By Carmen Wu, CRPC®
Egan, Berger & Weiner, LLC
According to the College Board, the average annual cost of attending a four-year college in 2020 will be $46,368—a 38 percent increase compared to today’s fees.
So how can American families successfully address the challenges of saving for all of their financial needs—raising a family, educating their children, and retiring successfully?
There is no simple answer. But a recent study by Sallie Mae suggests families are struggling to find the solution.
The report, “How Americans Pay for College 2013,” concluded that six out of 10 American families do not have a financial plan to pay for all years of college prior to the student enrolling, nor do they have a financial contingency plan should an emergency arise.
To help you gain control, try this four-step approach:
1. Prioritize Savings. Before you start saving for your children’s college education, make certain you have your finances in good order.
- Carry enough insurance. A sound financial foundation protects your family against catastrophes (becoming disabled or death), so be sure you have enough health, life, and disability insurance.
- Pay off your credit cards, and maintain cash reserves equal to three to six month’s salary/expenses as a cushion for unexpected life events, such as illness or the loss of a job.
- Retirement savings come first. “Fidelity’s point of view is that retirement savings should take priority over college savings,” says Keith Bernhardt, vice president of college planning at Fidelity. “With college, you have some flexibility with financing, but you can’t borrow money for retirement.” Note: If your employer matches your contributions to your retirement investments dollar for dollar, at a minimum, contribute up to the limit of the match.
- Last, but not least, re-assess your savings allocations. Once you have your basic financial needs in order, you’ll be ready to create a strategy for saving for college.
2. Dispel Four Myths About Saving for College
- Myth 1: There is a penalty for savings. It is true that financial aid decisions are based in part on the family’s assets. But the financial aid needs-based analysis does not count all assets. According to the College Board, “Parents’ income impacts financial aid decisions significantly more than their assets.” Most financial aid packages include a combination of loans, grants, scholarships, and work-study program. In fact: Getting into the habit of saving as much as you can reduces the burden of loans that you and your child may incur for college costs.
- Myth 2: It’s too late to start saving. Most advisers would agree that it is never too late to start saving for college. How much of the college expense parents will be able to cover is a factor in how soon you begin saving and what saving vehicles you use. In his article, “Saving for College,” student financial aid expert Mark Kantrowitz states: “You don’t have to save the full cost of college. … One third of college costs will come from past income in the form of savings, one third will come from current income and financial aid, and one third from income in the form of loans.” In fact: Starting to save sooner pays off because time is your most precious asset. Waiting to save can be expensive, as you can see in this hypothetical example. If you save $300 a month for 18 years at a 7 percent rate, you would save $126,000. Delaying just one year could cost you almost 10 percent and five years could cost you nearly half.
- Myth 3: 529 Plans are limited to certain colleges. Not true! Indeed, 529 plans apply to any accredited public or private college in the United States, as long as the program is eligible for federal student aid. In fact: All 50 states have their own 529 plans, but the parents’ home state may only offer tax deductions and credits when you invest in the state plan. Check with your accountant on tax deductions and/or credits for contributions.
- Myth 4: If you do not use your 529 college plan savings for higher education, you lose the money you invested. You will not lose you money—because it is yours. Be aware, however:
- If you completely withdraw the money, you will pay a 10 percent penalty and ordinary taxes on only the earnings.
- If your child receives a scholarship, you may withdraw your money without the 10 percent penalty and pay ordinary taxes on the earnings.
- If your child doesn’t use your 529 savings, you may also change the beneficiary to another child or a grandchild. Unlike the Coverdell Educational Plan, there is no age limit for the student in whose name the contributions are made and no age limit for students using 529 plan funds.
3. Establish a College Plan. To budget thoughtfully, have a good idea of the costs. Fidelity’s Keith Bernhardt insists that, “The time to access loan payments is long before senior year in high school.” I couldn’t agree more. Here’s how:
- Weigh in-state versus out-of-state expenses. According to the College Board, the average total for tuition, fees, and room and board for an in-state, public, four-year-college was $17,860. The average total for those same expenses at a private four-year college was $39,518 for the same period.
- Use a loan calculator. Several websites provide you with college/loan calculator, including finaid.org.
- Review the cost of the colleges on your child’s top-10 list, and on a spreadsheet, calculate the cost for tuition, room and board, etc. This will enable you to see the full picture and make decisions rationally rather than emotionally.
4. Take control. After obtaining an idea of college costs, investigate the various college savings vehicles that you can invest in, including:
- Uniform Gift to Minors Act (UGMA) / The Uniform Transfer to Minors Act (UTMA). Known as custodial accounts, these are the most common trust for minors. In most states, minors do not have the right to enter into contracts and are unable to own stocks, bonds, mutual funds, annuities, and life insurance policies. Plus, parents cannot transfer assets to their minor children—they must transfer the assets to a trust. To establish a custodial account, the donor must appoint a custodian (trustee) and provide the name and Social Security number of the minor. Then, the donor irrevocably gifts the money to the trust. The money now belongs to the minor, but is controlled by the custodian until the minor reaches the age of majority (18-21). Depending on the state, most UGMAs end at age 18; most UTMAs end at age 21. Note: Earnings will be taxed annually, and UGMAs/UTMAs do not have the tax-deferred benefits that other saving vehicles enjoy. If the student is applying for financial aid, these are assessed at 20 percent to 25 percent. So if a student has an extra $1,000 saved before applying for financial aid, the aid will come out to $200-$250 lower.
- US Saving Bonds Series EE Bonds and Series I Bonds. These provide a modest return for your child’s college education and are a low-risk investment. Series EE Bonds issued after 12/31/1989, and All Series I bonds, offer a tax-free benefit when redeemed to pay for qualified higher education expenses. Or, they may be rolled into a 529 plan. Note: There is an annual purchase limit of $30,000 per owner, and $30,000 for Series I Bonds. The purchase limit of Series I Bonds isn’t affected by the Purchase of Series EE Bonds. The bond proceeds may be used for your own education, your spouse’s education, or the education of a dependent for whom you claim an exemption on your tax return. There is an income phase-out on the interest exclusion based on the year you redeem the bonds; income limits are adjusted annually for inflation. If the bonds are in your child’s name, they are not eligible for the exclusion.
- Prepaid Tuition Plans. These programs allow you to pay for all or part of your child’s future college tuition at today’s prices. If you are able to place a lump sum of money into the plan when your child is born, you can purchase at today’s rates a four-year degree that your child will use in 18 years. Note: The plans are administered by individual states, and are typically only redeemed at public colleges and universities in that state. If the student opts to attend college out of state, the plan typically pays the average in-state rate and the parent pays the difference — which can be considerable. So refer back to your spreadsheet to determine the best option for your family.
- Coverdell Education Savings Accounts (ESA). This plan allows you to contribute $2,000/year, but there is no federal tax deduction. The accumulated investment interest earnings are tax-free, if used for education. Note: Parents must contribute to these accounts before the child turns 18, and the funds must be used by age 30. These plans can also be used for K-12 private schools.
- 529 College Plans. By far, this is the most widely used savings strategy for higher education. A tax-advantage plan that allows your investment earnings to grow tax-free, the distribution is not taxed—so long as it pays for tuition, fees, books, supplies, and any approved equipment the student may need to study at accredited institutions. Depending on your home state, you may have tax deductions and/or credits for contributions into the 529 plan. And unlike the Coverdell Education Savings Plan—which is limited to a $2,000 contribution a year—the 529 plan allows parents to contribute a larger amount: $14,000 from each parent, or $28,000 in one year. If you should come into a windfall, it is possible for each parent to contribute $70,000 each, or $140,000 as a couple, and treat it as if the gift was given over a five-year period. Parents can also contribute a lump sum, establish a dollar-cost average program, establish a systematic investment program from your bank—and also encourage contributions from family members and friends with gift certificates. Note: For purposes of financial aid, this plan has minimal impact since it is considered to be a parental asset, and is factored in using a financial aid formula at a maximum rate of 5.6 percent. (This means only 5.6 percent of the 529 assets owned by the parent are included on the Expected Family Contribution, EFC, which is calculated during the financial aid needs-analysis process.) This is lower than the 20 percent to 25 percent rate assessed by the UGMA/UTMA custodial accounts.
These are highlights of just some of the basic features of the best-known savings vehicles. Planning for college is very important, and complex, so families should make a savings plan based on their unique set of financial circumstances.
*Carmen Wu, CRPC®, partnered with Egan, Berger & Weiner, LLC in August 2007. She brings 25 years of experience in the financial industry, and has served as financial adviser, branch manager, regional manager, chief operations officer and vice president of a regional banking institution.
A graduate of the University of Southern California, with a Bachelor of Arts degree in Political Science/International Relations, Martinez is an active member of the Rotary Club of McLean, a community service organization, and has served on the board of directors for five years.
She is also an active member of the Financial Planning Association and the Financial Services Institute, and is currently enrolled in the College for Financial Planning.
Raised in California, Martinez moved to the east coast in 1987 and now resides in Alexandria, VA. The oldest of nine children, she enjoys spending time with her 19 nephews and nieces. In her spare time she pursues one of her lifelong passions for art by drawing and painting portraits, landscapes and still life.