As college costs have increased dramatically over the last decade, paying for a college education has become one of the greatest financial challenges many families will face. In fact, the cost of a 4-year education at many private colleges is approaching the median price of a single-family house in the United States.
College costs are expected to continue rising. Tuition at public colleges will continue to increase about 7 percent a year, and tuition at private colleges will rise as much as 9 percent annually.
The Tax Reform Act of 1986 created an even greater challenge for families saving for a college education. This law either eliminated or reduced many of the legitimate tax breaks that parents were using to save for a college education.
In addition, the 1986 Higher Education Amendments reduced assistance available in grants, and they placed restrictions on financial aid, requiring students to pay a larger portion of the total college bill.
In this article we will discuss steps to financial planning for a college education, including estimating college costs, evaluating savings programs, and analyzing sources for financial aid.
Estimating College Costs
The first step in financial planning for a college education is to estimate realistically how much college costs will be. College costs can be separated into two categories: direct and indirect.
Direct college costs include tuition, fees, room and board. Information concerning direct costs is available from each particular institution. Additionally, publications are available that provide information about college expenses.
The College Cost Book, published by The College Board, provides information on college costs and on how to apply for financial aid. The College Board can be reached by telephone at (212) 713-8142.
Another helpful booklet that identifies the average cost of every college and university in the country is available from the Life Insurance Marketing and Research Association by telephoning (203) 677-0033. Both of the above references can also usually be found at the local library.
Indirect college costs include other necessary educational expenses, such as books and supplies, transportation, medical coverage, clothing, recreation, and other personal expenses. These indirect costs vary considerably among students, and are, therefore, more difficult to estimate than direct college costs. Contact the financial aid office at the institution you are interested in for information concerning typical indirect expenses of students in a particular area.
Once you have gathered information concerning the current direct and indirect costs of college, you can project those costs into the appropriate year.
The College Costs Work Sheet can help you determine the amount of money you will need, as well as suggest the amount that you should save monthly, quarterly, or annually to reach that goal.
|College Costs Work Sheet|
|1. Enter current total annual cost of college of your choice.||$6,000||$ __________|
|2. Multiply amount in Step 1 by 4 to arrive at 4-year cost.||$24,000||$ __________|
|3. Enter the number of years until your child reaches college.||12||__________|
|4. Using the number of years in Step 3, select an inflation factor from Table A below.||(7%) 2.25||__________|
|5. Multiply 4-year cost in Step 2 by inflation factor in Step 4. This is the projected amount that must be saved prior to your child's attending college.||$54,000||$ __________|
|6. Select from Table B the investment factor that coincides with the annual investment return you expect to receive after taxes.||(6%) .057||__________|
|7. Multiply the inflation-adjusted 4-year cost in Step 5 by the investment factor in Step 6. This is the amount that you will need to save annually. Divide by 12 or 4 to determine your monthly or quarterly savings goal.||(Monthly) $256||$ __________|
Evaluating Savings Programs
Once you have realistically estimated the amount of money that will be needed to meet college expenses, you must find a place to save, or invest, your money. Many savings and investment options are available; therefore, you should seek expert advice. Professionals from banks or credit unions, financial planners, or stock brokers can help you make the savings or investment choice that best fits your needs.
Consider the following criteria when you select a savings program:Investment Contribution: Does the investment require a one-time contribution, irregular contributions, or monthly contributions? Is there a minimum or maximum contribution size?Carefully considering these five criteria can help you determine which savings vehicle is the right one for your situation.
Convenience: Will it be simple to establish the account, or will it require a lot of paperwork? Will you need the assistance of an attorney?
Ownership of the Fund: Do you want the money to be in your child's name, even if you cannot get it should the child decide not to go to college, or if you need the money for an emergency? Do you want your child to have control of the money now, in the future, or at all?
Risk: The younger the child, the greater the investment risk a parent can assume. For example, a parent starting a college fund for a 15-year-old may not feel comfortable investing in higher risk alternatives such as stocks, while a parent starting a college fund during the child's first year might be willing to assume such a risk.
Tax Considerations: Will your investment contributions be with before- or after-tax dollars? Will earnings be tax exempt, tax deferred, taxed as ordinary income in your tax bracket or your child's tax bracket? There are tax savings if investments are made in the child's name. Before age 14, the first $550 of investment income is tax free, and the second $550 is taxed at 15 percent. Any amount above $1,100 is taxed at the parent's rate. Once the child reaches age 14, all income is taxed at the child's rate.
Another consideration in selecting a savings program for college expenses is your child's age. The savings program should be matched to your child's age. For example, if your child is young, the best investment might be one that yields long-term growth. However, if your child is older, you may prefer safer investments that are more liquid.
The list below, "College Investment Options", gives suggestions on where you should go to secure a particular investment.
College Investment Options Type of Program or Investment Institution Custodial account Banks, savings and loans, credit unions, mutual fund companies, insurance companies, and brokerage firms Minor's trust Family attorney, bank trust department, and savings and loan trust department Outright Gift Not required Securities (stocks and bonds) Full-service and discount brokerage firms Mutual funds Mutual fund companies, brokerage firms, and insurance companies Savings or Deposit Accounts Banks, savings and loans, credit unions, and some brokerage firms Series EE savings bonds Commercial banks, savings and loans, and employer payroll deduction IRA's Banks, savings and loans, credit unions, mutual fund companies, insurance companies, and brokerage firms TDA's Life insurance companies and brokerage firms Non-qualified Annuities Life insurance companies, savings and loans, and brokerage firms
Ownership of Investment Options
There are four basic ways to structure ownership of the educational fund:
- Using a custodial account
- Outright giving
- Establishing a minor's trust
- Saving under your own name.
The Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) provide that a parent or adult may transfer securities, money, life insurance, or annuities to a minor. A custodial account is established by putting the account in the child's name and social security number, with a parent or other adult identified as the custodian for the benefit of the minor.
UGMAs and UTMAs are easy to establish at any bank, insurance company, mutual fund or brokerage office. These accounts allow income to be shifted from the parent's higher tax rate to the child's lower tax bracket. The actual tax advantages are determined by the child's age. The child will be treated as a separate taxpayer if he or she is over the age of 14. All unearned income from the custodial account will be taxed at the child's lower tax level. If the child is under the age of 14, the new "kiddie tax" rules apply. According to those rules, any unearned income over $1,100 will be taxed at the parent's higher tax rate.
UGMAs and UTMAs also qualify for the $10,000 annual gift tax exclusion. When gifts per child do not exceed $10,000 per year (or $20,000 if spouses join in the gift), there are no gift tax consequences.
Outright giving is simply giving your child the money for his or her education. This direct method of financing an education may be risky, as the parents do not have control over the money or savings.
In addition, if you wish to invest the money in securities instead of a savings account, you may find that investment brokers are reluctant to deal in securities owned by a minor because an agreement with a minor is usually not binding.
Although an outright gift will qualify for the $10,000 annual gift tax exclusion, kiddie taxes resulting from unearned income will still apply.
A Minor's Trust
A minor's trust, sometimes called a Section 2503(c) trust, is an irrevocable trust to consider if you have reached the kiddie tax limit of $1,100 of shifted income per child.
With a minor's trust, the principal and interest of the trust must be payable to the child when he or she reaches age 21, or sooner. This form of savings qualifies for the $10,000 annual gift tax exclusion.
In addition, income that is accumulated in the trust for the child's benefit is taxed to the trust. A trust pays taxes at a rate of 15 percent on earnings between $101 and $5,000 (the first $100 in income is tax-free). Income more than $5,000 but less than $13,000 is taxed to the trust at a 28 percent tax bracket.
Saving Under Your Own Name
This option of saving for a child's education allows you to have total control over the investment. It is also perhaps easier to establish and maintain an account that is under your own name. While there are a multitude of investments that you can choose from to save for your child's education, some have definite tax advantages.
Listed below are some investments you may want to consider:
- Series E United States Savings Bonds
- CollegeSure CDs
- Municipal bonds
- Mutual funds
- Individual Retirement Accounts (IRAs)
- Tax Deferred Annuities (TDAs)
- Non-qualified annuitiesSeries EE United States Savings Bonds: These bonds are bought at a discount from what you will receive when the bonds mature. You may be able to avoid paying income taxes on these investments altogether if the proceeds from the sale of the bond are used for qualified higher education expenses (usually tuition and other required expenses). If the proceeds are more than the qualified expenses, the amount of interest excludable is reduced.
College Sure CDs: CollegeSure CDs were created by the College Savings Bank of Princeton, New Jersey. They have a rate tied to the College Board's Independent College 500 Index. The index measures the yearly rise in the cost of attending college. The CDs don't pay the actual index. For investments of $10,000 or more, they pay one percent less. If the investment is less than $10,000, the rate is 1.5 percent below the index. The CDs have a 5 percent floor, are insured by the FDIC, and offer no income tax breaks.
Municipal Bonds: While municipal bonds do not yield as high a return as some other types of bonds, the interest earned is not taxable at the federal level (and possibly the state level). Many investors match the maturity date of the bond to the time the money will be needed for college expenses. Because these bonds are usually bought in denominations of $1,000, it is not an appropriate option for persons who want to make smaller, periodic investments over the long term.
Mutual Funds: You can expect mutual funds to earn a higher return than bonds or CDs. When the first year of college is only 3 or 4 years away, however, the risk increases that mutual fund shares will decline. Some funds now offer special college options that transfer part of the investment from stocks to a less risky money market fund once the college bound youngster becomes a teenager.
Individual Retirement Accounts (IRAs): An individual retirement account allows earned interest to accumulate on a tax deferred basis. Depending on your income and retirement plan status, the annual contribution to these accounts may also be deductible from your current gross income.
Tax Deferred Annuities (TDAs): Educational institutions and nonprofit organizations offer these special retirement plans for their employees. Federal and state income taxes are reduced during the years that contributions to a TDA are made, with taxes being paid when the earnings are withdrawn. Because of strict federal withdrawal regulations, a TDA is recommended only as a tool for college savings if the owner of the TDA will have reached the age of 59 1/2 when the minor reaches college age.
Non-qualified Annuities: This option provides for earnings from the annuity to accumulate on a tax-deferred basis, with withdrawals being taxed when received. Recent tax legislation did not place the same withdrawal restrictions on non-qualified annuities that were established for qualified annuities or TDAs.
Analyzing Sources for Financial Aid
In addition to starting a savings program, parents may choose to look for financial aid from other sources. This may require filling out many forms, but the results are usually well worth the effort. Often, free money or a loan with a low interest rate can be secured.
Loans, scholarships, and grants are available from private and public institutions. When your child begins applying for college, contact each financial aid office. Financial aid officers can advise you on what options are right for your child and where to look for money. Libraries also can provide information on state and private sources of financial aid.
If you want to use several methods to finance your child's education, look for a package of aid. The package may include savings, loans, grants, scholarships, gifts, your child's savings from summer jobs, and work-study programs.
Apply for aid early, because it is awarded on a first-come-first-served basis. Plan to apply for financial aid from a college by January of the year your child expects to attend in the fall. Check for deadlines with the school.
There are many options to choose from when looking for financial aid:
- Work-study programsLoansReferencesStafford Loans (formerly the Guaranteed Student Loan Program): Stafford Loans are federally sponsored. Almost any student who demonstrates need can qualify for one of these low interest loans. You do not have to repay this loan until the student graduates or leaves school. The total must be paid in 5 to 10 years, with minimum payments of $50 per month. The standard interest rate is 8 percent.In addition, a variety of other loan programs are available. State-sponsored loans are usually administered by one of the state offices or by the school itself. Check with the school's financial aid office for information concerning these types of loans.
Supplemental Loans: Students who are not listed as a dependent on their parents' federal income tax report are eligible for these loans. You do not have to qualify by a needs test. The maximum interest rate is 12 percent. A student may borrow up to $4,000 per year. Payments begin when the student leaves or graduates from school.
Loans for Parents Program (PLUS): This program allows parents to borrow up to $4,000 a year to help pay for their child's education. The maximum interest rate is 12 percent. A credit check is required.
The Perkins Loan Program (formerly National Direct Student Loans): The school's financial aid office administers this program. This below-market-interest-rate loan is made to students based on need and other aid received. A student may borrow up to $9,000 during 4 years of college, depending on need and other aid.
College-sponsored loans are made directly by the school. You should also check with the school's financial aid office for more information about these loans.
Conventional loans are available at market interest rates to parents and students who have good credit.
Also, home equity loans, which generally have lower interest rates than other consumer loans, may be an option.
Grants and ScholarshipsPell Grants: The Pell Grant program is the largest federal student aid program. Generally, students from large families with low incomes qualify for a Pell Grant. The amount of the grant is based on need and whether the student is full- or part-time, length of enrollment, and the cost of education at the given school. Pell Grants must be re-applied for each year.
Supplemental Educational Opportunity Grants (SEOGs): The federal government funds these grants, but they are administered by the college financial aid office. They are based on need and the availability of SEOG funds at that school. It is possible for a student to receive as much as $4,000 a year.
State Grants: You must be a resident of the particular state to be eligible for a state grant. Often, state grants are not based primarily on need. Many states give grants based on academic merit or field of study. Higher income families stand a better chance of receiving state aid than federal aid.
Scholarships: Scholarships are available from a variety of sources. Employers, major corporations, the military, colleges and universities, and religious, ethnic, and club affiliations are among sources to check for possible scholarship opportunities.
College Work Study ProgramsWork study programs usually pay a student at the federal minimum wage rate. The financial aid administrator is usually in charge of this program. Work hours are usually limited to 20 hours per week.
Cooperative education is another alternative. Under this program, a student works in his or her field of study while going to school. Generally, it requires students more time to complete their education using this method, but the reward is often a job with the company after graduation.
Bryant, J. E., Baran, N. H., & Jaquith, S. L. (1990).
Financing a College Education, Prospect Heights, IL:
Household International, Money Management Institute.
Maddox, E., & McLocklin, W. (1990). Planning Ahead for the Cost of Your Child's College Education.
University of Georgia Cooperative Extension Service.
Article written by Beverly Riggs Howell, Extension Family Economics and Management Specialist, Mississippi State University. This article is public information and may be reproduce in part or total.