Use tax planning to help pay for college

Planning for college is rarely an easy task.  Although many parents begin funding dedicated college savings vehicles in advance, sometimes a tuition-paying strategy is developed only when the kids are already choosing schools.  Fortunately, there are options for late-stage college planners facing a looming tuition bill:

1.) Liquidate the child’s investment accounts.  Evaluate the basis (cost) of the investments to determine the gain (or loss) that would be realized upon selling these investments.  If the investment can be sold with very little gains (and thus little tax impact) then it may make sense to sell the investments, use the proceeds to fund an education savings account (like the Michigan Education Savings Plan) which would allow the gains on the investments to be tax free (assuming they were used for qualified education expenses).  This would give the education savings account additional time to grow and thus increase tax savings (however if in the future the funds were not needed for education expenses then the gains would be taxable).

2.)  Fund an education savings account (like the Michigan Education Savings Plan).  This type of investment typically gives you less flexibility in the type of investments you can choose and investments are determined by age; thus, the older the student is the more conservative the investments become (because the student will need the money soon and it needs to be there when they do) and thus would typically mean reduced gains and thus minimizing any real tax savings. 

3.  Rollover a traditional IRA into a Roth IRA account.  If additional distributions are (or will be) required from an IRA to pay tuition then it might make sense to roll over an estimate of the funds needed into a Roth IRA account.  This would required that the taxes on any rollover amount be paid currently but would allow for:

    More flexibility of investments

    Distributions could be used for anything in the future (in case the student’s education plans change)

    Possibility for greater gains on investments (less conservative investments) which would be non taxable if held in Roth for more than 5 years after the rollover and thus increase tax savings.  (note you can designate distributions to be from principal before gains and thus be able to leave gains in account until five years has past)

This strategy would be very effective if you anticipated large gains in the future and thus paying the tax now on the roll over amount would be outweighed by tax free gains.  It doesn’t work so well if the investments decline or stay flat because by paying tax on the rollover amount you could be paying tax on investments that you would not otherwise have and may reduce future gains because you used principal to pay taxes.

Using tax planning strategies to pay for near-term college tuition needs can be a wise practice.  Be sure to contact your tax planning professional for an individual assessment.