Getting Started
A college education may be the best investment a person can make, but it does
come at a steep price. The average cost today for four years at a private
university runs about $100,000 when you factor in tuition, room, board and
general expenses. Even a public school education can cost $40,000. And the
shocking fact is that these figures will seem like chicken feed for parents
of a baby born after the year 2000 – the tab to put your child through
an average four-year private college is likely to approach $250,000!
Don’t even entertain the hope that these numbers might magically drop in the years ahead. They won’t. Wondering, then, how any but the most well-to-do can expect to pay for their children’s education? Take heart! It really is within your means, and we are going to show you how to do it.
Here’s the good news: There is plenty of financial aid available, and many new and innovative programs have emerged to help families like yours. Education savings assistance is now offered by multiple sources, from federal and state governments to mutual fund companies to colleges themselves.
In fact, as you’ll discover, there are a bewildering number of possible paths to take. Parents who conduct even the slightest bit of research into the different plans can expect to be bombarded with literature touting their merits – and in the end, you still won’t know which one is best for you. It’s not an exaggeration to say that you virtually need a college degree to figure out how to pay for one!
Pure and simple, the point of this series of articles is to help you make sense of the many choices out there and to point you toward the best way to help pay for your child’s college education. More than anything else, you will learn you don’t need to be a member of Bill Gates’ immediate family to pay for college. Yes, the costs are high, but there are multiple plans and products to make college an achievable goal for any family. In these articles you will learn what programs are available and how to choose the right one for your particular situation.
If your baby is still in diapers, it’s an ideal time to begin planning and saving for college. But even if your children are older, don’t believe for a minute that it’s too late to save. Some simple planning can go a long way in helping you properly structure your investments to reduce your tax burden and maximize financial aid.
Let’s get started!
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Costs, Financial Aid and Saving
Here are the three most vital questions you need to answer when planning for
college:
And the answers are:
All true, of course, but we can help you get a bit more precise than that. To this end, included here is a worksheet to help you figure out how much school is really going to cost you. This worksheet should help you put some real numbers around the challenge you and your family will be facing over the next few years.
To further guide you, here is some more information to explain where these numbers come from and how to best plan for the future.
1. How much is school going to cost?
Much of the cost depends on what kind of school you select. State-run colleges are less expensive than private colleges – if your child qualifies for in-state residential status. Two-year community colleges are cheaper than four-year universities. Tuition is the heaviest component of the college tab, but don’t forget about room (where your child lives at college), board (the food he consumes while there), books, travel expenses (to and from school) and various school fees – not to mention a little extra for the occasional night out to blow off steam after finals. It all quickly adds up.
In 2003-2004 the average total cost per year to attend a four-year public university was $9,929 for an in-state student. It was $23,443 for a four-year private university. At the most expensive private institutions, the price tag has already reached $40,000 a year. According to the College Board, if college costs grow at only 5 percent annually, by the year 2019 the total cost of a four-year college education could range from $95,000 at a public university to $240,000 at a private school.
While these numbers can be extremely daunting, it’s important to keep in mind that financial aid is available for eligible students and it can go a long way toward easing your burden.
2. How much financial aid can we expect?
By using our worksheet you should be able to compute a rough approximation of how much assistance your child is likely to receive. In the next article, “Financial Aid: A Primer,” we will go into greater detail about how this computation was made and how financial aid works.
3. So … how much should we save?
You should save an amount equal to your total out-of-pocket expenses for
four years of college per child. If you are unlikely to qualify for financial
aid, this will be the entire tuition-plus-extras bill. If you are likely to
qualify for financial assistance, it should be an amount equal to your Expected
Family Contribution, a term that refers to the amount left for you to pay
after you receive financial aid. Our worksheet will help you determine roughly
what that amount will be and how much you need to save.
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Financial Aid: A Primer
If you’re considering financial aid to help pay for your offspring’s
education, you won’t be alone. Nearly 55 percent of all college undergrads
received some type of assistance during the 1999-2000 school year (the most
recent year these statistics were compiled). In this article, we cover some
of the basics of how financial aid works.
First, let’s define it. Financial aid is any type of assistance used to pay college costs that is based on financial need. It generally comes in one of these three forms:
Grants and Scholarships
Also called gift aid, grants don’t have to be repaid and you don't need
to work to earn them. Grant aid comes from federal and state governments and
from individual colleges.
Loans
Most financial aid comes in the forms of loans — aid that must be repaid.
Loans are common, making up nearly 54 percent of all financial aid. Most need-based
loans are low-interest and sponsored and subsidized by the federal government,
which means no interest accrues until you begin paying them back after graduation.
Work-Study
Student employment and Work-Study aid help students pay for education costs
such as books, supplies and personal expenses. Work-Study is a federal program
that provides students with part-time employment to help meet their financial
needs.
The Family’s Contribution
One of the basic premises of college financial assistance is that the family is expected to contribute to the extent it is able. This is referred to as the Expected Family Contribution (EFC), and it can be thought of as the out-of-pocket money you and your child must pay for school. Financial aid can help bridge the gap if your EFC cannot cover all the costs.
The federal government and most universities compute the EFC through a formula keyed to both the student’s and the parents’ available income and assets. (Available income generally means total income minus a number of different allowances.) In calculating financial aid, the formula stipulates that the following percentages of income and assets be used for college expenses in any single year:
• 35 percent of a student’s assets
• 50 percent of a student’s income
• 2.6 to 5.6 percent of a parent’s assets
• 22 to 47 percent of a parent’s income
The percentage contributions for parents depend on their economic status and age. Lower-income families and older parents are expected to pay less; higher-income families with younger parents are expected to pay more.
Even at this simplest level, the formula reveals a very important point: To maximize financial aid, it is far better for any savings to be in the parent’s name than in the student’s name.
Making Every Penny Count
A discussion of financial aid invariably leads to the question: “Won’t saving for college just hurt my chances of receiving financial aid?” The short answer is yes, but only by a very, very small amount.
Let’s take a closer look at the numbers. As a parent, you can see from the formula that your assets are “taxed” at only 5.6 percent a year. This means that only about 20 percent of your assets in total are judged accessible for paying for college over the course of four years of school.
That’s not all. Under current rules, a large portion of a parent’s assets is deemed “protected” from being used to pay for college. The amount protected is based on the age of the older parent, with the benefit increasing with age. Here’s an example of how that works. If a two-parent family has $100,000 in assets and the older parent is 55, $50,300 of the assets will be protected. This means $49,700 will be “taxed” at 5.6 percent, for a total contribution to the cost of school of only about $2,800.
As all of this goes to show, the notion that a dollar saved for college equals a dollar lost in financial aid is far from correct. But in any case, the issue of financial aid should not stop you from saving. What you gain in overall financial health more than makes up for diminished college aid.
What we have tried to do here is provide some basic information about how
financial aid works. Needless to say, there is other important information
we are unable to include. If you still have questions, there are numerous
resources available out there to help you understand these issues better.
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What is the Right Way to Save?
Now that you know how much you need to save, the obvious next question is:
“How do I go about accumulating this money?” Here you generally
have two choices: taxable accounts and tax-free accounts.
Taxable accounts usually refer to traditional savings vehicles on which you
pay taxes every year. They include:
• Mutual funds
• Stocks
• Bonds
• Certificates of deposit
With tax-free accounts, you do not have to pay taxes on any of the earnings
on the account (i.e., the capital gains, dividends or interest earned on your
investments.) Tax-free accounts include:
• Coverdell Education Savings Accounts
• 529 Savings Plans
• Retirement accounts
• Uniform Trust to Minors Account/Uniform Gift to Minors Account (UTMA/UGMA)
The best choice for most people saving for education is likely to be a tax-free account because you’ll end up with more money. Putting $1,000 in a tax-free account on the day your baby is born will yield nearly $4,000 18 years down the road, assuming an 8 percent rate of return. Investing $1,000 in a taxable account would bring less than $3,300 over that same number of years, assuming a 15 percent tax rate.
Before you pour all your money into a tax-free account, however, be warned. If you don’t end up using the money for its designated purpose – either education or retirement – not only will you pay taxes on the money but a 10 percent penalty to boot. So if you are not certain the money you save will definitely be used for education, a taxable account is likely your best choice.
Before You Make That Choice, However …
Let’s first answer the all-important question: “How will saving affect the financial aid we get?”
We can’t emphasize this point enough: Keep as little savings as possible in your child’s name because those accounts will do the most harm when you go looking for financial aid. Accounts in a parent’s name will affect the amount of financial aid far less. Accounts in a grandparent’s name or someone else’s name will have almost no effect.
Based on this information, and because of quirks in the rules about who the account owner is deemed to be, the different accounts will have the following effects on financial aid:
Greatest Reduction in Level of Aid
• UGMA/UTMA
• U.S. Savings Bonds, if issued in student’s name
• Traditional investments, if in student’s name
Moderate Reduction
• 529 Savings Plans owned by parents
• Coverdell Education Savings Accounts with parent as “responsible
individual”
• U.S. Savings Bonds owned by parents
• Traditional investments owned by parents
Smallest or No Reduction
• Retirement accounts held by student or parent
• 529 Savings Plans owned by grandparent or other person for the
benefit of the student
• Direct tuition contribution, if someone else pays the student’s
tuition. This has no effect on financial aid and is also fully exempt from
any gift tax restrictions. (Caveat: Such a gift tax exclusion only applies
to tuition payments, not payments for room and board.)
Based on both tax ramifications and financial aid impact, you can start deciding
which plan is best for you. We start doing that and making recommendations
in Article Five.
Which Plan is Best for You?
There are a number of plans to help you save for your children’s education,
but the first investment you need to make is saving for your own retirement.
Unlike for college, you cannot borrow for retirement, and there is no financial
aid for the over-65, Florida-bound crowd.
Because of this, don’t even think about saving for education if you haven’t adequately funded your retirement yet. (“Adequately funded” generally means that your current savings plus future expected contributions will generate enough income to maintain your desired lifestyle when combined with any other money you will be receiving, for example Social Security.)
Here’s a second crucial point to consider: Unless you’re prepared to use college savings solely for education, you should not consider any of the education-focused plans. The reason being: If you find you have to spend the money for something else, you will have to pay taxes on it and face a penalty. If you can’t be sure what the money is going to be used for, a taxable account like a mutual fund or certificate of deposit is likely to be your smartest move. While you may not save on taxes, at least you can spend the money on whatever you want without worrying about penalties.
Now let’s take a closer look at your choices. If you have fully funded your retirement and are prepared to lock in money for education, probably your best bet is a 529 Savings Plan or a Coverdell Education Savings Account (ESA).
The Argument for a 529
While there are numerous differences between 529s and ESAs, the biggest is
that a 529 Savings Plan allows you to contribute far more than an ESA. Contributions
to an ESA are limited to $2,000 per year per student, while contributions
to a 529 Plan can be as high as $11,000 per year per contributor. For those
wishing to contribute even more, 529 Plans allow a one-time contribution of
up to $55,000 per contributor per student. This means that a couple could
put as much as $110,000 into a 529 account at one time. One-time contributions
come with a rule: You cannot give any more money to this student for a period
of five years.
Another advantage for a 529 Savings Plan is its flexibility. It is fairly easy to change beneficiaries and even take the money back, if you as the owner decide you need it for something else. Yes, you will have to pay a 10 percent penalty if the money is not used for education, but that is better than not having access to the money if you really need it.
The Pros and Cons of an ESA
If you are saving money for your child to attend a private primary or secondary
school, this is the plan for you. An ESA is the only savings program in which
the money can grow tax-free and still be used for private school. The money
from a 529 Savings Plan can be used only for college.
Unlike with a 529 Savings Plan, there are income restrictions for contributors to an ESA. Under current law, contributors must have less than $190,000 in modified adjusted gross income ($95,000 for single filers) in order to qualify for a full $2,000 contribution. Of course, there is one way around this issue: Simply gift the $2,000 to the student and have him or her make the contribution to the ESA. Be warned, however, that the effect this arrangement will have on financial aid eligibility is not yet clear. While ESAs are generally considered the asset of the parent – thus having only a small effect on financial aid – such a gifting arrangement may change this. If this arrangement translates into the ESA being considered the asset of the student, the hit to financial aid may be much larger. Stand by for what the government has to say on this.
The Pros and Cons of UGMA/UTMA
Uniform Gifts to Minors Act Accounts (UGMA) and Uniform Transfers to Minors
Act Accounts (UTMA) – frequently called custodial accounts -- are convenient
ways for parents to save for their children. Unlike education-focused investment
vehicles like 529 and ESA, money invested in an UGMA/UTMA can be used for
any expense that is related to the child. More important for many parents,
it is an easy way to save for a child’s future without giving up control
over the funds.
These accounts offer significant tax advantages, but there is a serious downside regarding financial aid. They are considered to belong to the student – and thus are “taxed” far more heavily than other investment vehicles we have discussed, specifically 529 Plans. For this reason, we recommend UGMA/UTMA only for students who are unlikely to receive financial aid.
Because most people are likely to go with a 529 Plan to save for college,
we devote Article Six to helping you sort through the options. There are still
more choices to make to find the savings plan that makes the most sense for
your family.
The Ins and Outs of 529 Plans
529 Savings Plans are among the most popular options for families saving for
a child’s college education. They allow you to save money for college
through state-operated investment accounts that can be used at virtually any
college or university in the country. Each state has slightly different rules
and requirements, however, and this can make choosing among the plans a cumbersome
and confusing affair. Here are some tips to make it easier.
Tip #1: Start by looking close to home.
Your own state’s plan may offer some advantages for residents. The answers to these three questions will tell you if this is the case.
1. Does my state offer any state tax deduction for choosing
its 529 Plan?
2. Does my state offer any matching grant programs for
contributions and do I qualify?
3. Does my state penalize residents for investing in
another state’s 529 Plan?
You can get the answers to these questions by calling the office of your state treasurer or the financial service company that handles your state’s 529 Plan. If the answer to any of the three questions is “yes,” it is highly recommended you choose your own state’s plan because it offers you advantages no other plan can. If all three answers are “no,” you are free to consider the plans available in other states.
Though such flexibility is good, making the right choice is anything but simple, particularly since there are so many dimensions on which to judge a plan. You’ll need to consider who the provider is, how the plan has performed recently, what services it offers, and what fees are charged.
Tip #2: Focus on fees.
Many people choose a fund based mainly on its performance, but this is not the best strategy. Rather than concentrating on which 529 Savings Plan had the best performance over the last year, it is far more worthwhile to look at the fees each charges, with a bias toward low-fee funds.
Here’s why. Although performance over time is an extremely important consideration, it is impossible to predict. Experience shows that, more often than not, high-performing funds one year will disappoint the next, and vice versa. Over time, nearly all funds will under-perform a comparable index fund. By concentrating on finding a fund that has low fees and by choosing an index fund, you will be far better off.
Here are four of the most common fees you will see:
Load/Sales Fee
This is mutual fund sales charge, paid on every dollar invested. It’s
generally computed as a percentage of the money you are investing (usually
two to five percent).
Enrollment/One-Time Fee
This is a fee charged when you make your initial investment. It’s generally
a standard dollar amount.
Annual Fee
This is the yearly fee you pay. It’s generally a standard dollar amount.
Annual Expense Ratio
This is a fee you pay to own a mutual fund. It’s generally
computed as a percentage of assets under management.
To see how the fees of the plan you are considering compare to two of the
lowest cost plans – Iowa and Minnesota – complete the matrix below.
(You should be able to easily get the information about the plan you are considering
by calling the plan’s toll-free number.)
State Plan You Are
Tip #3: Be absolutely sure!
As you begin weighing these savings plans, we caution again that there are
certain conditions under which a 529 would not be right for you.
Here they are:
Prepaid 529s: Another Option?
529 Prepaid Plans offer a different option in saving for college. With these,
parents can lock in future tuition at in-state public colleges and some private
schools at current prices. You make a payment now or over time, and when your
child is ready for college, the program takes care of the higher tuition and
fees at any state-owned college, in-state university or private school that
sponsors a prepaid plan.
Until recently, very few private schools offered a prepaid plan. That changed with the emergence of the Independent 529 Plan (www.tuitionplan.org), which is specifically for private colleges and universities. As with the state-sponsored 529 Prepaid Plans, participants can purchase tuition certificates at current prices – even with a small discount – and then use these certificates to pay for tuition at any private college that is taking part in the program. (Room and board are now excluded.)
This is considered a tax-advantaged plan because you have made an investment worth a certain amount, have seen that investment increase in value; and yet you haven’t had to pay any taxes on this increase in value.
Under certain circumstances, the accumulated savings of a prepaid program can be converted for use at other schools. In the case of the private prepaid plan, the tuition certificates can be used at any of the 300 or so institutions participating in the program. The conversion method varies from program to program, but roughly it involves a formula that assesses the percentage of the tuition you have paid for, translates those dollars into a sum based on the price of tuition, and then makes this amount available for another college or university.
A Look at the Disadvantages
Prepaid plans offer some advantages, including low-risk, guaranteed returns on your investment. But they also come with a catalog of disadvantages, in particular lack of flexibility and negative effect on financial aid.
Consider this scenario. You’ve invested in a prepaid program but your child decides to attend a college that isn’t in the private school consortium – or maybe she decides not to go to college at all. You want to get your money out of the plan, and you might be able to do that, but probably not without paying various fees and penalties that significantly reduce any earnings you would have had on this money. While some plans will pay some interest on your original contributions, a number will not, and invariably the rate of interest that is paid is extremely low.
Prepaid savings plans also can significantly reduce a family’s eligibility for financial aid. Because distributions paid to the college are treated like scholarships, a family’s “need” figure is reduced dollar for dollar.
Prepaid plans are the least beneficial of the savings programs we have discussed, and we do not recommend them. There are far better investment vehicles to prepare for college.
Investing Your Money
You’ve figured out how much you need to save. You’ve identified
the right savings vehicle for your needs. You’ve chosen a provider.
The question facing you now becomes: “What is the most appropriate way
to invest our money – how much should go into stocks, bonds, cash, international
investments, or something else?” In many ways, this issue of “asset
allocation” is the most important investment decision you make. Here
are a couple of tips.
Tip #1: Worry about the mix, not actual assets.
Research shows that 94 percent of your portfolio performance will be determined by the mixture of stocks, bonds and cash you choose. Less than 5 percent of your portfolio performance will be determined by the individual stocks, bonds or mutual funds you pick.
Tip #2: Consider your child’s age.
The combination of stocks, bonds and cash that is right for your education savings portfolio depends on how old your child is right now and how many years of investing you anticipate. Given the importance of asset allocation, below are some recommendations for an appropriate mix.
(These recommendations should be viewed as a general guide and not as the rendering of specific investment advice. In general, you will find they look very similar to asset allocations found in most “age-based” portfolios offered by 529 Plan providers.)
| Current age of child | 0-3 | 4-7 | 8-11 | 12-15 | 16-18 |
| Stock | 60% | 40% | 30% | 10% | 0% |
| Bonds | 25% | 50% | 65% | 90% | 67% |
| Cash | 60% | 60% | 60% | 60% | 33% |
| International stock | 15% | 10% | 5% | 0% | 0% |
While some might consider these asset allocations conservative, overall they should serve you well when investing for your child’s education. If you are more conservative in your approach to investing, you might choose to hold more bonds and cash and less stock. Investors wanting a more aggressive approach could hold more stock – particularly international stock – and less bonds and cash.
Once again, the asset allocations suggested here are simply to be used as
a guidepost to your investing choices. At the very least, they should prompt
you to ask questions about the advice you may receive when allocating your
assets and those of your child.
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A Final Word
As we emphasized at the start of these articles, a college education is the
greatest investment you can make – but it is undeniably pricey and this
situation is not going to improve as your child grows up. What better argument
for getting started on a savings plan as soon as possible?
In our discussion of the many decisions parents like you face in saving for college, we have covered the advantages and disadvantages of a variety of savings programs and showed you some ways to maximize financial assistance and your investments. We could not, of course, touch on all of the savings programs available out there, and here is a brief look at two options that were not discussed earlier. One is U.S. Savings Bonds, which under certain circumstances are tax-free if used for education. The other is Individual Retirement Accounts, which may be used penalty-free for education.
Saving for college involves making many choices, and making them wisely. We hope these articles have provided you with a useful roadmap as you get that important savings program underway. Here, again, are the basics for managing and achieving your family’s educational goals.
1. Understand how much school will cost, how much financial aid you will receive, and how much you need to save.
Use a worksheet like the one included in Article Two, “Costs, Financial Aid and Saving,” or access one at www.educationalinvestments.com to help you with this process.
2. Identify the savings vehicle that best fits your needs.
Start by understanding the difference between a taxable and a tax-advantaged vehicle. If you choose a tax-advantaged vehicle, be sure you are willing to pay a penalty if you do not use the money for education.
Whether you choose a taxable or a tax-advantaged vehicle, understand your different options (as detailed in Article Five, “Which Plan is Best for You?”) and see which one best suits your situation.
3. Find a provider for the investment vehicle you have chosen.
If you are considering a 529 Savings Plan, investigate your own state’s plan. There may be state tax advantages.
Keep costs low. Avoid paying any sort of commission or “load.” Look for mutual funds with low expense ratios
Don’t focus on performance. Performance varies from year to year. You will have better luck with a low-cost index fund.
4. Invest the money properly.
Identify a mix of stocks and bonds that is right for you, based on how old your child is and how many years of investing you anticipate. (See Article Eight, “Investing Your Money,” for recommended asset allocations.)
5. Know your limitations.
Be prepared to hire a financial advisor if you don’t feel confident investing, or if you need further assistance
Start Saving!
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