Saving for Your Child’s Education
One of the hottest topics today in the financial media is the cost of college education. The average four-year university education can cost thousands of dollars a year when you add up the cost of tuition, books, and room and board. To add to that, many students leave college with huge sums of student loan debt that keeps them from pursuing life goals such as buying a home, getting married, or saving for retirement. According to the Federal Reserve in Washington, D.C., Americans now owe $1.4 trillion in outstanding student loans. All of this information can leave parents and children feeling very anxious and fearful about how they will pay for college. The good news is there are many options available to parents and their children.
Options for Saving for College
Today there are many college savings alternatives available to parents and children. Each alternative has its own advantages and disadvantages, so before you begin saving for your child’s college education, consider what is going to be the best option for you and your child. Below is a summary of the most common college savings alternatives.
529 plans are one of the most common options of savings for college. 529 plans allow a parent to set aside up to $14,000 annually per child beneficiary. The biggest advantage of the plan is that income grows tax free and is not taxed if used for qualified education expenses. There is also no time limit on when the funds must be used. If your child uses only a portion of the 529 account for qualified education expenses, the remaining funds can be used for a sibling or cousin. One of the biggest drawbacks is that a 10% federal penalty will be applied if the funds are not used for qualified higher education expenses in addition to income tax to the extent there are earnings. Another drawback is that the account value of a 529 account will be used in the calculation of financial aid.
In a 529 plan, contributions are made to an investment plan sponsored by a state. All states offer 529 plans and if you live in a state with state income tax, you may receive a tax break if you make contributions to the plan sponsored by your state. Within the plan, there are often several investment options available ranging from age-based investment paths to single funds. The advantage of an age-based investment path is that as your child nears college, the account reallocates toward more conservative investments automatically.
Prepaid Tuition Plan
Prepaid tuition plans are offered and sponsored through various states, allowing parents to purchase future tuition hours at a set current rate. The tuition hours can be applied toward the state college or university that your child chooses. The rate you pay each month depends on how many years your child has until they begin college and the level of education you want your child to receive (associate’s degree, four-year bachelors at state college, four-year bachelors at university, etc.). Dormitory plans may also be purchased in addition to prepaid tuition plans.
The biggest advantage of these plans is that it guards against the risk that educational expenses will grow faster than investment returns you earn in an alternative plan. Some disadvantages to be aware of is that if your child does not attend college, you traditionally receive back only principal you contributed (no interest). Additionally, if your child wants to attend a private or out-of-state institution, the benefits paid out could fall short of the actual tuition costs.
Coverdell Education Savings Account
An education savings account (ESA) is a tax-advantaged account for educational purposes. The account can be established for any child under the age of 18 and contributions can total up to $2,000 a year. The earnings portion of any distributions will be income tax free as long as it is used for qualified education expenses. In addition to including qualified higher education expenses, distributions from ESAs can be used for qualified elementary and secondary education expenses.
If you do not use all of the ESA for one child’s expenses, you can roll the balance over to an ESA for a family member of your child. One disadvantage is that the maximum annual contribution you can make is low compared to other college savings alternatives. Distributions not used to pay qualified education expenses are subject to income tax and a penalty to the extent the distribution consists of earnings. Also, when your child reaches age 30, all remaining funds in the ESA must be distributed and those funds will be taxable to the beneficiary to the extent there are earnings.
Contribute Savings to a Taxable Account or IRA
Perhaps you are unsure of whether or not your child will attend college or how much they may need in funds to pay for their higher education expenses. Instead of contributing all of the funds you want to save for your child’s education in an educational savings plan, consider making part of the contributions to a taxable investment account or individual retirement account (IRA). When you make contributions to an educational savings plan, you have limited options for using the funds for anything besides qualified higher education expenses without incurring costly income taxes and penalties.
When you make contributions to a taxable investment account, any tax on earnings are deferred until you realize gains and taxed at more favorable capital gains tax rates. This gives you the freedom to use distributions for any purpose without incurring income tax at your normal marginal rate along with a penalty. You can also consider making contributions to your IRA. The main purpose of an IRA is for retirement, but you can take a disbursement from the IRA for qualified education expenses for your child without incurring a tax penalty. The type of IRA (traditional or Roth) you have determines if you must pay income taxes on the disbursement.
Your Child May Be Willing to Save for College
It may not seem apparent, but the trend of high school students saving for college is picking up. In fact, according to the College Savings Foundation’s website, 60% of high school students are already saving for college. If your child has a part-time job in high school, consider talking to them about setting aside a certain amount of each paycheck to help defray the cost of college.
Alternatives to Saving for College
For many families, the possibility of saving for college may not be realistic due to the fact that your child may enter college soon or there are budgetary constraints. In this case, there are several alternatives that can help with the cost of college.
Scholarships and Grants
Perhaps one of the greatest sources of funding college is scholarships and grants. The reason is simple, because scholarships and grants generally are not required to be paid back. Scholarships are granted by colleges and universities as well as civic and non-profit organizations. A student can receive scholarships for excelling in activities such as academics, fine arts, or athletics, as well as meeting other criteria such as financial need. When your child is a junior or senior in high school, research what scholarships are available. Generally, there will be certain requirements your child needs to meet and most scholarships have ongoing standards that must be met to continue receiving the scholarship. The website CareerOneStop.org has a free scholarship search tool if you would like to find out more about what scholarship may be available. Make sure to also ask any college or university that your child is interested in what scholarships they have available.
Grants are like scholarships in that they do not have to be repaid. They are traditionally offered through a variety of sources such as the federal government, state governments, colleges, and numerous private organizations. Grants are available for those with financial needs as well as those who meet certain merits. One of the most famous grants is the Pell Grant, which is offered by the federal government. Pell Grants are available to undergraduate students with exceptional financial need. In order to be considered for scholarships and grants offered by colleges or the federal and state government, it is generally necessary that your child complete the Free Application for Federal Student Aid (FAFSA), which can be found online. As with scholarships, ask any college or university that your child is interested in what grants they have available.
There are many different sources of loans available for both college students and their parents in order to fund college expenses. Loans are offered through both private and public sources. The most common student loan is the Stafford Loan, which is offered by the federal government. This loan is available for undergraduate and graduate students who are attending school at least half-time. Another loan available to students is the Perkins Loan. This loan is only available to those students with the greatest financial need. Perkins Loans are offered through individual colleges and are available on a first-come, first-serve basis. In the case of the two aforementioned loans, the interest rate is generally low and repayment can be deferred until the earlier of graduation or when your child stops attending college. Bear in mind that interest still does accrue while your child is in college.
PLUS loans are available through the federal government for parents of college students and/or individuals who are graduate/professional students. In this case, a good credit history is required to be eligible for this loan. This may be attractive to parents who do not want their children overburdened by student loan debt.
Recently, we met with a client who has a child who will soon graduate from college. He told us that his child will graduate with thousands of dollars of student loan debt. He had the idea of helping his child pay down the student loan debt after graduation, but he did not tell his child of his intentions just yet. He reasoned that he wanted to make sure his child had “skin in the game,” so his child would borrow more responsibly during college, since he would not know he would receive assistance later on. We really liked our client’s idea and would recommend it to other parents who are considering helping their child pay off student loan debt.
For many individuals, scholarships and grants are unlikely to be enough to cover all college expenses and loans may be undesirable. Part-time work is a great way for students to help pay for college expenses and also to establish a work history they can put on their resume when applying for their first job after graduation. This balancing act of working while in college can be very attractive to potential future employers as it may show an individual is more responsible. Additionally, students can participate in work-study programs at their college or university. This generally entails working on campus, so it may be a better way to balance attending class, studying, and working.
Is College Right for Your Child?
Perhaps one of the biggest questions a student gets asked when they become a junior or senior in high school is, “Where are you going to college?” The underlying assumption of this question is that a student will automatically attend college upon graduating high school. High school students constantly hear from guidance counselors and other individuals that the best way to increase your lifetime earnings is by obtaining a college degree. While this is generally true, students who do not have the aptitude or desire to attend college classes, may be better off going to trade or technical school or seeking employment directly after high school.
Trade or technical school can be far less costly than attending college. In many cases, you can get trained for a well-paid profession. For those individuals who enter employment directly after high school, hard work and determination can be rewarded with jobs in management that sometimes pay over six figures a year. As your child considers what they want to do upon high school graduation, try to have a candid conversation with them about what they most desire to do and discuss the costs and benefits of taking one path versus the other. Also, if your child does want to attend college, do research together on the field they intend to get a degree in to find out how easy it is to get a job in that field and what salary level you can expect to receive. This is especially important to keep in mind if your child will need to take student loans, because many students take loans without realizing the burden this can create post-graduation. You can visit CareerOneStop.org to explore careers, find training and education programs, and search for jobs.
Balancing Saving for Your Child’s Education and Retirement
Many parents want to assist their children in paying for part or all of college. While this is an admirable goal, many times it is done to the detriment of the parent’s retirement. Most individuals have thirty to forty working years to save for retirement. While this is a long time to save, many parents choose first to save for their child’s college education and only begin saving for retirement once their child has graduated from college. The earlier you can start saving for retirement, the more likely it is that you will have a sizeable nest egg at retirement. This is due to the power of compounding. The example below illustrates this point:
As can be seen with this example, Investor A starts saving $2,000 a year at age 25 and stops at age 35. Investor B starts saving $2,000 a year at age 35 and stops saving at age 65. Both investors earn the same rate of return, but at age 65, Investor A has a larger nest egg even though his or her total contributions were three times less than Investor B.
A good question to ask is, “Will my child help me financially in retirement if I sacrifice retirement savings now?” The reality is many children will not financially be in a position to assist their parents in retirement. Many individuals also believe that Social Security will help fund the majority of their retirement, when in reality, the average Social Security beneficiary only receives $20,000 to $30,000 a year. For most Americans, this falls far short of what they need for their yearly living expenses. We highlight these items not to discourage parents from assisting their children with funding their education, but instead to illustrate the importance of balancing retirement savings and saving for your child’s education. When helping your child decide where to go to college, we encourage parents to speak with their child about what they can realistically afford.
Putting it All Together
There are many options available to both students and their parents to help pay for college. Parents should have candid conversations with their children about what is going to be the best path after high school and the level of financial assistance they can offer. It is also important that if your child does plan on going to college that they have some “skin in the game,” either through saving now, working part-time in college, or being responsible to pay back some student loans.
At River Capital Advisors, L.C. and our affiliated CPA firm, Smoak, Davis, & Nixon, L.L.P., we regularly assist clients who have planning needs that center around funding their child’s college education. We also help clients with those decisions about how much to save for retirement and the myriad of tax issues that are present when making contributions to a tax-deferred account. If we can assist you, please contact us.