From 2008 to 2022, the cost of in-state tuition at public universities rose nearly 80%.1 The high price tag now associated with a college education makes it critical for families to carefully plan how to pay for higher education expenses. Part of this careful planning involves reducing tax liability—the more you pay in taxes, the less you will have available for these other important expenses. Here we discuss four especially tax-efficient ways to help your kids afford college.
Make direct contributions with a UTMA or UGMA custodial account
The Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) allow adult friends or family members to contribute to a custodial account on behalf of a minor child. While this account remains open, the minor may take distributions only for certain permissible expenses, including education, support, and medical costs.
Meanwhile, the person who opened the UTMA account, or the custodian, retains full control over this account—at least until the minor turns 18 (or 21, depending on how the UTMA account is set up).
Some tax advantages of an UTMA account include:
- Since the minor is the account's technical owner, any earnings on the account will not affect parents' or grandparents' income taxes.
- Any gifts or contributions made to an UTMA account will qualify for the federal gift tax exclusion.
Get tax credits with a 529 college savings account
When it comes to reducing taxes while saving for college, it is hard to beat a 529 savings account. Many states provide tax credits or deductions for 529 account contributions, and earnings on a 529 account are also tax free—that is, as long as they are used to pay for qualified higher education expenses. If your child does not exhaust their 529 funds by graduation, they can easily be shifted to another beneficiary—even a parent going back to school.
Consider placing tax-disadvantaged assets into an irrevocable trust
An irrevocable trust is a financial structure that allows you to place assets into a trust, but then they no longer belong to you. This can be a great way to transfer assets that do not have preferential tax treatment. For example, if your top marginal rate is 37%, you can transfer funds that would be taxed at this rate to an irrevocable trust. This reduces your tax burden while transferring the assets to an entity (the trust) likely to have a much lower tax rate.
Tap into a traditional or Roth IRA
A final way to create tax-efficient college savings is by withdrawing a portion of your traditional or Roth IRA. Although early withdrawal taxes and penalties normally apply to pre-retirement withdrawals, there are a couple key exceptions for these types of IRAs.
- For a Roth IRA, contributions can be withdrawn, tax- and penalty-free, any time.
- For a traditional IRA, funds can be withdrawn penalty-free to pay for qualified education expenses. However, you will still pay regular income taxes on anything you withdraw.2
One caveat: when using retirement funds to help pay for college, it is important to ensure you do not withdraw too much. After all, your child can take out student loans, but you cannot take out retirement loans.
