A Brief Guide: Tax-Efficient Strategies for Financing Higher Education

Published June 6th, 2023
Reading Time: 8 minutes
higher education

Written by:

Christopher Barker, CFP®, AIF®, MBA
Zoe Vetted Advisor

A Brief Guide: Tax-Efficient Strategies for Financing Higher Education

Published June 6th, 2023 
Reading Time: 8 minutes
higher education

Written by:

Christopher Barker, CFP®, AIF®, MBA
Zoe Vetted Advisor

Higher education has always been a crucial milestone in one’s journey, opening doors to opportunities and success. However, the increasing costs of pursuing higher education have made financing a concern for many parents. Regardless of the timeline, it’s vital to develop a well-thought-out plan to finance education.

In the quest for knowledge and personal growth, higher education has always stood as a pivotal milestone in one’s journey. It can unlock doors of opportunity, broaden horizons, and set individuals on a path towards success. As we raise our children, we dream about their admission to the nation’s top schools, where they’ll receive the best education. However, the cost of pursuing higher education has skyrocketed in recent years, making the financial component of this dream overwhelming. Funding higher education is a topic on many parents’ minds, especially as their children grow older. 

No matter how far out or close in the timeline this is for you, working on a well-crafted plan that will shape the path to financing higher education is crucial. This blog will guide you through systematic savings strategies that transform your big goal into manageable steps. Moreover, we’ll shed light on the erosive impact of taxes, exploring the pros and cons of popular strategies and uncovering how education savings can become a valuable tax deduction. These simple yet effective strategies will set you on the right path toward achieving your educational aspirations.

Did You Know?

Eye-opening and jaw-dropping reactions are expected when we look at the numbers related to high education over the last two decades. Tuition inflation has outpaced regular goods inflation significantly. From 2000-2020 the average annual tuition inflation was 5.1% at public colleges, while the average inflation on all other goods and services was only 2.47%. So inflation on higher education has outpaced inflation on all other goods and services by more than double in 20 years. Mathematically, if you want the market to help you grow your money, you must earn at least 5.1%. Otherwise, your tuition liability will increase. 

Here is an example to help you put it into perspective:

The average annual in-state tuition for the University of Colorado at Boulder, my alma mater, is about $32k this year. Consider this possible scenario:

  • If you’re starting to save for education when your child is born, 18 years later, the annual cost of tuition with a 5.1% inflation rate will be over $78,000 (for one year) when your child is a Freshman in college. 
  • The value of your child’s in-state tuition for four years would be more than $313k.

This is undeniably significant and might cause some anxiety, but don’t let it close your eyes to the truth. This goal can be achieved if it’s broken into baby steps.

Hypothetical Case Studies

There are hundreds of different scenarios under the college saving situation that you might relate to, but let’s imagine there are two general possibilities:

1. Saving For College is the #1 Priority

Meet Mr. and Mrs. Buffalo. Mr. and Mrs. Buffalo had a child a few months ago. Fortunately, they’ve worked hard and grown their wealth to live without financial stress, and their most important financial goal is saving for college.  

To fund this objective, they have 18 years to save and make a comfortable and ideal living with excess cash left over at the end of every month. Starting Day 1 until their child’s 18th birthday, they must save about $700/month, earning about 8% annually. If they meet this goal, they will have accumulated the full $313k to fund all four college years! Using systematic savings, Mr. and Mrs. Buffalo can fund their significant 6 figure goal with a much smaller monthly goal of $700/month.

2. Not Saving for College Since Day 1 

Others might have had to start saving later or have made it less of an immediate priority than the Buffalo family. Let me tell you about the story of Mr. and Mrs. Ram. 

Mr. and Mrs. Ram weren’t making much money when their child was born, but about nine years later, both careers have blossomed, and they have more resources to save for the education their daughter, Melanie, dreams about. The cost of waiting increases their savings goal to about $2100/month to reach the same $313k savings goal. Mr. and Mrs. Ram see the power of starting early and compound savings, but that is not always a realistic option, and some may even start planning later, thinking there isn’t much of a difference. 

The moral of comparing these stories is to do what you can and stay consistent with your savings; you may be surprised by how much you can put away.  

You’re Not Alone: Maximize the Benefits of 529 Plans

Amongst the many tax-saving strategies, 529 Plans intend to help pay for education while being a significant tax advantage. Nevertheless, they should be properly understood to ensure you maximize the tax benefits these plans offer. 

Keep an Eye Out…

Contributions to a 529 plan are NOT federally tax deductible; only about 30 states offer a state tax deduction for 529 contributions. You can find out if your state has such a program by talking to a financial advisor or even conducting a quick Google search. While the potential state tax deduction is reasonable, there is always a catch. The dollars in the 529 plan must be used for higher education. If you take the money out for anything besides qualified college expenses, you owe a 10% penalty on the earnings portion of the 529 account balance withdrawn

The message here is, if you choose to use a 529 plan, make sure you put only a little in it AND that you have sufficient emergency savings elsewhere so you aren’t tempted to tap into the college savings if there is a financial emergency.  

Bigger Families = Larger Savings Goals

On that note, you can use one child’s funds to pay for a different child’s education savings if you have multiple children. Thus far, we have discussed saving for one child and how expensive that can be. Nevertheless, if you have 2, 3, or more children, you can easily be looking at a million-dollar savings goal. Again, break it down into baby steps and systematic savings to make the goal seem less daunting. In the case of multiple children, if you are going to over-fund one of their 529 accounts, overfund the oldest child. If they don’t use it, you can always spend it on the younger children as needed.  

Expenses Don’t Stop at Tuition

Qualifying education expenses aren’t the only thing that costs money in college. Even if you saved the estimated $300k+, your child might have other expenses necessary to graduate. These include transportation expenses and health insurance, which in most cases is required by the university for the student to be enrolled. While housing MAY be considered a qualifying expense, 529 dollars may not be used to pay the mortgage on a house or condo in which the student lives. A loophole exists where you can purchase a property, pay the mortgage out of expected cash flows, and have your child pay you rent on that property (which then can be used to pay the mortgage). There are many creative options here that a financial professional can walk through with you and see what works for your situation.  

The primary benefits of a 529 plan are a potential state tax deduction and tax-deferred growth.  If you live in a state like Texas or Florida (just to name a couple of examples) that does not have a state income tax, you will not have a state income tax deduction, but you will have tax-deferred growth. 

Other states, like Arizona, have a state income tax, which is relatively low at 2.5%. Consequently, many might think the added benefit of 529 plans is lower. Meanwhile, in some states like New York, New Jersey, or Washington DC, where the state income tax rate is almost 11%, it might make more sense to utilize this vehicle for your family.  

Using a 529 Plan Post-College Graduation

There are some creative options for using your 529 dollars if there is some leftover when your children are out of college. One of my clients enrolled in a university aviation program to get his pilot license. Another one used his college funds to go to the PGA golf academy to become a better golfer. Some other ideas are to keep it on the sidelines if your child decides to attend graduate school or a professional certificate program. You can also use up to $10k for K-12 education. Check with your local jurisdiction to see if your state considers K-12 education a qualified expense.  

Potential Alternatives

If you are still concerned that the money you are working hard to save for college will not be used for college, there are still other options. For starters, you can save money in a regular taxable investment account. While you cannot deduct the contributions in a given year from your state taxes, you can use a 529 as a passthrough vehicle to take a state tax deduction in the year you incur the expense. In this strategy, if you owe $20k to your child’s school, you can open a 529 plan with a zero balance, put the $20k into the account for a short period, and then forward it to the school. If you are in a state that qualifies for a tax deduction, you will get the deduction when you spend the money. Again, check with your state or a financial advisor to see if this is a good strategy.  

The Bottom Line

College is getting more expensive, and the sooner you start saving, the better your chance of achieving your goals. Discuss with an investment advisor the options available to you and what makes the most sense for your risk tolerance and time horizon. Lastly, there are other ways to save for education besides a 529 plan, and sometimes a 529 plan is only the best option if your state allows state tax deductions for contributions to an education savings plan.

Disclosure: This blog is not investment advice and should not be relied on for such advice or as a substitute for consultation with professional accounting, tax, legal or financial advisors. The observations of industry trends should not be read as recommendations for stocks or sectors.

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