Thursday, July 31, 2014
College Planning

  

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.

When should I start saving for my child’s education?

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 in the long-run.

How much will my child’s college education cost?

It depends on whether your child attends a private or state school. In the late-90s, the total expenses--tuition, fees, board, personal expenses, and books and supplies--for the average private college are about $21,000 per year. and about $10,000 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 $25,000 per year, whereas the costs for a state school can be kept under $10,000 per year.

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.

How should I invest my child’s college fund?

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.

The following are often recommended as investments for education funds:

  • Series EE bonds: These are extremely safe investments. They should be held in the parents’ names. If the adjusted gross income of you and your spouse at the time of redemption is at or under the amount set by the tax law, the interest on bonds bought after January 1, 1990 is tax-free as long as it is used for tuition or other qualified education costs. If your adjusted gross income is above the threshold amount, the tax break is phased out. This phase-out begins at about $80,000 for married couples filing a joint return.
  • U.S. government bonds: These are also investments that offer a relatively higher return than CDs or Series EE bonds. If you use zero-coupon bonds, 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.
  • Certificates of deposit: These are safe, but usually provide a lower return than the rate of inflation. The interest is taxable. These should generally only be used by the most risk averse investors and for relatively short investment horizons.
  • Municipal bonds: Assuming the bonds are highly rated, the tax-free interest on them can provide an acceptable return 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: An appropriate mutual fund or portfolio containing stocks can provide you with a higher yield than bonds 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.  

What is the "kiddie tax"?

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.

Investment income over $1,700 of children under the age of 17 is taxed at the parents' rate. (This threshold is indexed annually for inflation.) Once the child reaches age 17, however, all income is taxed at the child's rate. Of this $1,700, 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 in 2008, the age limit will increase to through age 18, or through age 23 for full-time students.

Note: These rules apply to unearned income. If a child has earned income, this amount is always taxed at the child’s rate.

What is an Education IRA and who is eligible for one?

Effective starting in 1998, $500 per year can be contributed to an Education IRA from which distributions used to pay for qualified educational expenses are not taxable. The contribution, however, is not deductible. For those filing as single, the contribution is phased out once AGI exceeds $95,000. For joint filers, the contribution is phased out once AGI exceeds $150,000.

If you have insufficient savings for your child’s education when he is close to entering college, what should you do?

Many families find themselves in the same boat. Fortunately, 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.

What types of grants are available for college?

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.

  • Pell grants are federal aid based on need.

    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.

What types of loans are available for college?

There are various student loan programs available. Some are 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.

How can I increase the amount of financial aid my child is entitled to?

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:
  1. Defer capital gains.
  2. Sell losing investments.
  3. 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.
  4. Avoid distributions from retirement plans or IRAs in these years.
  5. 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.
  6. 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.
  7. Take advantage of vehicles which defer income, such as 401(k) plans, other retirement plans or annuities.
  • Detail any 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 from the application. The financial aid officer may be able to assist you in explaining hardships.
  • Have your child become independent. 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:
  1. Are at least 24 years old by the end of the year for which they are applying for aid
  2. Are veterans
  3. Have dependents other than their spouse
  4. Are wards of the court or both parents are deceased
  5. Are graduate or professional students
  6. Are married and are not claimed as dependents on their parents’ returns

How can I save taxes on college savings?

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 $1,700 in 2007 taxable income to an under-18 child.
  • You can buy U.S. Savings Bonds (in the child’s name) scheduled to mature after your child reaches age 18.
  • You can invest in equities that pay small dividends but have a lot of potential for appreciation. The dividend income earned when your child is under 18 will be minimal with tax relief, 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 18, then he or she will not pay social security taxes on the income.

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