College has become the second highest expenditure for many families, second only to the purchase of their home. According to the College Board, for the 2003–04 school year, the average four-year public college cost of attendance (which includes tuition, fees, books and supplies, room and board, and miscellaneous expenses) averaged $13,833. A four-year private university averaged $29,541. Tuition costs alone are up more than 40 percent over the last decade. Total college expenses have increased approximately 16 percent in the last three years.

It appears there is no foreseeable end in sight for these double-digit increases, as federal and state governments continue to struggle with deficits that have dramatically impacted their ability to provide subsidies and financial aid. Even today, it is easy to see why it is not unusual for a family to spend in excess of $100,000 on one child's college education!

Surveys routinely find that many parents are unaware of or greatly underestimate how much their child's college education will cost.

Upper-middle to high income or high net-worth families are faced with a significant college funding dilemma: they make too much income or own too many assets to qualify for traditional financial aid. More importantly, the higher the income tax bracket a family falls into, the higher the cost of college becomes because college is typically paid for with after-tax dollars. For instance, a family in a 35 percent federal and 5 percent state income tax bracket would need to come up with $166,667 over four years to send their child to a college that costs $25,000 per year!

Whether or not a family has enough savings or income to pay for college, if at all possible, most families would like to avoid paying for the full price of college.

Most families are unaware that proactive college funding planning may dramatically lower their college expenses by tens of thousands of dollars. There are dozens of academic, financial, and tax strategies that can be utilized to accomplish this result. This report focuses on a number of tax strategies that can be used to create "tax scholarships," so the IRS can pay a big piece of your family's college expenses. ( A tax scholarship is any new found tax deduction that creates money you can use to reduce the cost of college. The higher your income tax bracket, the greater the benefit of any tax strategy because it is gross income you do not have to earn to fund college.)

The effectiveness of the following ideas comes from taking certain portions of the Internal Revenue Code and applying it specifically to college funding planning. However, we recommend all educational tax strategies should be customized for your family with the help of your tax adviser and a professional who is a college-funding specialist. We are going to discuss three types of strategies that may enable you to create tax scholarships for your family. You should note that the following strategies should only be used if it is clear your family will not qualify for any significant "need-based" financial aid (aid awarded based on your family's income and assets.)

Tax scholarships can be created by gifting, shifting income and utilizing the tax capacity of your child.

#1 Gifting: If you fall into the higher income tax brackets, gifting highly appreciated assets can be an effective strategy in creating tax savings that can be used to pay for college expenses. Here is an example of one of many gifting strategies. Let's say you participate in an employee stock purchase plan (ESPP). You exercise your option to purchase a share of the company's stock. At the time the option was granted, the market value of the stock was $100. Instead of selling the stock, you make a gift of the stock on that day to your child. In this case, $15 can be included as compensation in your gross earnings (because you are able to purchase the stock at a 15 percent discount.) Your cost basis of $85 is increased by this $15 for a total basis of $100. The $100 also becomes your child's cost basis, as of the day of the gift, for determining the gain or loss when the stock is liquidated to pay for college. If there is a short-term gain on the stock when it is sold, if planned properly, your child will either pay no tax or only 15 percent versus you paying up to 35 percent in federal taxes. If there is a long-term gain, your child pays no tax or only 5 percent, versus you paying 15 percent. There is an annual $25,000 maximum that can be invested in an ESPP. At this funding level, you can save up to $8750 per year in taxes. As you can see, the tax scholarships that can be created in multiple years by this one strategy can be substantial. (A similar gifting strategy can be effectively used with stock options.)

An additional gifting strategy can be successfully used by both parents and grandparents alike to pay for college with pre-tax dollars. Let's say you have a low-yielding asset, such as a stock or a piece of land. You can set up a vehicle called a "charitable remainder trust," where you would receive a large tax deduction in the year the asset was gifted to the trust. The asset would then be sold, tax-free, and the assets could then be reinvested to produce a higher amount of income to pay for college. Grandparents love this strategy due to its ability to save both income taxes and remove assets from their estate as an estate planning tool.

#2 Shifting Current Income : You can also shift current income to create tax scholarships for your family. For instance, if you are a business owner or own investment real estate, you can establish what's called an Education Assistance Program. You hire your child for, let's say, $1500 or $2000 per year (or more) and then establish this plan which allows you to pay up to $5250 per year totally income tax-free to your child to pay for higher education expenses. And your company gets to fully deduct the contribution! This tactic contains two benefits. First, by paying wages to your child, you are able to shift income to your child who will pay little or no income taxes on those wages. (We will discuss more about compensating your child below.) Second, it allows you to pay up to $5250 per year of college expenses from your business totally tax-free! This is truly a win/win strategy. (Please be aware there are some very specific IRS regulations that must be followed in order to qualify for this benefit. Make sure you consult a professional familiar with this type of plan so you can set it up correctly.)

Another great way to shift income for a business owner who employs their spouse and children is to utilize a Medical Reimbursement Plan. This plan allows you to take out-of-pocket medical expenses off your Schedule A where they are usually not deductible and makes them 100 percent deductible! (Medical expenses are only deductible to the extent that they exceed 7.5 percent of your adjusted gross income.) This fringe benefit is not considered taxable income to the employee, yet provides a tax deduction for the employer.

What may be even better yet are the newly created Health Savings Accounts (HSA). These plans allow families with a higher deductible health insurance policy to pay for medical expenses pre-tax. Pre-tax contributions are made to a custodial account each year from which out-of-pocket medical expenses can be paid. And money that is deposited into the HSA account that is not spent that year can continue to rollover to subsequent years indefinitely. Substantial tax savings can be potentially achieved here. (The HSA can be utilized by all wage earners, not just the self-employed.)

#3 Using the Tax Capacity of Your Child: Let's explore using the tax capacity of your child to create additional tax scholarships. This involves shifting income from a higher tax bracket to a lower tax bracket. There are three stages of a child's tax capacity: 1) Birth through age 13 (which are called "Kiddie Tax" years because a child is limited to the amount of investment income they can earn without paying higher taxes), 2) Age 14 through high school, and 3) the college years. The last two stages are determined by what standard deductions, exemptions, and education tax credits can be utilized.

You can utilize the strategy of compensating your child to shift income to a lower tax bracket. A child can be employed to perform various duties for a family business or even household duties. The compensation paid to your child is earned income and is not subject to Kiddie Tax. Your child is taxed on compensation, but at a lower tax rate than the business. If your children are under age 18, they can be paid without Social Security or self-employment tax. Depending on your individual family's situation, there are other guidelines that need to be considered to ensure this strategy works most efficiently. You should plan as far in advance as possible and incorporate a multiyear strategy to determine how to compensate your child to receive the most benefit.

This report attempts to introduce you to a handful of strategies that might help you lower your college expenses. There are numerous additional strategies that can be utilized in various combinations that can produce an optimal outcome for a particular family. College funding tax strategies such as the ones discussed above, combined with academic and financial planning strategies, may be able to literally save you tens of thousands of dollars on your child's college education. Each family's situation is unique. It is important to create a customized plan for your family, preferably with the help of a professional who is a college funding specialist.

College funding planning needs to be coordinated with your tax and retirement planning.

If you do choose to work with a college funding specialist, be certain he or she is familiar with the types of strategies discussed above and is qualified to make suitable recommendations based on taking all of your other financial priorities into account. (Only a small percentage of financial advisers are trained in college funding planning. However, the majority of those advisers focus on trying to help families qualify for more "need-based" financial aid. There is no value to this type of planning for upper-middle and high income or high net worth families who will not, under any circumstances, qualify for this type of aid.) Seek out a professional who specializes in planning for the higher income or higher net worth market.

A college education is expensive. Families who pay the lowest college expenses are the ones who have taken the time to understand and control the college funding process. Good planning can make a tremendous difference in what you pay. To find out more about how you can take control of your family's college funding process, click here to find out how a professional college funding consultant can help your family avoid paying the full price for college.