Tax-Saving Ways to Plan for College

Paying for college is one of the greatest financial worries most parents endure.  Aside from your own retirement, college tuition is probably the biggest expense you will ever face.  It takes planning, research and belt-tightening (and maybe some debt) to provide a college education for your children.  Funds will likely come from three sources:  savings, financial aid and tax relief.  Most importantly, you should not save for college at the expense of your retirement savings.  Many organizations, including the federal government, are willing to help your child pay for college.  However, no one is likely to give you a hand-out if your retirement fund comes up short.  Also, a qualified retirement fund will not count against you when applying for financial aid.

Investments & Savings – It pays to start early and compound interest.

Allocate your assets based on the age of your children to make sure the money is available when you need it.  If your children are very young (under 11), invest for long-term growth with a large portion in the stock market.  Despite market fluxations, stocks provide the best results over the long-haul if started early enough.  Before your children reach their teens, you may want to direct new contributions to more conservative investments such as short-term bonds and money market funds.  Make sure that by the time they reach their mid-teens, you start moving all money to safer investments that are easy to cash out.

529 Savings Plan/Qualified Tuition Program

Almost all states have at least one 529 Savings Plan, also known as a Qualified Tuition Program.  The benefits of this type of plan are 1) earnings grow tax-free and distributions are free from federal tax if the funds are used to pay for qualified educational expenses, 2) no income limits on contributions, 3) investment minimums are low, 4) a child can be the beneficiary of more than one account (i.e. one from a parent, another from grandparent), 5) assets are managed by a professional financial services firm, 6) if the beneficiary decides not to attend college, assets can be shifted to another close relative without penalty.   Most states do not have an annual cap on the amount you can contribute, but you should limit to avoid paying gift tax.  You can contribute to a plan in any state, so you should shop around because plans differ from state to state.

Prepaid Tuition

Careful consideration should be taken since there are many pluses and minuses with a Prepaid Tuition Plan.  On the plus side, 1) you pay for future semesters at today’s lower rates; you won’t pay extra no matter how much costs may rise in the interim, and 2) a very low-risk option for the novice investor.  On the downside, 1) negatively affect your chances of receiving financial aid, 2) lack the flexibility of other savings plans, 3) harder to predict what school your child will attend, 4) if not used, tuition paid is refunded to you without the accumulated interest and they may charge you a cancellation fee.

Coverdell Education Savings Account

Created by Congress to allow families to save for education expenses in the same way they save for their own retirements.  You can open an account at most banks and brokerage houses, and contribute up to $2,000 per year, and invest it in any manner.  Contributions are not tax-deductible, but funds may be withdrawn tax-free if used for qualified education expenses.  The ability to contribute to a Coverdell is based on your Adjusted Gross Income (AGI), your income before you itemize deductions or take the standard deduction.

Uniform Gift to Minors Act

Parents can use the Uniform Gift to Minors Act (UGMA) to open custodial accounts for their children.  These accounts allow unlimited investment options a well as parental control over assets until the children are 18 or 21 (depending on the state).  Be aware that income in these accounts may be subject to “kiddie tax”.  These accounts do have a tax advantage over taxable accounts you hold in your name.  The drawback is at the age of 18 or 21, all the money belongs to the child to do with what they wish.  In addition, UGMA accounts negatively impact financial aid.  Assets in a child’s name are counted much more heavily than in the assessment of your ability to pay.

Savings Bonds

Savings Bonds are another popular means for saving for college.  Series EE and I bonds provide a decent rate of return with little risk.  The interest earned is free from local and state taxes.  Federal taxes may be deferred until the bonds are redeemed or reach maturity.  For some, the interest may be totally tax-free if used to pay qualified educational expenses.

What about when savings is not enough?  Despite your best efforts, your college funds may come up short.  Financial aid and tax-related options may provide additional funds.

Financial Aid

First, never assume that you won’t qualify for financial aid.  The first step to getting financial aid is to complete the Free Application for Federal Student Aid (FAFSA) in January of the year your child will begin college.  Aid is awarded on a first-come, first-serve basis.  Be sure to complete the paperwork as soon as possible.  Information from your tax return will be needed; be organized so you can file early.  The information supplied in the application will be used to determine your “Expected Family Contribution” or EFC.  As a parent, you are expected to contribute 25 to 30 percent of your current income to meet education costs.  You are also expected to contribute 6 percent of your assets, excluding your home and retirement accounts.  Your child is expected to use up to 35% of their assets to pay the bills.  Keeping assets in your name is helpful if you are hoping to receive financial aid.  Your EFC is subtracted from the cost of education, the remainder is used to determine your family’s financial need.

Grants & Scholarships

These awards do not have to be repaid.  Grants are given by the federal or state governments or through the individual college.  Individual schools are more likely to provide grants to attract certain types of students or to encourage study in a particular field.  Scholarships are most often awarded on merit.


Loans make up a large portion of the student aid package.  Most are offered through federal government programs with low interest and a long repayment period starting after schooling is complete.

Tax Relief

The use of tax credits and deductions can be another way to ease the burden once your child is in college.  Tax credits reduce your tax liability dollar for dollar.  They are more valuable than a deduction which only lowers your taxable income. 

Read this article for more on the differences between credits and deductions. Examples of college tax relief are The Hope Credit and the Lifetime Learning Credit.  Click here for more information on the available credits and deductions.

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