One of my biggest financial regrets centered on college costs and student loans.
Don’t get me wrong — I loved my college experience; I met the future Mrs. Harbor Crest the first day of freshman orientation (ask her the story — she tells it better than I do!). But I took on too much student loan debt, and I never thought through the long-term implications of that debt. Of course, it became top of mind when I graduated… and had to cover monthly loan payments larger than my rent.
I decided to aggressively pay down my loans, rather than save for my future self (over-and-above my minimum 401(k) contributions). Paying off my student loans in three years made me feel good, but it was a purely emotional decision. I let my attitudes toward debt make the decision for me.
I should have run the numbers and made a plan. Doing so would have undoubtedly led to a better financial outcome since I missed nearly all of the post-financial crisis market outperformance. As a parent to a young son, I see that history could repeat itself if I’m not careful.
With tuition costs increasing every year, I wanted to find a better way for our family to prepare for our future education needs. With enough time, smart moves made today will pay massive dividends in our family’s future.
As you, too, navigate your own education funding journey, here are some tips on preparing for the cost of college.
1. Have a Discussion with your Partner about College Planning Now
This is an underrated first step in college planning. Simply put, are you and your spouse aligned on your family’s college goals? While you may have views about what you expect to cover, these may differ from your spouse. Here’s a list of questions that can help spur the conversation.
- Do you both expect to pay for all of your child’s college costs? If not, are you in agreement about how much to contribute, and how you will fund those goals?
- Do your children need to go to your alma mater, or is a cheaper in-state option a better target in which to fund?
- What are your and your spouse’s views on student loan debt, both for yourself and your children?
- How do you balance saving for retirement with saving for college?
This last question is important. Sacrificing your own financial future can’t be an option. There are no loans for retirement.
Once you have solidified your college funding goals with your spouse, you can start building a plan to get there.
2. Approach It Like Business Planning
Yes, approaching your child’s future education like a business investment might conflict with your desire to provide your children with unwavering support. I get it. As parents, we want nothing more than the absolute best for our children. And most of the time, this is a perfectly acceptable approach. It can get us parents into trouble, though, when we want the shiniest star regardless of the cost.
Choosing the most stimulating wooden blocks for our adorable baby is a slightly different decision, and price point, than paying for our precocious teenager’s undergrad studies at Columbia University. So rather than committing blindly to what’s typically the largest financial purchase outside of our home, try running a college cost/benefit scenario analysis.
For instance, would you like to save for tuition at a four-year, private university? Look up the current all-in costs, which include more than just tuition. Room and board, books, fees, and other expenses can meaningfully increase the cost over and above just tuition. Grow those costs to the years in which your child, or children, will attend college. Tuition inflation rates are well above general inflation rates; assume 5 percent is a reasonable starting point.
Now try it with a range of college choices, scholarship or grant levels, and rate of return assumptions for your investment choices. Now you know the range of expected future outlays. Are these numbers something you can realistically save for? And what’s the best way to do it?
3. Find the Best College Savings Account for Your Situation
With a range of funding scenarios in hand, it’s now time to implement a savings and investment strategy. Several college funding account options exist, each with different advantages and disadvantages.
A 529 plan is a college savings plan that offers unique tax and financial aid benefits. There are two types of plans: college savings plans and prepaid tuition plans. Every state offers a 529 college savings plan, though not every state offers a prepaid plan (in fact, only nine do at this time).
While contributions to 529 savings plans are not tax-deductible at the federal level, earnings are tax-deferred and withdrawals, if used for qualified education expenses, are not taxed. Note, though, that some states allow 529 savings plan contributions to qualify for a tax-deduction against state income taxes. Each state has their own 529 plan, with different investment options, fees, and tax considerations, so it’s important to consider all factors when choosing the best 529 savings plan for your family.
Another advantage of 529 savings plans is the ability to contribute meaningful amounts early on to benefit from years of compounding. One can contribute up to $15,000 per year per person (the annual gift tax exclusion amount). 529 savings plans also have an interesting provision where you can fund five years of contributions at once ($150,000 per person), though additional tax documentation is needed.
An additional perk, recently rolled out as part of the Tax Cuts and Jobs Act (TCJA), allows for funds in 529 plans to be used for up to $10,000 annually for K-12 tuition, though check to see whether or not your state plan allows this new feature.
529 prepaid plans allow you to prepay all or some of the costs of your in-state public college tuition costs. You are effectively locking in the cost of (public) college credits at today’s prices. 529 prepaid plans can also be transferred to other private or out-of-state options, though the value of the credit may differ from what you originally locked in.
While Roth IRAs are typically thought of as a retirement account, their versatility also extends to college funding. Like a 529 plan, Roth IRA contributions are made with after-tax dollars. Contributions made to a Roth IRA can be withdrawn at any time for any reason, tax- and penalty-free.
Earnings are typically hit with a 10 percent penalty if withdrawn prior to age 59 ½ and the Roth IRA hasn’t yet met the five-year rule. However, the normal 10 percent penalty is waived if the withdrawal is for qualified higher education expenses.
While Roth IRAs offer tremendous optionality, there are some important tax and timing considerations to consider. Though Roth IRA money is not included as an asset as part of the Free Application for Federal Student Aid (FAFSA), a tax-free withdrawal of contributions that is then used for higher education expenses counts as untaxed income to the beneficiary, which could reduce any needs-based aid by as much as half. Given this, building a proper withdrawal strategy is just as important as building a proper savings and investment strategy.
Similar to a 529 savings plan, Coverdell Education Savings Accounts offer tax-deferred investment growth and tax-free withdrawals when used for qualified education expenses. They can also be used for certain primary school expenses. While this is similar to the new functionality of 529 savings plans post-TCJA, the range of expenses covered by Coverdell ESAs is more expansive.
Despite the broader usage relative to 529 savings plans, they do have a few serious shortcomings. Coverdell ESAs have a much lower annual contribution limit ($2,000) and there is no ability to “super-fund” like the 529 savings plan. Additionally, there are income eligibility limits for contributions.
Custodial Accounts (UGMA / UTMA)
Custodial accounts created by the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA) is a type of account that is established by an adult for the benefit of a minor. The funds in the account can be used for anything, not just qualified education expenses. There’s also no limit on how much you can invest, and there are fewer restrictions on contribution eligibility or amounts (being mindful of gift tax rules).
However, they do have some distinct disadvantages. First, earnings and gains are taxed at the “kiddie tax” rate. Second, they count as an asset for the student on the FAFSA, which can reduce aid by 20 percent of the account value. Third, once the beneficiary is of legal age, they can use that money for whatever they choose — cars over college, for instance.
Other College Funding Opportunities and Considerations
Outside of investment accounts, there are other opportunities to maximize your ability to fund your children’s education. When college applications are within sight, the first tip is to always fill out the FAFSA, no matter your income or asset level. The goal is to fill out these forms as soon as they are available, which is typically the October of the student’s senior year. Getting them done early is critical since most financial aid is given out by colleges and the federal government on a first come, first served basis.
Though they have received much negative press given their massive growth over the past twenty years, student loans may be necessary to bridge the gap between college costs and investment savings. Student loans come in many colors and flavors, from public vs. private to parent vs. student. The rules can get complicated quickly, though, and the borrowing decision has to be individualized to each family’s financial situation.
Another way to boost affordability is by taking advantage of federal and state tax benefits, deductions, and credits. We’ve previously mentioned how specific accounts offer tax features designed to encourage investment, whether it’s through a 529 savings plan or Roth IRA or Coverdell ESA.
The American Opportunity Tax Credit allows parents to claim a tax credit for 100 percent of the first $2,000 and 25 percent of the next $2,000 of a dependent’s college tuition and related expenses, up to a maximum of $2,500. The Lifetime Learning Credit also allows taxpayer parents to claim a tax credit of 20 percent of up to $10,000 in combined tuition and mandatory fees, up to a maximum of $2,000. Finally, student loan interest may be deducted, up to $2,500, as an above-the-line deduction as long as it was used for college costs.
Both tax credits as well as student loan interest deductions have income phase-outs and other considerations, so please consult with your tax advisor for more details.
Education Planning with Harbor Crest Wealth Advisors
Planning for your child’s education doesn’t need to be a stressful experience. This guide provides a blueprint to help you define your education goals and build a plan to get there. If you would like some help getting started or discussing different scenarios, please send us a note and we are happy to help.