Get an Early Jump-Start on Your Kids College Finances
No matter how young your kids are now, their college years will soon be here. The author of Paying For College For Dummies, says it’s not too early to start preparing—and explains why it might be the perfect New Year’s resolution.
We all hope 2021 will be a better year, but let’s be real: COVID-19 isn’t going away anytime soon. And if you have a school-age child (or younger), you may feel the outlook is bleak. Another semester of virtual classes, of juggling work and school supervision, or canceled (or scaled-down) sports and activities. Another uncertain summer.
Unfortunately, you can’t control any of that. What you can control, is starting to plan for college. Colleges are returning to normal, and there have never been so many options for higher education. If you have young children, it may feel like college is a long way off—but it will be here before you know it. This year might be the perfect opportunity to start taking some real steps to save and prepare for it.
While many people have struggled financially over the past year due to job loss and pay cuts, that’s not true for everyone. In fact, for some families, staying home has functioned much like a forced savings plan as they curtail vacations, dining out, commuting expenses, and other “normal” activities. Let this spur you on to start planning your finances with college in mind.
Regardless of how the pandemic has affected your finances, make 2021 the year you get serious about planning for the future. Parents need to know that college is not beyond the reach of their kids, and that’s true even if they’re of modest means. Learning, and taking action, is reassuring and empowering. It provides a much-needed sense of control.
Commit to spending less than you earn.
In general, it’s a good idea to save money throughout life, but it’s especially wise if your goals include sending your kids to college. Saving 10 percent is a good starting point, but you may need to save more than that to hit your goals. There are numerous ways to crunch some numbers to see how much you should be saving monthly to hit a particular goal.
Know that “financial aid” may cut your bill in half.
Financial aid is a bit of a misnomer, but it basically means that a college or university will charge your family less the less able they deem you to pay the full retail price of college. This means for non-affluent families, the average price that colleges typically charge and collect from each family equals about half of the stated full cost of attendance. So, for example, with private colleges charging around $60K per year, the average family is actually paying about $30K.
Get familiar with the components of financial aid now.
Colleges will look at your income and assets to arrive at an expected family contribution (EFC). That number is compared with and subtracted from the college’s total cost of attendance. In many cases, the total cost of attendance at a given college exceeds a family’s EFC, so the difference can be made up in various ways:
Grants and scholarships: Awarded by the school, this is essentially cutting the proposed price by the amount of the grant or scholarship—it’s a reduction from their full price that may be based solely on financial need but can also be for academic merit.
Federal work-study. These are low-paying jobs on college campuses that are subsidized by the federal government.
Student loans. Some loans provide for subsidized interest (at federal government expense) while the student is in school, and beginning repayment is not required until six months after graduation.
Save and invest with a “financial aid” mindset.
Under the current financial aid needs analysis system, the value of tax-sheltered retirement plans is not considered an asset. By contrast, money that you save outside retirement accounts, especially money in the child’s name, is counted as an asset and reduces financial aid eligibility, and increases the price colleges will charge you.
Here’s what you should take away from this:
1) Presuming one of your longer-term goals is financial security and independence, save money earmarked for your retirement in a tax-advantaged retirement account.
2) If you plan to apply for financial aid, save money in your name rather than in your children’s names (such as via custodial accounts). Colleges expect a much greater percentage of the money in your children’s names (20 percent) to be used annually for college costs than the money in your name (about 5.65 percent).
However, if you’re affluent, know that a custodial account can save you some money.
If you’re affluent enough to foot your child’s college bill without financial aid, investing in your kid’s name can potentially save you a little money in taxes. Parents control a custodial account until the child turns 18 or 21, depending upon the state in which you reside. For 2020, prior to your child’s reaching age 18, the first $2,200 of interest and dividend income generally isn’t taxed. Any unearned income above $2,200 is taxed federally at the relatively high rates that apply to trusts and estates.
Over the $2,200 threshold, unearned income is taxed at these rates:
Up to $2,600 falls into the 10 percent bracket
Between $2,600 and $9,450 is in the 24 percent bracket
Between $9,450 and $12,950 is in the 35 percent bracket
Above $12,950 is in the 37 percent bracket
Upon reaching age 18 (or age 24 if your offspring are still full-time students), all income generated by investments in your child’s name is taxed at your child’s rate, which is presumably a lower tax rate than yours.
Figure out if a 529 savings plan is right for your family.
A popular way to save for college is 529 state-sponsored college savings plans. A parent or grandparent can generally put upwards of $300,000 per beneficiary into one of these plans. The attraction of the 529 plans is that money inside the plans compounds without taxation, and if it’s used upon withdrawal to pay for college tuition, room and board, and other related qualifying education expenses, the investment earnings and appreciation can be withdrawn tax-free.
A potential drawback is that college financial aid offices treat assets in these plans as parental nonretirement assets. If your family isn’t wealthy and you aren’t funding your retirement accounts, you gain better tax benefits and help your financial aid profile if you instead put your extra tax dollars into your retirement account(s).
“These plans make the most sense for higher-income parents who don’t expect their children to qualify for financial aid,” says Eric Tyson. “However, less affluent parents may want to consider saving some money in these plans as the investment returns aren’t taxed when the money is used for educational expenses.”
Look for late-in-the-game ways to save.
In an ideal world, you manage your finances with a long-term perspective. But in the real world, stuff happens. If you find yourself needing to pay for college in the near future, there are still steps you can take to minimize the price you pay:
Remember that retirement account money is generally ignored by the financial aid process. Keep in mind, however, that for the retirement account contributions made during base years, reported on your financial aid forms, the financial aid analysis process will add those contributions back to your taxable income. Contribute more if you can in the years prior to those base years.
Reduce your cash by making planned purchases. If your car needs replacing, you might do so and use up some of your cash for that purpose before your kids apply to college. Don’t go overboard, but the reduced cash should improve the pricing offers you get from college.
Pay off high-cost debt. Again, the reduced cash can help improve your financial aid awards. And the financial aid needs analysis doesn’t make any allowance for your consumer debt.
Use assets in kids’ names. If you put money into your kids’ names in the past and now realize that wasn’t a wise move, perhaps you have current expenses for their benefit that you can use this money for.
Eighteen years go by quickly, so by the time your children are ready to head off to college, you’ll be so glad you took early action to plan for their futures. Saving for college when they’re young is an investment in your kids, but it’s also an investment in your peace of mind—and it gives you more options.
Eric Tyson is the author of Paying For College For Dummies®. He is a syndicated personal finance writer, lecturer, and counselor. He is dedicated to teaching people to manage their personal finances better. Eric is a former management consultant at Bain & Company to Fortune 500 financial service firms. Over the past three decades, he has successfully invested in securities as well as in real estate, started and managed several growing businesses, and earned a bachelor’s degree in economics at Yale and an MBA at the Stanford Graduate School of Business.
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