A hot-button issue this time of year that brings clients to advisors is funding their child’s college education. “The reason is just plain, old cost,” explains Susan Hirshman, managing director for JPMorgan Asset Management in New York. “College is just so much more expensive now.” In fact, the rate of increase in college costs has outpaced inflation by as much as 6% to 8% in the last decade. For the 2006-2007 academic year, the estimated cost of four years at a public college is $55,152 and the estimated cost of four years at a private college jumps to $130,886, according to The College Board (Go to www.investmentadvisor.com to see estimated future costs of college). To boot, a greater number of kids are going to college, and a significant amount of those students are living away from home and/or attending private schools, adds Hirshman. But these factors are just part of the reason why education funding is becoming more difficult. Saving habits have a lot to do with it as well, which is why even the more affluent families are having college funding issues. “There is a significant percentage of affluent people who do very well at earning money, but save nothing,” explains Hirshman. The fact is that saving for college tuition remains a top priority among families. The problem is that the priority exists more in concept than in practice.
Unrealistic and Unprepared
“It’s not that people don’t have the money,” explains Michael Conrath, VP of college savings plans at AllianceBernstein Investments. In fact, the major problem is that parents are unprepared, according to research conducted in the summer of 2006. The AllianceBernstein College Savings Crunch study surveyed 1,350 parents to understand their attitudes and behaviors related to saving for college. Recent college graduates and financial aid administrators were also interviewed. The study found that 95% of parents intended to pay some or all of their children’s college expenses, even though one-third of those parents hadn’t started saving yet, and 64% had saved less than $10,000. “It’s become a moving target,” states Conrath. “College costs are rising at a rapid rate while parents are not saving enough to begin with.”
According to Conrath, there are two major reasons why parents aren’t saving. The first is overspending. “We’re living in a consumer society and you can almost say that there’s a compulsive consumerism today among many families,” he explains. “A lot of people are spending at the expense of their kids’ future college education.” In fact, a staggering 58% of parents surveyed spent more on dining out in a given year than they saved for their kids’ education, according to the AllianceBernstein research. “If you ask parents what is the most important investment they can make, the answer is helping their children pay for college, but there’s a big gap between what their wishes are for their kids’ futures and what they’re actually doing today,” reveals Conrath.
The second reason why parents are unprepared is because they are relying too heavily on financial aid. “That’s one area where there are a lot of misconceptions,” Conrath says. More than two-thirds of parents surveyed believe that colleges will design a financial aid package that will allow them to afford paying for their kids’ education. However, financial aid officers paint a completely different picture. Nearly all financial aid administrators surveyed said parents have a false sense of security that colleges will help them cover education costs. This goes for scholarships as well. A majority of parents think their kids’ talents will guarantee them a scholarship–84% of respondents believe there are lots of scholarships that will help cover costs, and 72% believe their child has a unique or special talent that will qualify them for a scholarship. The reality is that scholarships are few and far between. “I’ve never met a parent who didn’t think their child wasn’t the smartest,” recalls Paul Donas, a registered rep for John Hancock based in New York. He counsels clients that it’s better to save more and have extra, than counting on something that may not come to fruition.
The Perfect Plan
So once you convince clients to start putting money away, how should you advise them to do so? Let’s list the ways.
529 Plans The most popular education savings vehicles and the first choice of most planning professionals are 529 plans. In fact, there is almost $100 billion in 529 savings plans now, says Conrath. Susan Black, director of financial planning at eMoney Advisor, a wealth planning technology firm, agrees. “Use a 529 plan and get as close as you can to pay for the education,” she says. Black recommends frontloading. “If you have extra means or if [the child's] grandparents do, you can pump up the 529 plans,” she says. “Instead of just making an annual gift, you can dump in the first five years of annual [gift tax] exclusion.” For example, if a client can make annual gifts right now of $12,000, they can deposit the first five years–$60,000–into a 529 plan today without incurring any gift tax. The catch is that the client can’t make any subsequent gifts to that child within the five years. Also, if the client is married, both the client and his spouse can contribute $60,000–totaling $120,000–to the plan today. “That amount, growing at 8% for 18 years, can turn into a sizeable amount of money, instead of putting in $12,000 a year for 18 years,” explains Black. In fact, assuming an 8% return for 18 years, a 529 frontloaded in year one with $60,000 has an approximate future value of $239,700. If you were to invest the same $60,000 at $3,333 per year for 18 years, the fund would amount to only $124,800. The more you have upfront, the more bang you’ll get for your compounded buck.
Donas recommends putting more money into an older child’s account, since the client has more time to save for the younger child and the beneficiary of the original account can be changed to the younger child. He also believes in considering the in-state 529 plan first, as there may be tax benefits to clients if they invest in their state’s plan versus an out-of-state plan.
Roth IRA For parents who own a business, Black suggests the untraditional move of opening up Roth IRAs for the kids as a way to save for college. The money in the individual retirement account grows tax-free, and a large portion of it can be distributed without penalty to pay for qualified education expenses. Since IRAs are available only to workers who have “earned income,” parents would need to determine a business reason to hire their children and provide them with a paycheck. “Employ your child to do administrative work and with that earned income, you can open a Roth IRA,” advises Black. “This is a way for parents with a family-owned business to take a tax deduction for paying the child for the work, while also getting the benefit of putting money away in a Roth IRA for school.”
Insurance “The perfect plan has a 529 component and an insurance component,” suggests Donas, who says the life insurance component is important because a client may be putting about $1,000 away each month, and if something happens to that client, the child can still go to college, regardless of whether the parent is around for graduation. “You can always put money in an investment, but insurance should be the initial decision,” Donas insists. “If the parent doesn’t spend time on the 529 plan, we still know the account is taken care of and getting more conservative as the child ages [as the allocation within the plan changes], so it’s a great vehicle.”
Gifting Gifting strategies can be used by both parents and grandparents to pay for college with pre-tax dollars. “It’s really knowing who your client is and knowing their situation,” explains Hirshman. “You must have a good relationship with your client and the client must have a good relationship with their parent.” Hirshman advises that clients talk with their parents before asking them to meet with an advisor. The client should educate the older generation on the features associated with education funding that are beneficial to them and to the grandchild as well. “In the affluent world, the benefit with the 529 plan is that it’s the only tool that exists where the assets are removed from your estate, yet you still have some type of control over them–you can change the beneficiary,” says Hirshman. “It’s really about how it’s going to benefit them. Understand what their emotional drivers are and respond to them. For certain people, it’s about minimizing tax, for some it’s about the legacy.” Additionally, Black recommends writing a check directly to the college institution instead of writing it to the grandchild, since it could be taxed. “The money shouldn’t flow through the child’s hands,” she says.
Financial Aid According to Hirshman, an affluent family can qualify for financial aid, especially if it has more than one kid in college, or if the parent is older and near retirement. “The formula changes in certain situations,” she says. “It depends on how you hold your assets.” She advises that clients put more money into their retirement accounts, because it’s looked at differently on the FAFSA and other financial aid forms. Early awareness is crucial, as well. Hirshman recommends spending down the student’s money first when purchasing computers and other school supplies. Clients should do this a year or so out, if the student has money in their own name, since the child is expected to contribute a higher percentage of her savings under the qualifying formula for financial aid than are the parents.
UGMAs, UGMTs Black warns against using UGMA or UGTA custodial accounts. Formerly, many people used custodial accounts to take advantage of the lower tax rates for children, but since tax laws have changed, this no longer makes sense. With a custodial account, it’s easier to dip into the money, and parents may use it for costs other than college tuition.
Another warning comes about the use of loans. The financial aid game is pretty difficult to navigate in general, and in some recent cases, pretty shady, too. If it’s necessary to use them, federal loans are the best place to start. Also, clients do not have to borrow from a school’s preferred lenders list. If a school recommends borrowing from certain lenders, find out why.
After School, and Before
As many college graduates enter the “real world,” they are faced with the task of finding a career and becoming financially independent for the first time. However, a majority of graduates leave school with not only a diploma, but years of debt that will overshadow their post-graduation plans.
The average outstanding student loan balance for newly graduated students is $29,000, according to AllianceBernstein. “Due to student loan debt, students are prolonging a lot of the milestones many of us look forward to–buying their first home, getting married, and having children,” explains Conrath. “All of these dreams are being put on hold, and what we’re seeing is boomerang kids–they move back in with mom and dad because they can’t afford to be out on their own.”
Hirshman suggests that advisors help clients’ recently graduated children when they get their first job by helping them figure out a budget and talking to them about their retirement planning options. According to Black, arranging an IRA for a client’s child is crucial. “If you make contributions to an IRA between 20 and 30 and stop, the money continues to compound,” she explains. “You’ll actually have more money than if you start at 30 or 35 and make contributions for 20 years. That’s the power of compounding.” Black recommends making a list of all the debt, so the recent grad knows where she stands. “List credit cards and loans and what the interest rates are,” she says.
AllianceBerstein’s research reveals that 42% of those who graduate from college with debt describe themselves as living paycheck to paycheck, and 44% have delayed buying a home. In order to avoid, or at least limit, college debt, Hirshman suggests that advisors get a group of clients’ kids together before they say farewell and disappear into college and credit cards for four years.
Until college costs come under control, 529 plans remain the planning tools of choice. The problem arises when clients get so overwhelmed with the thought of college costs that they feel they will never be able to save enough, fail to save at all, and then plan on dealing with costs as they happen. It’s the advisor’s job to insist the client do as much as they can early on. Understand how much it’s going to take and find out the client’s commitment level. Involve the student as well–it will liken the chances that they will incur less debt and may secure them as a future client. In the words of Hirshman, “Don’t get crazy–it’s not black or white, there is a gray area” where the advisor can play a key role for the client and the student.
E- mail staff editor Kara P. Stapleton at firstname.lastname@example.org.