Illustration by Christophe Vorlet
George gallup once said he could prove statistically that God existed. It may be true that our perception of reality is influenced by numbers, by facts and statistics, and that we are encouraged to think and act accordingly.But that doesn't mean we always do, or should.
For example, according to The College Board, a century-old not-for-profit educational association helping the college-bound, a child born today can expect in 2018 to shell out some $225,000 in total expenses for a private college education; the price tag at a public institution would probably be almost half that amount. The numbers seem to indicate that, by then, few Americans would be able to foot the bill for college. But as ridiculous as these projections may be to a middle-class family, as many or more students will attend college then as attend now. Why? And how on earth will they do it?
College Board President Gaston Caperton offers this perspective: "The cost of not going to college is much higher than the cost of going to college," adding that there has been too much focus on the price of a college education and too little on its value.
But there's another reason, clouded by misperceptions and often overlooked by students and their families, who, when faced with higher education's weighty tab, tend to throw up their hands in despair. The federal government makes it possible with various loan programs for virtually anyone to attend college, regardless of cost. The real question, and one that advisors need to help their clients answer, is not so much how to get the money as it is how to do so without inflicting a loan burden great enough to compromise the clients' own financial well-being, especially for retirement and long-term health care.
Never before have so many Americans been in the position of having to plan retirement and fund college tuition at the same time - the fate of baby boomers who decided to procreate later in life. It's downright frightening to some, and for most, requires culling specific knowledge from a vast trove of data full of inaccuracies and myths. That's where the advisor can provide expertise and a perspective that higher education is only one piece of a family's lifetime financial puzzle.
Looking Out for No. 1
There is a fundamental notion growing in acceptance these days that parents don't owe their children a college education. The concept warrants serious consideration before families start visiting schools and exploring tuition funding strategies. "Who says the parent is obligated to provide a full ride for college for their kids?" posits Nancy Bryant, of Bryant Financial Advisory in Baltimore. "Is it pride?" People don't realize how important it is to hold onto their retirement savings, she says. "I tell clients their priority is to themselves. Kids have many years to work off tuition debt; parents don't."
Judy Miller, of Financial Vistas in Alameda, California, puts it this way: "You can borrow to pay for college but you can't borrow to pay for retirement."
College planning specialist and advisor Phil Johnson of Philip C. Johnson, in Clifton Park, New York, relates this anecdote: One of his clients had a son, good in math, who was accepted at Harvard and another well-respected technology college. Harvard would cost the client-family about $18,000 a year, while the other school was offering a full scholarship. The question parents must answer, he says, is this: Is giving your child the chance to earn a Harvard degree worth putting yourself $70,000 in debt?
"There are a lot of parents who would live in absolute dread of that conversation," says Johnson, "but that's real life." In this case the teenager chose Harvard, with his parents' blessing. But Johnson continues to tell clients that "it's okay to say no."
A Shift to Merit
One of the most significant trends Johnson observes is the pronounced shift in financial aid from need-based to merit-based, especially in private schools. Financial aid is monetary assistance in the form of grants and scholarships, work-study loan programs, and student loans.
This shift in no way signals the end of financial aid, and as Judy Miller says, "It is an absolute certainty that families will not receive it if they do not apply for it." The College Board notes that too many families assume they won't qualify because they fear they are too wealthy.
Actually, families with incomes in the six figures often receive aid or land a government-subsidized loan for their child, according to the Board. In 1998-1999 more than $64 billion in total aid from federal, state, and institutional sources was available to students and their families. According to the U.S. Department of Education, more than half the 16.7 million students enrolled in post-secondary schools in the U.S. receive some sort of financial aid.
Reports of there being millions of dollars in unclaimed merit-based scholarships, however, is a myth, says Miller, though there are a lot of scholarships out there. Student Advantage Inc. claims its Web site (www.studentadvantage.com) has a database containing over 2.5 million awards worth over $21.6 billion. Nonetheless, private scholarships account for less than 5% of all financial aid. Grants, which are an outright gift based on financial need, are awarded to some 30% of students with family income between $50,000 and $70,000, and average $1,700. In addition to private grants, the federal government offers the Pell Grant, worth up to $2,340. As an extension of this there is the federal Supplemental Education Opportunity Grant, available for Pell Grant recipients only and offering up to $4,000 per year.
The Federal Trade Commission recently issued a warning about scholarship scams. Nationwide each year some 350,000 persons are duped, costing students and parents more than $5 million, the FTC says. Typically, a scholarship is guaranteed in return for a "modest" fee, ranging anywhere from $50 to $400. The FTC recommends avoiding any money-back guarantees and scholarships requiring a fee, as well as contests that are unsolicited but promise to offer money.
Miller maintains it's far better for families to utilize financial aid effectively, if they can get it, than to spend enormous amounts of time researching and applying for independent scholarships and grants (ones not offered by the student's chosen school).
While the amount of available financial aid is 85% higher than it was a decade ago (after adjusting for inflation), the vast majority of this growth has come in the form of student borrowing, not grants and scholarships. Loans now represent 58% of all aid, compared to just over 40% in 1980-1981. In short, what the new merit-based over need-based trend has done is place greater emphasis on saving for college and considerably less emphasis on trying to work the system. People who hold to the model of basing their college tuition funding strategy on hiding assets and negotiating financial aid packages are going to find themselves at a disadvantage, says Johnson.
Now for Some Real Numbers
The rate of increase in yearly college tuition hikes dropped during 1999-2000 to its lowest rate (5%) in four years. According to the College Board, average educational and living expenses these days for a private four-year college or university will run about $22,533, with tuition and fees representing $14,508. At a public in-state school, costs will be $10,458, including $3,243 in tuition and fees; for public out-of-state schools, tack on an average of $5,228 in tuition and fees. The Board notes that the majority of all students nationwide attending four-year schools will pay less than $4,000 per year for tuition and fees.
There are three types of families with college-bound youngsters: those with a savings issue, those with a payment issue, and those wealthy enough to be concerned with neither.
The savers are the parents who have been socking away money from at or near the time their children were born, while the second group are the parents of high school-aged kids who have put away little to nothing. The third group, the high-income families, has special planning needs as well. We'll address them first.
Diane M. Pearson of Legend Financial Advisors, Inc. in Pittsburgh, says that for most of her clients (all with net worths north of $1 million), how they pay for college tuition isn't really an issue. Nine out of ten don't qualify for any kind of financial aid, and don't intend to seek it. "It's an excellent opportunity," Pearson says, "to do a little estate planning. Remove some of the assets from the estate so that they aren't going to be hit with income taxes, or aren't going to be hit with estate taxes once the client passes away."
The strategy is especially relevant for clients who have bought and held securities over the past two or three years, with appreciation so substantial that to sell out or lessen their position within the portfolio would be a serious tax faux pas. As a solution that helps with both tuition and planning, Pearson recommends gifting to the child appreciated stock and mutual funds, allowing the child to sell them in his or her own tax bracket, thus assuming capital gains at a lower rate (10%) than would his parents. However, with regulations governing the gift exclusion that limit the amount gifted from a parents to a total of $20,200 per year, this approach will cover just a year's worth of school expenses.
There's another strategy, too. Paying tuition monies directly to the institution is not considered gifting, and therefore is not subject to the gift exclusion ceiling or gift tax. Advisor Nancy Bryant cites the example of a recent IRS private letter ruling allowing a grandmother to prepay tuition fees of $163,000 without gift tax consequences, including the generation skipping tax.
Tell Them To Start Saving Now
If there's one thing about which advisors agree, it's emphasizing to clients the importance of establishing a regular savings program early on, though it's easier said than done. As Johnson notes, "saving for college is one of the great ma?ana issues in financial planning." Johnson also hammers home to clients the wisdom of making sure the life insurance of the principal family earner is sufficient to cover college if circumstances require.
In almost every instance, he advises putting savings in the parents' name, so they retain control. While having the savings in the child's name allows certain distributions to be taxed at the child's rate, Johnson feels that the best bet while kids are young is tax-efficient growth-oriented mutual funds, index or tax-managed. Regular funds, with judicious redirecting of dividends and capital gains for rebalancing, can also be used effectively.
UTMA (Uniform Transfers to Minors Act) and UGMA (Uniform Gifts to Minors Act) accounts have in the past been popular with college savers, but they lack the "control" feature, in that the child gets the money at his state's age of majority (UGMA) and at 21, or older (UTMA). Also, the assets of the child have a negative impact on the financial aid formula, if the student is seeking financial aid.
Bryant considers the federal Education IRA "worthless," since its yearly limit is a mere $500. As an alternative, Bryant recommends college pre-paid and college savings plans, offered at the state level.
Using Roth IRAs and 529 Plans
Another viable savings route for parents is the Roth IRA. Tax-free withdrawals and estate retirement planning benefits aside, Roths can be an excellent college savings tool, says Legend's Diane Pearson, as long as they're used five years or more before the funds are needed. Federal laws allow contributions of $2,000 yearly in a Roth if adjusted gross income is below $150,000. The money contributed and its earnings can be withdrawn penalty-free prior to age 59 if it is being used to pay for college. These early withdrawals may go untaxed, since for tax purposes the first monies withdrawn from a Roth are considered the non-taxable contribution.
For many families, the old state pre-paid tuition plans and newer college savings plans - the so-called 529 plans - are the way to go. Both allow parents, grandparents, or anyone else to save for a child in a special account, invested in stocks, bonds, or mutual funds, regardless of income, making it attractive for families with high incomes who are ineligible for financial aid or other savings plans or tax benefits. Some plans are administered by state agencies, others by companies such as Fidelity, TIAA-CREF, and Vanguard. Both state plans are federally tax-deferred until monies are withdrawn for school, upon which earnings are taxed at the student's rate; most states waive their income tax if the student is a resident.
Their strengths and weaknesses? The old pre-paids guarantee the family's money to be equal to college costs at the time the student goes to school, while the savings plan comes without any such guarantee.
With pre-paids, the student usually must attend school in-state; with the savings plan, the student can, with some exceptions, attend anywhere. Pre-paids are considered assets of the student; college savings accounts are considered assets of the account owner.
College savings plans are eclipsing the older pre-paid plans. There are about 10 state pre-paids left and 30-plus savings plans at present, with some 850,000 students enrolled in both. In terms of investment options, while the savings-plan burden of risk lies with the investor-parents, it offers better investment options than does the pre-paid. Both plans have been criticized for investing student dollars too conservatively. But as competition for investors heats up among various state savings plans, a more aggressive investment posture will likely result.
"While the college savings plan has a role to play in college savings, it's not an either/or proposition," says Johnson. The plan can be used as the conservative element of a family's college savings plan, especially with families who have significant income. But for people who are "looking to get some bang for their investment buck, I think they have to try to blend some more mainstream growth investing into their college plan."
Timing Is Everything
It's never too late to start saving for college - or too early. For families with 15 years to go, the Princeton Review recommends investing about 75% of the parent's funds in higher-risk investments, the remaining 25% in those that lock in a reliable rate of return. With 10 years, keep 70% invested aggressively, with the balance in fixed-return investments with limited risks; at five years, cut back aggressive investments to 50%, leaving 30% in limited-risk vehicles and 20% in insured liquid accounts. At three years, consider if financial aid will be sought; if not, and especially if the family has received job raises or inheritances, the Review recommends parents shift assets into the child's name. When all else fails, as it does for many, it's time to look into loans.
Enter the federal government. As mentioned earlier, the Perkins loan was designed for undergraduate and graduate students showing exceptional need. The Stafford loan comes in two flavors: subsidized and unsubsidized. The government pays accrued interest on the former until the student graduates (eligibility is based on financial need); with the latter, the student must pay interest from the get-go (anyone is eligible). Amounts vary from $2,625 to $5,500 annually for dependent students to $6,625 to $10,500 for independent students, according to Student Advantage. The Parent Loans for Undergraduate Students (PLUS) are extremely popular since they enable parents to borrow up to the total amount of their child's education less any financial aid. Interest makes the PLUS one of the best credit-based loans you can get, according to the Princeton Review. It has a variable annual rate based on the 52-week T-bill rate plus 3.1%, with a capped rate of 9%. An increasing number of schools is participating in the Federal Direct Loan Program, wherein the government supplies the money and the school becomes the bank, making borrowing logistics easier.
|A Unique Approach|
Heather Seiche, of Komack Management Services, Inc., in Natick, Massachusetts, shares this interesting approach to saving on college costs. "We have a client who encouraged his son to take AP (Advanced Placement) tests before graduating high school. The client said that the fees for the review courses and testing were significantly less than college tuition for the same classes. By passing five AP tests, his son saved one semester's tuition ($13,000)."
For more information on advanced placement, visit www.collegeboard.com. For more information on college savings plans, surf to www.collegesavings.org and www.savingforcollege.com.
All federal loans must be repaid with interest, but the interest is relatively low, and payment can often be deferred until after graduation. As a supplement to these loans, consider the need-based Federal Work-Study (FWS) program, whereby the government covers a portion of the student's pay for part-time work.
Advisor Judy Miller doesn't favor private loan sources, since they do little more than "pay a nice commission to the person selling them." Her sentiments notwithstanding, the Princeton Review notes that Merrill Lynch "provides a wide variety of excellent loans." There is an increasing number of other loan providers, including Citibank (www.studentloan.com), which works with more than 2,500 schools nationwide. Miller and other advisors don't think much of college funding mechanisms in the form of life insurance annuities, either, noting they are designed to serve different purposes, and that only in very limited situations are they appropriate to "solve the college problem."
Home equity loans have their place - interest is usually deductible - as long as parents have sufficient cash flow to make the monthly payments. It's also a good idea to apply for a home equity line of credit well before college bills come in. The least desirable option is borrowing from a pension plan or 401(k) plan. As Phil Johnson reiterates: "Paying for college is really a retirement issue, and I would prefer people wouldn't diminish their retirement plan to pay for college."
While advisor Diane Pearson finds that clients are becoming more aware of the vagaries surrounding college tuition funding, she says the area remains extremely complicated. Johnson, who often lectures on the topic, says it seems that new funding plans are issued almost monthly by the state or federal government. At speaking engagements he keeps "cheat sheets" in front of him to knowledgeably relate to his audience not just the existence of these plans, but their advantages and disadvantages. To negotiate tuition funding strategies within the context of sound financial planning, parents need good advice now more than ever. Will you be there, and be able to help them?