How to Minimize Your Taxes and Pay for Your Kid’s College

The goal of tax planning is to arrange your financial affairs so as to minimize your taxes. There are three basic ways to reduce your taxes, and each basic method might have several variations. You can reduce your income, increase your deductions, and take advantage of tax credits.

Putting your money away into your tax-sheltered retirement accounts helps you reduce your tax burden and may help your children qualify for more financial aid. However, accessing retirement accounts before age 59 1⁄2 incurs tax penalties. So how do you pay for your children’s educational costs? There isn’t one correct answer, because the decision depends on your overall financial situation.

Here are some ideas that can help you meet expected educational expenses and minimize your taxes:

1. Apply for aid, regardless of your financial circumstances. Qualifying for federal aid, of course, means first filling out the dreaded Free Application for Federal Student Aid (FAFSA). This is the form that most financial-aid officers use to compare your family's finances with what your child's colleges of choice cost, before calculating your expected family contribution (EFC). (If your child is applying to private colleges, you may also need to fill out the CSS/Financial Aid PROFILE, a form administered by the College Board, a nonprofit membership association.)

A number of loan programs, such as Unsubsidized Stafford Loans and Parent Loans for Undergraduate Students (PLUS), are available even if your family isn’t deemed financially needy. Only Subsidized Stafford Loans, on which the federal government pays the interest that accumulates while the student is still in school, are limited to those students deemed financially needy. In addition to loans, a number of grant programs are available through schools, the government, and independent sources. Specific colleges and other private organizations (including employers, banks, credit unions, and community groups) also offer grants and scholarships. Some of these have nothing to do with financial need.

2. Help your kids find a work. As a parent, you can play a helpful role in assisting your child search for jobs. Your child can work and save money to pay for college costs during junior high, high school, and college. In fact, if your child qualifies for financial aid, he or she is expected to contribute a certain amount to his or her educational costs from money earned from jobs held during the school year or summer breaks and from his or her own savings. Besides giving the student a stake in his or her own future, this training encourages sound personal financial management down the road.

3. Save in your name, not in your children’s. Many parents set up accounts in their child’s name to build up college funds. Don’t do this. If you’ve exhausted your retirement account contributions, saving money that you’re earmarking to pay for college is okay. Just do it in your name. If your children’s grandparents want to make a gift of money to them for college expenses, keep the money in your name; otherwise, have the grandparents keep the money until the kids are ready to enter college.

4. Don’t try to do it all yourself. Unless you’re affluent, don’t even try to pay for the full cost of a college education for your children. Few people can afford it. You and your children will, in all likelihood, have to borrow some money.

5. Borrow against your company retirement plans. Many retirement savings plans, such as 401(k)s, allow borrowing. It's common for such plans to let you borrow a percentage of your money that doesn't exceed $50,000. The interest rate is usually reasonable, with a specified repayment schedule. The downside of borrowing from your 401(k) is that if you lose your job, the loan must be repaid quickly.

Just make sure that you’re able to pay back the money. Otherwise, you’ll owe big taxes for a premature distribution.

Remember that just because you can doesn't mean you should. In fact, borrowing against your 401(k) account should be considered a last resort. Your 401(k) is your retirement nest egg - not an emergency savings account.

6. Borrow against your home equity. This is the oldest trick in the book. It's also one of the best because you can exert almost total control over the process.
If you’re a homeowner, you can borrow against the equity (market value less the outstanding mortgage loan) in your property. Doing so is usually wise because you can borrow against your home at a reasonable interest rate, and the interest is generally tax-deductible. Be careful to borrow an amount you can afford to repay and that won’t cause you to default on your loan and lose your home.

Here's how it works: Say you need $50,000, your home is worth $250,000 and you owe the bank $100,000 on your mortgage. You can borrow against the equity, in this case $150,000.