-intro-to-self-directed-iras-how-to-invest-in-real-estate-tax-liens-physical-gold-and-silver-structured-settlements-horses-livestock-farmland-timberland-and-more-in-your-ira/
Thanks Joshua for the quick reply! I’ll definitely check out your latest podcast and look into it further. Take care.