The Responsible Investor

College Payment Strategies: Where Should the Money Come From?

Everyone knows college is expensive. This year, the average tuition and fees for a private college are nearly $45,000 per year. And the price tag for some schools might be more than double that amount when factoring in the total cost of attendance with room and board.

Some families may not end up paying the full sticker price. Grants, scholarships and financial aid packages can help bring down costs, although these can be hard to get.

What is the best way to cover the cost?

Consider All Your Options

First, take stock of possible funding sources. These may include 529 college savings plans, taxable brokerage accounts, traditional savings accounts, cash from current income, gifts from family members and loans. Each comes with its own rules and tax treatment. And which sources you tap—and in what order—matters.

• 529 plan: Contributions to a 529 college savings plan grow tax-deferred. Withdrawals are tax-free when they’re used to cover qualified education expenses—anything else will likely come with an income tax hit and a 10% penalty on the earnings portion of the withdrawal. The good news is that qualified education expenses cover more than just tuition. You can use tax-free withdrawals to pay for room and board, textbooks, computers and more. One important note: 529 plans owned by parents are treated as parental assets and may reduce financial aid awards.
  
  
• Brokerage account: When you sell assets to make a withdrawal from a brokerage account, any profit is subject to capital gains tax. Long-term capital gains are taxed at preferential rates, but even so, brokerage account funds are generally less tax-efficient than 529 plans in covering education expenses. Your brokerage account balance is also factored into financial aid eligibility.
  
  
• Savings account: Interest earned on a savings account is taxed as ordinary income. Withdrawals don’t create taxable events. Like brokerage accounts, savings accounts can reduce financial aid eligibility, more so if held by the student.
  
  
• Current income: Making payments from your income doesn’t offer a direct tax advantage, but it can help you avoid tapping into accounts you’d rather not touch. Income is a major factor in financial aid determinations.
  
  
• Gift from a family member: Family members can gift up to $19,000 ($38,000 for married couples) per recipient in 2025 and 2026 with no tax consequences. Gifts received can affect financial aid if they’re deposited into an account owned by the student or a parent. Family members can also pay tuition directly, avoiding the annual gift tax exclusion limit and any impact on financial aid decisions for students and parents.
  
  
• Student loans: Parents have access to student loans in the form of Federal Direct Parent Plus Loans and private student loans, both of which can help bridge the gap when savings, income and other resources aren’t enough. Federal loans may offer lower interest rates than private loans. As a parent, you can deduct up to $2,500 in student loan interest from your taxes every year.

Conventional Wisdom Around Payment Strategies

As a rule of thumb, first take advantage of any “free” money such as scholarships and grants before deciding which source of funding to draw from. Next, consider drawing from taxable accounts before tapping into tax-deferred accounts. The goal here is to let your tax-deferred assets grow as much as possible so they can take advantage of the miracle of compound growth. When these sources of income are exhausted, you may turn to federal or private student loans, which charge interest and can therefore be the most expensive way to pay for college.

Of course, rules of thumb are broad. The strategy that works for one family may not work for yours. That’s where financial advisors can help. They can examine your complete financial picture to develop a withdrawal plan that aligns with your situation and helps keep you on track toward your long-term goals. For instance, it may make more sense to take 529 withdrawals first if your taxable accounts are likely to trigger short-term capital gains, which are taxed at a much higher rate than long-term gains.

The American Opportunity Tax Credit is another factor to consider. Your tuition payments may qualify you for a maximum tax credit of $2,500, but any expenses covered from a 529 plan don’t count toward the tax credit. Making sure you pay tuition bills from more than your 529 can help ensure you maximize the “free” money from the tax credit. At the same time, the size of the credit phases out for higher earners, which can change the calculus depending on your income.

Avoid Touching Your Retirement Savings

Securing your retirement is fundamentally more important than funding college. That’s because college is something that can be financed with loans if needed. Retirement is not.

Your best bet is to steer clear of using funds from your 401(k) or IRA accounts. While there is a provision allowing penalty-free withdrawals from IRAs for education expenses, it’s generally not worth it to make them. Withdrawing early from a retirement account can mean sacrificing years of tax-advantaged growth. And because these accounts are subject to annual contributions limits, the amount you withdraw can’t always be replaced quickly.

There are many different factors to consider and weigh when designing a college payment strategy. Fortunately, you don’t have to wade through them alone. If you’re wondering about ways to pay for college, a financial advisor can help you find the approach that’s best for you.

Learn more about Derek Van Calligan

Hello! I’m Derek, a wealth advisor and director of investment research at Allodium Investment Consultants, located in Minneapolis, MN. I am passionate about helping individuals and families build holistic financial plans to help them reach their goals. When I’m not helping our clients make investment decisions, I enjoy spending time in the mountains in Colorado—skiing, fishing and hunting with my wife, Kelly, and my dog, Hank. I am also an active church member and volunteer at Big Brothers Big Sisters and Junior Achievement.

The information provided is for educational purposes only and is not intended to be, and should not be construed as, investment, legal or tax advice. Allodium makes no warranties with regard to the information or results obtained by its use and disclaim any liability arising out of your use of or reliance on the information. It should not be construed as an offer, solicitation or recommendation to make an investment. The information is subject to change and, although based upon information that Allodium considers reliable, is not guaranteed as to accuracy or completeness. Past performance is not a guarantee or a predictor of future results of either the indices or any particular investment.