How can you properly fund your children's education without draining your current cash flow? What should you do if they are a few years away from college and your education fund won't be enough? How can you increase your chances of getting financial aid? What tax benefits might be available to you? This Financial Guide answers these questions.
With the costs of a college education rising every year, the keys to funding your child's education are to plan early and invest shrewdly. However, there are steps you can take if you get a late start. Moreover, there are a number of effective techniques for increasing financial aid opportunities and reducing taxes.
Savings And Investment Strategies
According to the College Board, over the most recent decade, the largest one-year increases in average published tuition and fees at public four-year colleges and universities were 11% beyond inflation in 2003-04, and 9.3% beyond inflation in 2009-10. The inflation-adjusted increase was under 1% in 2008-09, and is 4.5% for 2011-12. However, proper planning can lessen the financial squeeze considerably, especially if you start when your child is young. It should also be noted that in 2010-11 the average amount of aid for a full-time undergraduate student was about $12,455, including more than $6,500 in grants that don’t have to be repaid.
Here are some guidelines--geared to parents whose children are no older than elementary school age--for funding your child's education.
Start Saving Early
We cannot emphasize enough that getting an early start is basic to funding your child's education. The earlier you start, the more you'll benefit from the compounding of interest.
Planning Aid: For an estimate of the amount of money you would have at the time your child enters college if you begin saving now, see the Financial Calculator: College Savings Calculator.
When should you start saving? This depends on how much you think your children's education will cost. The best way is to start saving before they are born. The sooner you begin, the less money you will have to put away each year.
Example: Suppose you have one child, age six months, and you estimate that you'll need $120,000 to finance his college education 18 years from now. If you start putting away money immediately, you'll need to save $3,500 per year for 18 years (assuming an after-tax return of 7%). On the other hand, if you put off saving until the child is six years old, you'll have to save almost double that amount every year for twelve years.
Another advantage of starting early is that you'll have more flexibility when it comes to the type of investment you'll use. You'll be able to put at least part of your money in equities, which, although riskier in the short-run, are better able to outpace inflation than other investments after time.
Find Out How Much You'll Need To Save
How much will your child's education cost? It depends on whether your child attends a private or state school. In the 2010-2011 school year, the total expenses--tuition, fees, board, personal expenses, and books and supplies--for the average private college are about $35,636 per year and about $15,213 per year for the average public college. However, these amounts are averages: the tuition, fees, and board for some private colleges can cost more than $55,000 per year, whereas the costs for a state school can be kept under $10,000 per year.
Planning Aid: Use College Search, a database of over 3,200 two-and four-year colleges, to find and select the best colleges for your child.
Don't forget to add the costs of graduate or professional school to the amount your child will need.
Planning Aid: If you're trying to estimate future costs, you can estimate that school costs will grow by about two percentage points above the inflation rate. To be on the safe side, we suggest you assume costs will grow by at least 7% per year. For the most recent increases, refer to 2011 Trends in College Pricing.
Choose Your Investments
As with any investment, you should choose those that will provide you with a good return and that meet your level of risk tolerance. The ones you choose should depend on when you start your savings plan-the mix of investments if you start when your child is a toddler should be different from those used if you start when your child is age 12.
Related Financial Guide: For a general overview of investing principles, please see the Financial Guide: INVESTMENT BASICS: What You Should Know.
The following are often recommended as investments suitable for education funds:
Series EE Bonds are extremely safe investments. For tax treatment of redemption proceeds used for college, please see the Financial Guide: HIGHER EDUCATION COSTS: How To Get The Best Tax Treatment.
U.S. Government Bonds are also safe investments that offer a relatively higher return. If you use zero-coupon bonds for your child's education, you can time the receipt of the proceeds to fall in the year when you need the money. A drawback of such bonds is that a sale before their maturity date could result in a loss on the investment. Further, the accrued interest is taxable even though you don't receive it until maturity.
CDs are safe, but usually provide a lower return than the rate of inflation. The interest is taxable.
Municipal Bonds, if they are highly rated, can provide an acceptable return from the tax-free interest if you're in the higher income tax brackets. Zero-coupon municipals can be timed to fall due when you need the funds and are useful if you begin saving later in the child's life.
Tip: Be sure to convert the tax-free return quoted by sellers of such bonds into an equivalent taxable return. Otherwise, the quoted return may be misleading. The formula for converting tax-free returns into taxable returns is as follows:
Divide the tax-free return by 1.00 minus your top tax rate to determine the taxable-return equivalent. For example, if the return on municipal bonds is 5% and you are in the 30% tax bracket, the equivalent taxable return is 7.1% (5% divided by 70%).
Stocks contained in an appropriate mutual fund or portfolio can provide you with a higher yield at an acceptable risk level. Stock mutual funds can provide superior returns over the long term. Income and balanced funds can meet the investment needs of those who begin saving when the child is older.
Deferred Annuities provide you with tax deferral, but the yield may not be acceptable because of the relatively high cost of these investments. Further, amounts withdrawn before you reach age 59-1/2 may be subject to a 10% premature withdrawal penalty.
Related Financial Guide: For further information on investing in annuities, please see the Financial Guide: ANNUITIES: How They Work And When You Should Use Them.
If You're Caught Short
If you have insufficient savings for your child's education when he or she is close to entering college, there are ways to generate additional funds both now and when your child is about to enter school:
You can start saving as much as possible during the remaining years. However, unless your income level is high enough to support an extremely stringent savings plan, you will probably fall short of the amount you need.
You can take on a part-time job. However, this will raise your income for purposes of determining whether you are eligible for certain types of student aid. In addition, your child may be able to take on part-time or summer jobs.
You can tap your assets by taking out a home equity loan or a personal loan, selling assets or borrowing from a 401(k) plan.
- You (or your child) can apply for various types of student aid and education loans (discussed below and in Info Sources).
Related Financial Guide: For further information on Equity Loans, please see the Financial Guide: HOME EQUITY LOANS: How To Shop For The One That's Best For You.
Tip: Sources of student aid and education loans should be exhausted before other types of loans are used, since the former make better sense financially. In some cases, however, a home equity loan can be advantageous because of the deductibility of interest.
Sources Of Financial Aid
Here is a summary of the possible sources of financial aid. The types of aid and tax implications change frequently, so consult your financial advisor for specifics when you're approaching the time to seek financial aid.
Grants, the best type of financial aid because they do not have to be paid back, are amounts awarded by governments, schools, and other organizations. Some grants are need-based and others are not.
- Federal Pell Grant Program. Pell grants are need-based.
Tip: Don't assume that middle class families are ineligible for needs-based aid or loans. The assessment of whether a family qualifies as "in need" depends on the cost of the college and the size of the family.
- State education departments may make grants available. Inquiries should be made of the state agency. Employers may provide subsidies.
- Private organizations may provide scholarships. Inquiries should be made at schools.
- Most schools provide aid and scholarships, both needs-based and non-needs-based.
- Military scholarships are available to those who enlist in the Reserves, National Guard, or Reserve Officers Training Corps. Inquiries should be made at the branch of service.
Tip: Try negotiating with your preferred college for additional financial aid, especially if it offers less than a comparable college.
Loans may be need-based, and others are not. Here is a summary of loans:
- Stafford loans (formerly guaranteed student loans) are federally guaranteed and subsidized low-interest loans made by local lenders and the federal government. They are needs-based for subsidized loans; however an unsubsidized version is also available.
- Perkins loans are provided by the federal government and administered by schools. They are needs-based. Inquiries should be made at school aid offices.
- Parent loans for undergraduate students (PLUS) and supplemental loans for students are federally guaranteed loans by local lenders to parents, not students. Inquiries should be made at college aid offices or by calling 800-333-4636.
- Schools themselves may provide student loans. Inquiries should be made at the school.
Work-Study Programs. This is a program that is federally funded and based on the family's financial need. The student works on-campus and receives partly subsidized pay. The receipt of work-study funds does not affect the level of "need" for purposes of need-based grants and loans.
To make a thorough investigation, you should fill out the financial aid application, which you can obtain from the school's financial aid office. You will have to provide tax returns. The amount you are determined to be eligible for depends on your income, the size of your family, the number of family members currently attending college, and your assets.
Related Financial Guide: For information on Equity Loans, please see the Financial Guide: HOME EQUITY LOANS: How To Shop For The One That's Best For You.
How To Increase The Amount Of Financial Aid
Here are some strategies that may increase the amount of aid for which your family is eligible:
- Try to avoid putting assets in your child's name. As a general rule, education funds should be kept in the parents' names, since investments in a child's name can impact negatively on aid eligibility. For example, the rules for determining financial aid decrease the amount of aid for which a child is eligible by 35% of assets the child owns and by 50% of the child's income.
Example: If your child owns $1,000 worth of stock, the amount of aid for which he or she is eligible for is reduced by $350. On the other hand, the amount of aid is reduced by (effectively) only 5.6% of your assets and from 22 to 47% of your income.
- Reduce your income. Income for financial aid purposes is generally determined based upon your previous year's income tax situation. Therefore, in the years immediately prior to and during college, try to reduce your taxable income. Some ways to do this include:
- Defer capital gains.
- Sell losing investments.
- Reduce the income from your business. If you are the owner of your own business, you may be able to reduce your taxable income by taking a lower salary, deferring bonuses, etc.
- Avoid distributions from retirement plans or IRAs in these years.
- Pay your federal and state taxes during the year in the form of estimated payments rather than waiting until April 15 of the following year.
- Since a portion of discretionary assets is included in the family's expected contribution from income, reduce discretionary assets by paying off credit cards and other consumer loans.
- Take advantage of vehicles which defer income, such as 401(k) plans, other retirement plans or annuities.
Detail your financial hardships. If you have any financial hardships, let the deciding authorities know (via the statement of financial need) exactly what they are, if they are not clear on the application. The financial aid officer may be able to assist you in explaining hardships.
Have your child become independent (if feasible). In this case, your income is not considered in determining how much aid your child will be eligible for. Students are considered independent if they:
- Are at least 24 years old by the end of the year for which they are applying for aid,
- Are veterans,
- Have dependents other than their spouse,
- Are wards of the court or both parents are deceased,
- Are graduate or professional students or
- Are married and are not claimed as dependents on their parents' returns.
How To Reduce Taxes
As noted above, education funds should generally be kept in the parents' names because of financial-aid considerations. However, in specific cases, it may be better to keep the investments in your child's name since the tax rate on the income will be less than if they are held in your name. Professional advice should be sought in making this decision.
In the past, parents would invest in the child's name in order to shift income to the lower-bracket child. However, the addition of the "kiddie tax" mostly put an end to that strategy. Now, investment income over $2,000 for 2013 (up $100 from 2012) of children under the age of 19 (or 24 if a full time student) is taxed at the parents' rate. (This threshold is indexed annually for inflation.) Once the child reaches age 19, however, all income is taxed at the child's rate. Of this $2,000, one-half probably won't be taxed due to the availability of the standard deduction while the other half would be taxed at the child's rate.
Note: These rules apply to unearned income. If a child has earned income, this amount is always taxed at the child's rate. If you decide to invest in your child's name, here are some tax strategies to consider:
- You can shift just enough assets to create $2,000 in taxable income to an under-19 child.
- You can buy U.S. Savings Bonds (in the child's name) scheduled to mature after your child reaches age 19.
- You can invest in equities that pay small dividends but have a lot of potential for appreciation. The income earned when your child is under the age of 19 will be minimal, and the growth in the stocks will occur over the long term.
- If you own a family business, you can employ your child in the business. Earned income is not subject to the "kiddie-tax," and is deductible by the business if the child is performing a legitimate function. Additionally, if your business is a sole proprietorship and your child is under the age of 19, then he or she will not pay social security taxes on the income.
Note: The Kiddie Tax does not apply if the earned income of a student over age 18 exceeds half of the child's living expenses. Living expenses include food, housing, clothing, medical, dental, education and other necessary costs of support. Students over 18 are considered independent from their parents if they provide more than 50% of their own support.
There are also a number of tax incentives that you might be able to take advantage of. Please see the Financial Guide: HIGHER EDUCATION COSTS: How To Get The Best Tax Treatment.
Tip: Reporting the kiddie tax on the child's return using the required Form 8615 calls for showing the parents' taxable income. A parent reluctant to show that item to a teenager may instead report the child's investment income of the parent's return, on Form 8814. But this is not allowed, and the Form 8615 route must be followed, where the child has taxable earned income, as many teenagers would.
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