Paying for College
The cost of post-secondary education has never been so high. The average college tuition has dramatically increased over the last few decades, particularly in comparison to the average household income. While tuition rates have skyrocketed, salaries have not kept pace.
This discrepancy has resulted in parents and students taking on unprecedented levels of student debt. According to the Q3 2018 report from the Federal Reserve Bank of New York the total amount of outstanding student debt in the U.S. is now a staggering $1.4 trillion and the average individual student loan balance is currently over $37k.
Saving for college is a major financial commitment and should be a well-planned and intentional process. Each family’s plan will differ based on household income, assets, and other savings priorities such as retirement. However, one thing is true in all situations: the earlier you start planning, the better off you will be when the first tuition payment comes due.
Saving vs. Borrowing for College
While it is not possible for most families to save enough to fully fund college expenses, every bit saved helps reduce the amount the student or parents will have to finance through loans. As the graphic below details, borrowing money to fund educational expenses dramatically increases the total out of pocket costs. In order to have $25,000 available in ten years, you would only need to save $18,240 ($152 per month assuming a 6% annual return), whereas borrowing to obtain $25,000 will ultimately cost you $33,360 out of pocket. With this in mind, saving should be a priority.
Saving is Key – 529 Plans
There are several types of educational savings accounts, but 529 plans have emerged as the most popular for a variety of reasons. A 529 plan is a tax-advantaged savings plan for educational expenses that is maintained by a state or state agency. For a list of the various 529 plans offered by each state, please view www.savingforcollege.com.
Under a 529 plan, one saves for a beneficiary’s qualified educational expenses through contributions to an investment account. While investment options are plan dependent, they generally include mutual funds, exchange traded funds and money markets. Some plans may offer age-based investment options known as target-date funds, wherein the investments automatically become more conservative as the beneficiary nears college age. The funds invested in these plans are not guaranteed by state or federal governments, and there is a risk the investment may lose value due to market volatility.
Contributing to a 529 Account – Limitations and Requirements
Anyone can contribute to a 529 account and contributions must be made in cash. Contributions are treated as taxable gifts so contributions up to the annual exclusion amount ($15,000 in 2019) for each beneficiary can be made without incurring a gift tax. Individuals may also prefund a 529 account with five years of annual exclusion gifts (e.g. $75,000 in 2019), provided the individual does not make additional gifts to the beneficiary for a five-year period. Lastly, contributions to an account cannot exceed what is needed to provide for the qualified educational expenses of a beneficiary. This overall contribution limit varies by state plan
529 Plan Advantages
Tax-free growth: The major advantage of a 529 account is tax related. As contributions are made to a 529 account, the principal grows free from federal and state income tax.
Tax-free withdrawals: Withdrawals made from a 529 account are exempt from federal income tax provided the funds are used for qualified educational expenses. Withdrawals for qualified educational expenses may also be exempt from state income tax, depending on that state’s income tax rules.
Qualified educational expenses are expenses related to enrollment or attendance at an eligible postsecondary school, including: tuition, fees, books, supplies, and equipment, such as a computer (if it is primarily used by the beneficiary while enrolled at an eligible school). Room and board is also a qualified educational expense for students enrolled at least half-time and can include a portion of the cost of off-campus housing. Starting in 2018, qualified educational expenses may also include elementary or secondary school tuition up to $10,000/year, depending on the state’s plan provisions.
Income tax deduction/credit: Some states offer their residents an income tax deduction or credit when making contributions to 529 accounts established under the donor’s state’s plan.
Out-of-state options: Each state’s plan has subtle differences related to taxes, matching grants, contribution limits and investment options. You are not limited to using your home state’s plan, so it is important to evaluate the differences between plans before deciding which plan to use.
Transferability: Assets can be transferred from one 529 account to another provided the assets are rolled over to a 529 account for the same beneficiary or a member of the beneficiary’s family. This is helpful in the event your child gets a full scholarship or decides not to attend college. In addition to rolling a 529 account to an eligible family member, one can also simply change the beneficiary of an existing account to an eligible family member.
529 Account Drawbacks
Penalties for non-qualified expenses: Withdrawals from a 529 account for expenses other than qualified educational expenses are not only subject to income tax on the earnings portion of the distribution, but also a 10% early distribution penalty for the amount included in income. There are very limited circumstances where the penalty is waived; e.g. the beneficiary becomes disabled or dies.
Limited investment options: 529 account investment options are limited to a preselected menu of mutual funds and/or exchange traded funds and the number of available options can vary between state plans. To keep administrative expenses low, most state plans also limit the number of annual portfolio changes the owner can make.
Impact on Financial Aid: As discussed later, a 529 account will impact a student’s eligibility to receive need-based financial aid.
Since most families are unable to save enough to fully cover the cost of a college education, it is important to be aware of financial aid that is available from federal, state, school or private sources. The US Department of Education is responsible for the three types of federal financial aid: grants, work-study programs and loans.
Grants are a form of financial aid that do not have to be repaid and are often need-based. There are several types of federal grants, the most familiar being the Pell Grant which is awarded to undergraduate students with exceptional financial need. For the 2018-2019 school year, the annual Pell Grant award is up to $6,095.
Work-Study programs are administered by schools and offer students part-time jobs, providing income they can use for educational expenses. The total amount of your work-study award will depend on when you apply, your financial need and your school’s funding level.
Loans are funds that you borrow and later pay back with interest. Types of Federal loans include:
1. Direct Subsidized Loans – these are loans for eligible undergraduate students who show financial need.
The US Department of Education pays the interest on this loan while the student remains in school at least half-time, for six months after the student leaves school and during any period the loan is in deferment.
2. Direct Unsubsidized Loans – these are loans for eligible undergraduate, graduate and professional students that are not based on financial need. Unlike subsidized loans, the student is responsible for paying the interest. You can pay the interest while in school or the interest can accrue and be added to the principal balance of the loan.
3. Direct PLUS Loans – these are loans made to graduate or professional students, as well as parents of dependent undergraduate students. These loans are not based on financial need, but a credit check is required. The maximum loan amount is the cost of attendance, less any other financial aid received.
Other sources of financial aid can come from your state, the school or scholarships. Scholarships need not be repaid and are often awarded outside of the financial aid process. Students should research available scholarships through their high school guidance office, the college’s financial aid office and online resources. The Finance Authority of Maine has a scholarship search tool available on their website for Maine students, as well as links to websites to conduct nationwide scholarship searches.
If there is a gap between your financial aid and the cost of attendance, private student loans may also be available. These are loans offered from banks and credit unions where the student is the borrower.
Obtaining Financial Aid – Where to Begin – FAFSA
When considering financial aid for college, a student must start by completing the Free Application for Federal Student Aid (FAFSA). FAFSA is the form that families submit to obtain federal, state and institutional financial aid for college students, including grants, loans, and work study programs. FAFSA is administered by the US Department of Education and the application is found at www.fafsa.gov.
The FAFSA takes into consideration parent and student income and assets, household size, and number of enrolled college students in the household to determine the Expected Family Contribution (“EFC”), or the amount of money a family is expected to pay for college for the upcoming school year. The EFC is subtracted from a student’s cost of attendance to determine the student’s federal financial aid eligibility.
If the student is a “dependent student”, the application looks at income and assets of the student and their parents. Parents must list assets such as their bank accounts, investment accounts, college investing accounts, and certain real estate (rental or second homes). Parents may exclude retirement accounts, primary residence, and any family farm or small business that is owned and controlled by the family, personal possessions, pensions and whole life insurance.
Expected Family Contribution (EFC) Formula:
The FAFSA is available each year on October 1st and must be completed each year for a student to be considered for financial aid. The deadline for the completion of the FAFSA varies depending on the school. Students should submit their FAFSA application early as some schools issue financial aid on a first-come, first-served basis. Even if you have not yet been accepted to a school, you should complete your application as soon as possible.
Impact of 529 Accounts on Financial Aid
It is important to be aware that a 529 account will impact a student’s eligibility to receive need-based financial aid. How a 529 account impacts financial aid depends on who owns the account. If the account owner is the student’s parent, the 529 account is determined to be an asset. If the account owner is someone other than the student or their parents, the 529 account is considered income for the years in which a distribution is made.
The Best Savings Plan is the One Customized to You
How much you should save for college is part of a higher-level savings strategy, which should involve prioritizing your objectives. It is important for parents to make sure they are adequately saving for their retirement before allocating funds to college savings. Remember – you can borrow money to pay for college, but you can’t borrow money to finance your retirement.
It is important to work with a trusted advisor who will help you make the right choices during both the savings years and the distribution years. If you’d like to explore supporting your family’s future scholars in the context of a smart overall financial strategy, we’d love to help. Call H.M. Payson at 207-772-3761.