The Best Ways to Pay for College
Saving for College 101
There is an old saying when it comes to saving for education. Either save a lot of money or don’t save anything at all. However, don’t fall in between the two strategies. The cost of education has gone up dramatically over the last several decades for various reasons. Rather than explore the economics of why, since that is largely beyond your control, let’s look at the best possible course of action.
Like any other area of financial planning, each situation is unique. Some of us can fall into income ranges where neither of these possible approaches will work. But for the average American, this is what you need to be concerned with.
Don’t save anything…The logic here is essentially that you want to utilize the maximum amount of aid/loan capability that is possible. When applying for school aid, the most common form to be completed is the Free Application for Federal Student Aid (FAFSA) form. FAFSA is typically updated annually for any information that has changed, and is actually not a single application for one program. It is a form that addresses multiple avenues of student aid, from the nine different Federal programs to the hundreds of state programs that are available depending on your state. This form can be a bit complicated and it should be noted that as a professional financial planner, I use a specialist in this category for clients whom are in need of assistance in college planning.
There are many misconceptions about how aid works. One of which is that you make too much money. While this may be true, the reality is that your income is less important. Rather what matters is your income relative to essential expenses. Another common statement I have heard is “I own a home so I can’t get aid for my kids”. That is also not true. Again, it is more of an income to expense comparison. The mere fact that you own a home and its value will not necessarily disqualify you. However a secondary residence such as a vacation home will be problematic.
The argument for applying for aid even if you think you can cover all or some of the cost is still valid. There are multiple reasons behind this. One of which is the power or tax deferred growth. FAFSA does not penalize a parent applying for aid based on the size of retirement assets that they hold. So for example if you are in your early to mid 30’s in age and expect your children to go to college, it makes more sense for you to maximize your own retirement savings. This should be a priority since first of all, if you don’t fund your retirement…who will ??? If you feel you have more than enough in the way of assets to cover educational costs then consider taking retirement distributions at 59 1/2 years old penalty free to help pay for your child’s student loans on their behalf. The rates on student loans are often favorable and the compounded return on your assets in your retirement accounts are likely to fair much better on a tax deferred basis. The contributions to things like your 401k for example actually bring down your adjusted gross income and make grants or loans more likely. Furthermore, the withdrawals from our retirement accounts later in life to pay down the liability will likely take place at a lower marginal tax rate.
If you have substantial liquid assets that you feel will inhibit you from applying for such aid, consider deferring a large portion of it. Should you fund either a tax deferred fixed or variable annuity, these are considered to be retirement accounts under FAFSA. A non-qualified annuity has nearly an unlimited contribution and can provide an excellent resource to tax shelter money. Keep in mind that when purchasing annuities, the cost can be extremely high. However there are some very low cost variable annuities through companies like Vanguard that can provide you with a tax shelter towards your retirement savings and hide assets from the eye of the FAFSA application. To better understand annuities you can view our prior article on the topic here…
Another possibility is that of permanent life insurance. While these types of policies are more of an estate planning tool, and not the best savings vehicle from the perspective of expenses, they provide a similar shelter in their cash values from FAFSA reporting.
Self Employment...Those individuals whom own their own business with fewer than 100 employees would be wise to limit the distribution of profits prior to applying for student aid. Any assets of a company with less than 100 employees are also not includable in FAFSA reporting
Another consideration is more of a parental one. Over the years I have seen numerous cases in which parents have funded substantial dollar amounts towards the education of their children. In some cases the child may not take school as serious as a parent might like. Should your child drop out or produce a diploma in a field that offers little to no economic rewards, you may be disappointed. However, your disappointment will not get you a refund in the $40,000.00 of tuition you may have paid last year. My experience has shown me that when someone knows they are required to pay the bill, they take the purchase of what they’re buying a bit more serious. You can always tell your kids that once they graduate with the grades you expect, you’ll help pay off the loans for them. If they drop out it is their responsibility. This approach allows you to maximize current tax benefits while still eventually paying for the cost of education.
Below is a summary of assets and income sources and how they affect a "needs assessment" for FAFSA Purposes.
Income That Counts
Income That Does Not Count
Asssets That Count
Assets That Do Not Count
Student Wages under $6,000 Annually
Stocks & Bonds
Second Home (Net Value)
Tax Deferred Annuities
Taxable Portion of Social Security
Commercial Property (Net Value)
Business Assets (If More Than 100 Full Time Employees)
Retirement Plans (401k/403B)
Business Assets (If Fewer Than 100 Full Time Employees)
It should be noted that hundreds of universities also utilize the CSS form issued by the college board when assessing financial aid. While FAFSA is the gateway to Federal programs, the CSS form is the gateway to private aid from the University itself. In such cases, they often will look at the market value of investments in vehicles such as Non-Qualified Annuities.
What if you wish to simply just save money on your own and choose not to try to shelter assets ??? Generally speaking, saving assets under the child’s name in a custodial account is the worst place to maintain your savings. However you have many different possible options. The best of which is the 529 college savings plan. You can contribute a substantial amount to the plan. Yet, each contribution to a minor is ordinarily limited to the $13,000.00 per year for gift tax purposes in 2012. That means you and your spouse could gift $26,000.00 to each child in total for the tax year 2012. However the 529 plan allows for you to front load the first 5 years up to $65,000.00 per beneficiary for tax year 2012, that is $130,000.00 per couple. Most state plans will restrict further contributions once the balance has exceeded somewhere around $300,000.00. ($375,000.00 in NY state). The assets in the 529 plan for the purpose of FAFSA are considered assets of the parent and not the child. The child is merely a beneficiary. That means only 5.6% of the plan assets will be calculated as an asset of the child in the Federal student aid formula.
Furthermore if you reside in a state that is subject to the state income tax, you can receive a state income tax deduction for the annual contribution to the maximum allowable deduction in your state. In states that have no state tax, you can typically use the plan of any state sponsored by any broker dealer. The 529 College plans regardless of the state you reside in offers tax free growth on withdrawals as long as the funds are used for higher education. However the definition of higher education is not necessarily college. Funds can be used for various forms of education such as a trade school to become an electrician or a plumber. They are extremely flexible in that regard.
DO NOT allow a broker dealer to sell you a commissioned version of the 529 plan. These plans are run with either a fixed allocation or an aged based strategy tied to the age of the beneficiary. This means they are effectively self-managed. For example in the state of NY there are several versions of the same plan. One is completely no-load/sales charge. The other version is sold by commission brokers that sell similar investments in terms of risk, managed in a very similar strategy. The plan is managed almost identically whether you pay the higher cost or not.
A Grandparent can also establish a 529 plan for their grandchild. However they should address this with their estate planning attorney first as there can be complications. If a grandparent is further on in years and has a sizeable estate, the plan assets will be included in the estate tax calculation at death. Should the grandparent pass away before the assets are spent on education there may be a sizeable tax on the plan for Federal and/or State estate taxes. Additionally when someone other then the parent or the child owns the plan, the distributions may be reported as income to the child therefore altering their ability to benefit from student aid.
One other option is the Coverdell savings plan. This is also provides tax free growth towards education. However the limits to contributions per account are limited to $2,000.00 per year. Furthermore, these accounts are not self–managed. They require you to select your own investments from essentially a nearly unlimited set of choices including individual stocks and bonds.
Both the Coverdell and the 529 plan also allow the account owner the flexibility to change the beneficiary should the child not need the full balance of the plan or opt not to attend school. This means the plan assets can be redirected to a brother, sister or even a cousin of the same generation.
Lastly, regardless of which route you take, try and remember that college is a business. Universities very often offer specialists to help you apply for assistance with your tuition. That is usually not the best route to take. It is not in their best interest to bring down your cost. The local high schools may offer similar services in filling out student aid forms. While they may be well intended, they rarely have the necessary expertise. A specialist in this area whom is not selling products will often be aware of things such as which private universities currently have sizeable endowments funds that must be spent. As a result sometimes a relatively top tier private university can at times be less expensive than a State school for a student with adequate enough grades.
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