How to Plan for Higher Education in 2019?
Before you begin to save for higher education, you need to understand some tips and Financial Aid for better planning. In this blog, we explain How to Plan for Higher Education.
As with any financial planning goal that may be quantified, the first question to answer with respect to planning for your child’s higher education is how much money you will need.
The answer to that question depends on several factors, including how many children you have and whether you wish for them to attend public or private colleges or universities.
In 2019, private-college Ivy League institutions (elite institutions), such as Harvard and Yale, are among the most expensive to attend, with tuition, fees, and room and board costs averaging at least $50,000 per year.
Meanwhile, private liberal arts schools throughout the country are not far behind in cost. Finally, the cost of attendance at public schools varies greatly, but for planning purposes, using half of the current cost of attending an elite private school—or $25,000 annually—is not unreasonable.
The first step in computing the cost of your child’s education is to inflate or calculate in today’s dollars, what the current cost of attendance—say, $25,000 annually—will be when your child is ready to attend college.
To do this, you need to assume an annual increase in costs of a certain amount—say, 7 per-cent annually (this is higher than the current ten-year average increase, but not unrealistic when considering the financial pressure that the 2007–2009 recession placed on many state budgets).
You can input these numbers into a web-based calculator (at Yahoo!, for example), or you can enter them on a financial function calculator.
Higher Education Financial Aids
Before you begin to save for higher education, you need to consider whether your child is likely to qualify for federal financial aid. As you ponder this issue, ask yourself the following questions:
What do you expect your income to be at the time that the child enters college—or, more precisely, when you complete the Free Application for Student Aid (FAFSA) form in the second semester of your child’s junior year of high school?
Most federal financial aid is need-based; and if the child’s parent makes too much money, the child is unlikely to qualify for the aid.
Do you believe it is your responsibility or financial obligation to provide the child with a college education? Do you expect the child to assist financially or cover the complete cost of attendance?
Do you anticipate that your child will receive an academic or athletic scholarship to cover the cost of college attendance? Be realistic: although we all believe our children are uniquely talented, more realistically, this is probably not the case.
Do you have relatives or family members such as grandparents who have offered—or expect to offer—financial assistance when the child goes to college?
Fundamentally, you may be somewhat ambivalent about whether your child attends college or pursues higher education, but remember this: studies have shown that over the course of a lifetime, a college graduate will earn in excess of a million dollars more than an individual who only receives a high school diploma.
Let’s return to the question of in whose name you should save for college, which is a critical concern if you anticipate that your child will need financial assistance to cover the cost of college attendance. As you complete the mandatory FAFSA form, you are asked to list your assets and income as well as those of the child.
This is necessary to the federal government can determine an amount of expected family contribution (EFC) toward the cost of college attendance. If your child needs financial aid, you want to achieve an EFC determination that is as low as possible. Accordingly, you should know the formula the federal government uses to compute the amount that the family is expected to contribute.
The most critical component of this formula is the fair market value of the assets held in the name of the child versus those that are held in the name of the parent. In other words, what percentage of these assets is expected to be contributed to the cost of a college education and should, therefore, be counted against the family in the formula?
The answer is 35 percent for the child and less than 6 percent (5.64 percent, to be exact) for the parent. Just from this entry into the formula alone, it is generally much more advantageous to save for college in the name of the parent rather than in the name of the child.
If you decide to save for your child’s college education in your own name, you should probably embark on Section 529 private savings plan. Meanwhile, if you have decided to save for your child’s college education under their name, you should open a custodial account, such as a Uniform Gifts to Minors or Uniform Transfers to Minors account.
Other savings strategies may also reap dividends when you are saving for college. They are as follows:
Spend down the student’s assets first. This may easily be understood when recognizing the disparity in count-able children’s assets (35 percent) versus parental assets (approximately 6 percent).
Maximize contributions to your retirement fund. Whereas annual contributions to your 401(k) (or other) retirement plan are included in the computation of countable parental income, the vested account balance in a retirement plan is not counted among available parental assets that may be used to help pay for college costs.
If you are going to borrow to help fund the cost of your child’s college attendance, do so through a home equity loan or line of credit.
Pay off as much as possible of your credit card and other unsecured debt before filing the FAFSA. This will reduce the amount of cash or other assets that you must list and that is counted against you when applying for federal financial aid on behalf of your child.
Try to pay down your original mortgage as much as possible before applying. This yields two benefits: it can free up cash flow that you may need to fund your child’s college education, and the amount of equity in your home is not included among parental assets when computing the expected family contribution.
To determine the amount of assistance required, most publicly funded college financial aid offices use a formula determined by the federal government known as the federal methodology.
This formula does not consider the value of a family’s home in arriving at the EFC. Meanwhile, some private colleges and universities use a formula known as the institutional methodology when computing the EFC.
In this formula, the amount of equity in your home is added back (and is thus counted against you). You know that a school is using the institutional methodology if it asks you to file the CSS/Financial Aid PROFILE along with the more exhaustive FAFSA form.
Unlike the information requested on the FAFSA, the PROFILE form requires the parent’s expected income during the child’s college years and not just your current or past year’s income.
As a parent, be aware of a bait-and-switch tactic used by some colleges or universities in enticing your child to attend their institution.
Although this practice is not as prevalent as it once was, some schools may offer an extremely lucrative financial aid package to a student whom they want to attend the institution, only to reduce the amount of financial aid given to that student after their first year of attendance.
If the student is not comfortable at the school, they are then forced to consider transferring to another school (often with the disadvantage of not being able to transfer credit hours) or continuing studies at the same school and trying to resolve acclimation problems.
As a result, once your child has obtained a financial aid package from a school, be sure to ask the financial aid officer how long the current aid package will be offered or, absent that, whether your child can easily transfer credit hours to another school if they become uncomfortable at the institution.
Types of Financial Aid
The two most common federal need-based loans are the Perkins and Stafford loans. Unlike grants or scholarships that do not need to be repaid, both Perkins and Stafford loans require repayment by the student after graduation.
The federal Perkins loan is a campus-based loan, meaning the school disburses the loan proceeds to the student through its financial aid office. The loan may be taken out by both undergraduate and graduate students, although the annual limit is slightly higher for graduate students than it is for undergraduates.
Financial need must be demonstrated to qualify for a Perkins loan, but repayment is not required to begin until nine months after the student graduates from graduate or undergraduate school. Interest on the loan does not accrue on the loan principal until repayment is required.
The federal Stafford loan (also known as a direct loan ) may be subsidized or unsubsidized. A subsidized Stafford loan means the US Department of Education pays the interest on the loan while the student is in undergraduate or graduate school, as well as during grace and deferment periods.
An unsubsidized Stafford loan, on the other hand, means the student is responsible for the repayment of interest during the life of the loan and should repay the loan interest while they are still in school.
If the student does not repay the interest as it is due, it is simply added to the principal of the loan for repayment at a later date. For both subsidized and unsubsidized Stafford loans, financial need by the student must be demonstrated.
The third type of federal loan is made available to the parent of a student in the parent's name: the Parent Loan for Undergraduate Students (PLUS). This is the only type of loan available on behalf of a student for whom financial need is not determined under the FAFSA formula.
As a parent who makes too much money or has a significant net worth such that the child cannot qualify for federal financial aid, a PLUS loan is the only recourse offered by the federal government to assist with the child’s college education.
Good financial planning dictates that you have already planned for the cost of your child’s college attendance; but if you have not, the PLUS loan will be offered to you. Interest begins to accrue immediately on the loan, and repayment begins 60 days after you receive the money.
There are also need-based government grants, which do not need to be repaid, that may help you pay for your child’s college education. The most prevalent grant is the federal Pell Grant, for which the student is eligible if the family’s EFC does not exceed a specified amount as determined annually.
Scholarship awards do not affect student eligibility for the Pell Grant, although there is a limit on the amount of grant money that any student may receive annually (the maximum is $5,550 for the school year 2018–2019).
The student must be eligible for the Pell Grant on the basis of need before they can also qualify to receive federal Perkins or Stafford loans. Furthermore, the Pell Grant is available to undergraduate students only.
How Do I Save?
Section 529 Savings Plans
Two types of savings plans are described in Internal Revenue Code Section 529 (from which the savings plans get their popular name).
The first is a qualified prepaid tuition plan (QTP) that may have been established by your state to assist your child financially while they attend college. A QTP allows the contributor (typically the parent) to prepay tuition at a particular school using today’s tuition price.
As such, the parent is protected from future increases in the annual cost of the child attending college. In addition, the earnings made on the prepaid tuition grow income-tax deferred.
If the parent withdraws the accumulated contributions and earnings in a QTP (or a private-savings type of Section 529 plan, which we discuss shortly) only for payment of higher-education expenses, the entire distribution is free of income tax.
The problem with the QTP plan, however, is that the child is restricted in choosing where they will attend college. For example, the state of Florida may dictate that the prepaid tuition feature is valid only if your child attends a publicly funded institution in that state.
If your child attends a private school in Florida or another state, or a public college or university outside of Florida, you may not be able to use the money accumulated in the QTP.
This is also the result if your child is unfortunate enough to be denied entrance to the qualifying public school under the provisions of the state plan. Another problem associated with a QTP is that most plans only cover tuition, fees, and books at the qualifying institution and not room and board.
As a result of the disadvantages associated with the QTP, in 2001 Congress adopted the second type of Section 529 plan: the private savings plan. This plan is very similar to a private investment account, but unlike the QTP, a private savings plan does not lock in future college tuition payment at today’s prices.
Rather, the private savings plan affords the contributor the opportunity to earn a rate of return on funds invested that hopefully exceeds the annual increase in college tuition (currently averaging 5 to 6 percent annually).
Earnings in the account grow income-tax-free as long as distributions are used to pay college education expenses, including room and board.
In addition, although contributions to a private savings plan are not federal-income-tax deductible, some states permit a state income-tax deduction for contributions offered by their state for state residents. Generally, however, Section 529 private savings plans are open to investors from any state.
So, what should you look for when selecting among the many choices offered in Section 529 private savings plans? Here are among the most important factors:
Look for a plan that offers a variety of good choices— typically, mutual funds. Ask the same questions you would ask before investing in any mutual fund, such as what its investment objective is, how much investment risk you will assume, and what the fund’s longer-term, risk-adjusted investment performance has been.
Try to choose a plan with relatively low expenses. Some of this total amount depends on the mutual-fund manager in charge of the assets, but the higher the fund expenses, the more the manager must beat the market. And remember, the market in this instance is the ever-increasing annual cost of attending college.
Consider the possible availability of a state income-tax deduction for contributions made to the plan. A top-performing fund of another state plan may offset the loss of the deduction from not investing in your own state’s plan, but you should at least consider the advantage of the possible state income-tax deduction.
Approach an investment in a private savings plan as you would an investment in any mutual fund. If you like the manager and the funds in the fund family, you may wish to invest in the plan of the state where the fund company is responsible for managing the plan investments. If not, consider another state’s plan.
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Other Methods of Saving for the Cost of College
There are several other methods of saving for your child’s higher education, including establishing trust on their behalf. All trusts that may be used for this purpose are irrevocable, meaning you cannot get the money back, and ultimately the trust principal must be distributed to the minor.
Perhaps the most popular trust used in planning for the college education of a child is Section 2503(c) trust, also known as a minor’s trust. This trust must be drafted by an attorney, with the trust principal made available to the child once they reach age 21.
The age of distribution may be extended at your discretion by adopting an alternative trust, referred to as a Section 2503(b) trust, but the income from the Section 2503(b) trust must be distributed annually to the child, thus resulting in additional Kiddie Tax concerns.
You can also purchase Series EE and inflation-adjusted Series I US Savings Bonds and dedicate them to the purpose of paying for your child’s college education.
With both of these alternatives, the bond must be purchased in your name or in the name of an adult who is at least 24. Furthermore, AGI limits apply at the time of redeeming the bonds.
For example, if you purchase the bond in your name with the intent to use it to pay for the college expenses of your child, and your AGI is too high (a specified amount under law) when the child attends college, you will have to pay income tax on the bond interest at the time that you redeem the bond.
However, if your AGI is below the prescribed amount, you will not be taxed on the interest as long as the bond is used in payment of qualified higher-education expenses.
Tax Deductions and Credits Available for Paying for the Cost of College
This section addresses the benefits provided by the income-tax law to help you or your child pay for costs incurred while in college or pursuing some other type of higher education. The deductions available are a deduction for interest paid on student loans and a qualified higher-education tuition deduction.
Important credits include the American Opportunity Tax Credit and the Lifetime Learning Credit. But since 2001, these deductions and credits cannot be taken together in payment of the same expense.
As such, the use of each must be planned for carefully so as to take maximum advantage of every benefit available to you.
Deduction for Student Loan Interest
Under current law, the interest paid (never the principal paid) by any individual who is obligated to make repayment on a student loan is deductible regardless of whether the taxpayer itemizes their deductions.
However, the deductible amount is limited to a maximum of $2,500 per year, and an income phase-out range applies based on the taxpayer’s AGI level.
Although these phaseout ranges are very high, particularly for a student borrower, they can operate to deny the deduction for high-income taxpayer borrowers, such as parents who opt to take out a PLUS loan to pay for their child’s education.
For this deduction to be taken, any debt incurred by the borrower must be used solely to pay for qualified higher-education expenses, including tuition, fees, books, and room and board.
There is no restriction with respect to whether this debt is incurred for study toward an undergraduate or a graduate degree, but as part of the definition of a qualified higher-education expense, the debt must be taken out for study at a qualified educational institution.
Qualified Higher-Education Tuition and Fees Deduction
Unlike the student loan interest deduction, which may be taken by a parent or child, the deduction for qualified higher-education tuition is almost always taken by the parent.
Also, unlike the loan interest deduction, the qualified higher-education tuition deduction is not limited to a specified maximum amount but rather is tiered based on the taxpayer’s AGI.
For example, in 2018 a higher-tier $4,000 annual deduction is permitted for single taxpayers whose AGI does not exceed $65,000 and for married taxpayers filing jointly whose AGI does not exceed $130,000.
Meanwhile, a lower-tier maximum annual deduction of $2,000 is permitted for single taxpayers whose AGI is between $65,000 and $80,000 and joint taxpayers whose AGI is between $130,000 and $160,000.
Above $80,000 AGI for a single taxpayer or $160,000 AGI for a joint taxpayer, no deduction is permitted for higher-education tuition and fees.
How does the parent determine how much they have paid in qualified tuition? You need to obtain assistance. The educational institution your child attends during any part of the academic year must report those qualifying expenses to you on an IRS Form 1098-T. Then, in order for you to deduct those expenses, you must be able to claim the child as a taxable dependent.
Although this is typically not a problem if you are the parent of a child who has not yet completed an undergraduate degree, it is an issue if you are attempting to claim the deduction for graduate school expenses.
In part, this is because one of the tests for dependency dictates an age limit—the child must not have reached age 24 by the end of the calendar year. It also occurs because most children are financially independent by the time they attend graduate school.
As we discuss shortly, a parent may also potentially claim a tax credit, such as the American Opportunity Tax Credit (AOTC) or Lifetime Learning Credit, for higher-education tuition expenses.
But if they do so, the tuition deduction is not permitted for the same expense for the same student. This presents an interesting dilemma if you are a parent with two children in college at the same time.
You should give some thought as to how to best maximize any tax credit that is allowable for one child and any deduction of up to the maximum limit of tuition for the other.
In essence, although a two-student parent may mix and match tax credits and the tuition deduction, you cannot double-dip when trying to take advantage of both tax breaks for the same student.
Higher-Education Tax Credits
a tax credit (or a dollar-for-dollar reduction in tax due) is a very valuable tax-avoidance technique. In most cases, if a taxpayer can qualify to take advantage of any tax credit, they should structure their financial affairs to do so.
When a tax benefit is sought in paying for the considerable cost of pursuing higher education, three credits are permitted: the Hope Scholarship Credit, the American Opportunity Tax (modified Hope) Credit, and the Lifetime Learning Credit.
Planning for Your Child’s Higher Education
We now move to the last step in the PADD process of wealth accumulation and management: distributing your wealth. Toward that end, this section of the blog focuses on the distribution of wealth during your lifetime and considers the common financial goals of saving and planning for your child’s higher education and your own retirement.
It also discusses how to save and plan for other lifetime financial goals you may have, such as starting your own business. Then, the last section of the blog takes up the process of distributing your wealth at death.
If you are married and have children, one of your first goals when evaluating how to distribute wealth during your lifetime is probably to afford your family members the best opportunity to pursue a profitable career—and that requires, at a minimum these days, a college degree.
There are many colleges and universities, public and private, that they may attend, and the costs of attendance will vary dramatically based on their eventual choice.
The common thread to whatever choice they make is that college is expensive—and getting more expensive by the year.
According to the College Board, over the ten-year period ending 2017–2018, tuition at public four-year institutions increased by an average of 5.2 percent per year nationally (tuition increases at private four-year institutions averaged 4.9 percent per year nationally over the same period). This compared to an average annual inflation rate of only 2.5 percent over the same period.
For the 2017–2018 school year, the total annual cost of attending a four-year public college or university for an in-state student was approximately $18,000 ($31,000 for an out-of-state student) and close to $40,000 at a private institution. It is closer to $50,000 annually at an Ivy League institution.
Fortunately, the availability of financial aid increased during this same ten-year period, although most of this aid is based on financial need, with the amount necessary to qualify decided by the school and other factors beyond the control of the average middle-class parent. The key thing to keep in mind, then, is that it is very important to plan for your child’s higher education as early as possible.