Education Cost-Savings Strategies for All Taxpayers

10 minute read

Postsecondary education is expensive. For most taxpayers, finding new ways to save for college is essential. Fortunately, there are many different options on the market to help parents and grandparents save for college.

UGMA Accounts

The Uniform Gifts to Minors Act (UGMA) created a simple way for individuals to transfer assets safely to minors. UGMA accounts are custodial accounts that hold financial assets for the future benefit of a minor. The account belongs and is taxable to the minor, but a separate (adult) custodian is tasked with managing the account’s assets until the child reaches the age of majority in their state. At that time, the beneficiary has access to all assets within their account.

Here are a few things to note about UGMA accounts:

  • UGMA accounts are considered assets to the minor, so if their UGMA account is significant, they may not be eligible for means-based scholarships, grants or federal student aid.
  • Anybody can contribute to a minor’s UGMA account. Donors make contributions with after-tax dollars that are subject to gift tax.
  • UGMA accounts are not tax-advantaged accounts. This means that all income earned by assets held in the account are presently taxable to the minor. If parents elect to (and are eligible to) report their child’s income on their own returns, those earnings may be subject to kiddie tax.
  • UGMA accounts can only hold financial assets like cash, stocks, bonds, mutual funds, insurance policies and annuities.
  • The custodian has a fiduciary responsibility to manage investments that are in the best interest of the minor. This job can be outsourced to a professional.

Typically, UGMA accounts are created to fund future education costs, but the UGMA does not dictate how beneficiaries use their funds; once the minor reaches adulthood, those assets are theirs to use as they wish. Beneficiaries can use their UGMA assets to:

√ Pay college tuition√ Pay off a credit card
√ Buy a car√ Pay for utilities and groceries
√ Make a down payment on a house√ Take a vacation
√ Fund a gap year abroad√ Anything else!

UTMA Accounts

The Uniform Transfers to Minors Act (UTMA) is like the UGMA in that it provides a mechanism for transferring assets to a minor. But UTMA accounts differ from UGMA accounts in one significant way: UTMA accounts can hold any tangible or intangible asset. While UGMA accounts are limited to financial assets, UTMA accounts can hold financial assets and any of the following:

√ Real estate√ Intellectual property
√ Artwork√ Precious metals
√ Other collectibles√ Certain business interests

UTMAs and UGMAs, though not tax deferred, are good options to save for college because:

1. They are flexible to both donors and beneficiaries

2. They are simple to set up and simple to operate

3. They can play a part in a parent’s or grandparent’s estate plan

4. Earnings on account assets are taxable to the minor, who is typically in a lower tax bracket than the donor

Education Savings Accounts

Education savings accounts (ESAs) are tax-deferred investment vehicles families can establish to help pay for their children’s or grandchildren’s education. In most ESAs, investments grow tax deferred, and that growth will never be taxed if earnings are used to pay for qualified education expenses.

There are a few different types of education savings accounts, but the most popular are Coverdell ESAs and 529 plans. These plans help save for college because:

1. They are simple to set up and simple to operate

2. They are tax-deferred investments

3. If used to pay for education, growth within those funds is never taxed

Click here to explore ESAs in more detail.

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Roth IRA for Education

Roth individual retirement accounts (IRAs) are typically used to save for retirement, but some taxpayers use them to save for college.

Roth IRAs are funded with after-tax dollars, which means that contributions won’t produce any current-year tax benefits. However, assets held in a Roth grow tax deferred, and if you hold those funds for at least five years and you’re at least age 59½, you can use those funds however you’d like and your withdrawals will not be taxed.

Typically, taxpayers who take withdrawals from a Roth IRA before they are age 59½ will owe a 10% penalty on earnings. There are a few exceptions to this rule, one of which is if withdrawals are used to pay for qualified education expenses.

If a taxpayer is not yet 59½ but pulls from their IRA to pay for college (for them, their spouse, their child or their grandchild), they will owe taxes on the withdrawal but will not owe the 10% penalty.

Roth IRAs can be good tools to save for college because:

1. They offer a wide range of investment options

2. Earnings are tax deferred

3. Earnings may never be taxed if the account owner has held their account for at least five years and is at least 59½

4. If funds aren’t needed to pay for college, they can remain in the Roth account and be used in retirement

Each of these three education savings options has its pros and cons. Here is a helpful comparison:

UGMA/UTMA AccountsEducation Savings AccountsRoth IRA for Education
Who owns the account?The beneficiaryThe contributor (generally)The contributor
Are contributions deductible for federal tax purposes?NoNoNo
How much can you contribute per year?Any amountVaries$6K or $7K, depending on age
Are contributions considered gifts?YesYesNo
Are account earnings taxable if used to pay for college?YesNoYes, if account owner is younger than 59½ or has held their account for less than 5 years
If yes, when are earnings taxed?PresentlyN/AWhen withdrawn

Other Methods for Defraying College Costs

Aside from savings accounts, taxpayers have other opportunities to offset education costs. Here are just a few:

American Opportunity Tax Credit

The American opportunity tax credit (AOTC) is awarded to eligible students in their first four years of postsecondary education. The AOTC is calculated based on a percentage of qualified education expenses and can be taken each year for four years to offset those costs. Up to 40% of the $2.5K annual credit is refundable. The AOTC phases out for high-income taxpayers.

Lifetime Learning Credit

The lifetime learning credit (LLC) is also an annual tax credit, but unlike the AOTC, there is no limit on how many years you can take the credit. The LLC offsets up to 20% of qualified tuition costs. The credit is nonrefundable and maxes out at $2K per year. The LLC phases out for high-income taxpayers.

Student Loan Interest Deduction

The student loan interest deduction is worth up to $2.5K (for both single taxpayers and married taxpayers who file jointly) for student loan interest paid. The deduction is taken as an adjustment to AGI, so even taxpayers who don’t itemize can benefit. The deduction is phased out for high earners.

Educations Costs Require Tax Planning

Education costs can be steep, but some of those costs can be managed with the right tax plan in place. To get the most benefit from education savings plans, you must establish them early, which is why it’s important to discuss education costs with your tax planner as soon as possible.

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