Funding a College Education
A Crash Course in the Options Available to Parents and Students
Doug Wheat
The parents’ concern is enhanced by the uncertainty of college costs and financial aid, the complexity of the application process, and the desire to provide the best education for their children. With a long-term plan that carefully balances savings, borrowing, and college selection, parents can help their children reach their dreams without bankrupting their retirement.
According to the College Board, for the 2012-13 school year, the average cost of one year of tuition, fees, room, and board was $17,860 for public in-state students and $39,518 for nonprofit private college students. These costs were up nearly 4% from the previous year. Locally, a year at UMass Amherst costs $23,000, Springfield College costs $46,000, and Amherst College costs $59,000.
The cost of college is having an increasing impact on the selection of schools. According to the Higher Education Research Institute, in 2012, 43% of college freshman reported that the cost of attending their school was important, compared to only 31% of college freshman in 2004. In addition, 13% of students were unable to afford their first-choice college.
An important tool now available on most colleges’ websites is called the ‘net price calculator.’ These calculators let you have an idea of the type of cost you might be expected to pay at specific schools depending on your specific financial resources.
There are six primary sources of funding for college: grants and scholarships, federal tax credits and grants, current income, savings, student borrowing, and parent borrowing. A comprehensive plan for school financing will try to balance these factors along with school selection to match a student with the school that fits his or her education goals.
Grants and Scholarships
While we all would like our children to get grants and scholarships to cover the full cost of college, the truth is that these will cover only a portion of the costs for most students. The amount a student receives from a college will depend on a combination of the financial resources of the family, the resources of the college, and the attractiveness of the student to the college.
Some students may qualify for ‘merit’ assistance from the college based on their academic or other accomplishments. But most students will require need-based financial aid. Need-based assistance starts with the expected family contribution (EFC), which is calculated after filing the federal FAFSA aid form and CSS Profile aid form for a small group of elite colleges.
The need for financial aid will be determined by subtracting the expected family contribution from the total cost of attending a college. If the cost of attendance is more than the EFC, the student will qualify for need-based financial aid, which may come in the form of grants, scholarships, loans, and work study. The more desirable a student is to the college, the more likely their need-based ‘aid package’ will be more desirable.
Since the EFC is the primary driver of financial aid, parents may be able to increase their award by understanding how the EFC is calculated. For example, some parents that have control of their income may try to decrease their income in the year leading up to college in attempt to show they need additional aid. Parents may also want to understand how colleges use student and parental assets in the aid formulas to determine their best college funding strategy, which will be discussed below.
Federal Tax Credits and Grants
There are two federal tax credits available to help pay for college, but you can only utilize one at a time. The Federal Opportunity Tax Credit provides a $2,500 credit per student for the first four years of post-secondary school. This credit (formerly known as the Hope Credit) is phased out for higher income levels (married couples with incomes above $160,000).
The Lifetime Learning Credit is worth up to $2,000 as a credit per tax return toward education expenses.
Pell grants are available for up to $5,550 per student. Students with family incomes up to $60,000 are eligible to apply, but the majority of awards go to students with family incomes below $30,000.
Current Income
Most parents would find it impossible to pay $60,000 per year out of current income. But by cutting corners and planning in advance, it is possible for many families to make a significant contribution to college costs from their current paychecks, which will help them avoid having to rely overly on debt.
One strategy parents might consider is to pay off their mortgage and other debt before their children get to college. This strategy will help free up cash flow while the student is in school, help the family adjust to living on a smaller budget, and reduce the amount of savings that might be used to determine the expected family contribution.
Income does have the largest impact on the financial-aid calculations that will ultimately determine the expected family contribution. The more you make, the less likely your children will qualify for need-based financial assistance (even if you have little savings).
Savings
Many parents have mixed emotions about saving for college. On one hand, they know college is expensive and they will be expected to pay a portion of the costs. On the other hand, they do not want to spend years saving for college only to have the financial-aid package from the prospective school reduced as a direct result of their savings.
To parents, it is not fair that they receive less aid for saving than a family of similar means that was not as prudent.
While the issue of fairness may nag at parents, it is important for them to take the long view and make sure they position themselves and their children in the best possible financial circumstances. To do this, the number-one priority for parents is to fully fund their retirement. Parents need to understand how much they need to save annually to pay for their retirement. The second priority for parents is to start saving early in the most advantageous types of accounts.
A 529 college savings account is generally the best savings vehicle, since these plans allow for tax-free growth and are considered parental assets for financial-aid purposes. The federal aid formula expects parents to contribute 5.6% of their savings to college costs each year. Accounts in the name of a student, such as UTMA accounts, are assessed by the federal aid formula at 20% per year. Since there is no tax deduction in Massachusetts for contributions to a 529 plan, residents are free to choose the plans with the lowest cost and best investment selections. In Connecticut, the state tax deduction for contributions means residents will want to participate in the CHET 529 plan.
Some people may find saving for college in a Roth IRA account advantageous if they are already fully funding their retirement in 401(k) or 403(b) plans. A Roth account’s advantages include being excluded from the federal aid formula, the ability to take penalty-free withdrawals to pay for qualified higher education, and withdrawals do not count as income. But withdrawals may limit your ability to take the Lifetime Learning tax credit, and there are rules that apply to withdrawals if the account is newer than five years old and you are under age 59 1/2. Be sure you understand all of the rules about Roth accounts and be sure your retirement savings are adequate before you use them as a college savings vehicle.
While few people can afford to save the $1,100 per month per child for 18 years that it takes to accumulate adequate savings for an elite private school, most people can save something each month. Undoubtedly, you will be glad to have saved as much as you can when it comes time to start paying college tuition bills.
Student Borrowing
Student borrowing has become one of the main sources of college funding as the cost of school has increased and the amount of government assistance has decreased. Dependent students may currently borrow up to $27,000 in subsidized and unsubsidized Stafford loans for four years of school. The interest rate for subsidized loans is currently 3.4%, and the interest does not start accruing until after the student graduates. Subsidized loans are available based on need. Unsubsidized loans have a current interest rate of 6.8%, and the interest starts accruing immediately.
Students should also check with their college to see if Perkins loans are available if they have extraordinary financial need.
Borrowing beyond the direct student lending amount of $27,000 will in most cases require parents to co-sign the loans and may come with higher interest rates. Many personal financial advisors recommend that students try to limit their loans to the amount that they can personally take out in order to make sure they do not enter the workforce straddled by too much debt. It is important to remember that student loans can rarely be discharged through bankruptcy, and this debt will stay with a student until it is paid off.
Parent Borrowing
Parents have the ability to take Parent Plus loans or private loans to make up the difference between the cost of attendance and any financial aid their son or daughter receives from a college.
Even if students qualify for need-based assistance, some schools may not have the ability or willingness to provide that aid (each school reports on the percentage of students whose ‘need’ is met). Filling a missing gap often results in parents being asked to take out huge college loans. Taking out tens of thousands of dollars or even hundreds of thousands of dollars in loans to pay for college may not be a wise financial step for parents.
It is important for parents to make sure they do not jeopardize their own retirement by paying for the college education of their children. Parents can inadvertently do this by taking out a large amount of debt only to see their ability to pay it back diminished by losing a job. For older parents, they might consider that they do not have many earning years left to pay back the loan if the parents are in their 60s when their children graduate from college.
For people with equity in their homes, taking out a home-equity loan to pay for school is currently attractive since home-equity rates are currently lower than the 7.9% Parents Plus loan interest rate. But before mortgaging their house to pay for college, parents should carefully consider their ability to pay off the debt. Maybe a less expensive school is a better choice for the family.
Know Your Contribution Limits
It is possible for nearly every person who wants a college degree to find a combination of school selection and financial resources that will allow them to attend. Today many families prefer to find less expensive options for attending school to help make college affordable. For example, a year of classes at Holyoke Community College costs less than $2,500, and you can attend Westfield State University for less than $10,000 per year if you live at home.
Regardless of where your children ultimately decide to attend college, be prepared to know what you can afford to contribute from tax credits, savings, income, and loans. By knowing the limits of your contributions up front, it can help guide the selection of the best colleges academically and financially for your children.
Doug Wheat, CFP is manager of Wealth Management for Holyoke-based Meyers Brothers Kalicka; (413) 536-8510; www.fwmgt.com
