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College Savings: Do Your Homework

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David Blain of D. L. Blain & Co., LLC in New Bern, North Carolina, recounts a new client couple who came to him already buried by their son’s college debt: $150,000 worth of student loans they’d guaranteed. The boy had racked up huge tuition bills in the quest to become a video game designer and then couldn’t find a job, so his parents were on the hook for the whole amount.

If there’s one thing clients seem to be blind about, it’s their kids’ college educations. Sometimes advisors need not only to help them find money to pay the tuition bills, but also to be the voice of reason when it comes to parents sinking themselves into debt to help out.

“I’ve been fortunate in that none of our [existing] clients…did that [went into so much debt], contrary to our advice,” says Blain, who says his firm tries “to encourage our clients to plan in a totalistic manner, meaning that we incorporate different goals–college, new house, etc.–into an overall scenario” so that the money will be there when they need to draw upon it. He has plenty of ways for his clients to meet college expenses for children or grandchildren. Moreover, while for the majority of his clients it’s not a question of saving a couple hundred bucks a month for that long-distant tuition–he says they either plan to pay for it from their salaries or from an already-existing account–even they sometimes need to economize.

Blain is somewhat unique in that he doesn’t generally carve money out into 529s or other vehicles specifically aimed at paying for college, but he’s certainly not unique in having to help his clients face facts about how much to pay for college and how much to mortgage their own futures in doing so.

Pay Yourself First

Martha Schilling of Schilling Group Advisors in Philadelphia says she’s been telling clients determined to shoulder the entire tuition burden to “stop it…You can’t finance retirement; you can finance college.” She also has a telling client horror story; professionals with two children and more than $200,000 in annual income decided they needed a larger home. But in the real estate downturn they were unable to sell the first house, so were paying two mortgages. “They ramped up five credit cards to $117,000,” she says, and the husband also borrowed the maximum $50,000 from his 401(k).

When “they came to me…they were $2,400 short a month,” Schilling recalls. “The first thing that went was the 529, and then their 401(k).” They went on a bare-bones budget, she says, and with her help they were able to refinance their mortgage and get out of the PMI they were paying.

Says Schilling, “Isn’t it better to take care of yourself? Otherwise you’ll be a burden to those children,” leaving them to support parents in old age and perhaps even pay for long-term care.

She’s far from the only advisor to advocate a pay-yourself-first philosophy: nearly every advisor we spoke with stressed the importance of seeing to one’s own financial health before plunging into debt to finance an education. Rick Kahler, of Kahler Financial Group in Rapid City, South Dakota, concurs, pointing out that “it’s a lot more expensive on the kids when the parents don’t fund their retirement.” Clients of his were determined to finance their grandson’s education, all the way through medical school, but they’d suffered losses in the stock market, and to keep that promise they would have had to make some drastic lifestyle changes. Kahler showed them how much it would cost; “they had to decide between him and retirement.”

Right now they’ve decided, he says, to pay for the first four years of their grandson’s education and after that just help him with his rent, unless circumstances improve. “I say ‘Right now,’” Kahler explains, “because their hearts continue to get away from them and I have to help them remake that decision from time to time.”

Michelle Goldstein of Goldstein Financial Futures in Dallas says that with more parents facing job loss, she’s encouraging more clients to go back to financial aid counselors and say, “I need to renegotiate; my circumstances have changed.” Part of her job, she says, “is reminding them that safety nets are out there.”

The 411 on 529s

One of the most well-known, if not well-loved, strategies is the 529 plan, whose popularity and effectiveness have suffered quite a bit during the downturn. Still, advisors do make use of 529s to varying degrees. Schilling suggests that families with several children open only one 529 for four reasons: first, not all their children may attend college; second, one or more may receive scholarships; third, the larger balance in a single account will compound at a quicker rate of growth; and fourth, if there is money left in the account after the first child has finished, the remaining balance can be transferred to the next youngest.

Robert Cheney of Westridge Wealth Strategies in Portola Valley, California, believes that “529 plans as an estate planning and asset protection tool are generally underappreciated.” He explains that “529 regulations allow five years of the gift exemption to be contributed…in one year, and the gift claimed evenly over five years for tax reporting purposes.” A married couple, whether parents or grandparents, could therefore gift a total of $130,000 in a single year with no estate tax consequences, or, in the case of, say, five children, $650,000 in a single year. “The money and the potential growth get out of their estate faster than if regular annual gifts were made.” Not only that, but even though the funds are out of the estate, the parent or grandparent retains control of the account, and in the case of litigation, judgment, or creditors leveling a claim against the estate, the 529 funds are protected. The caveat here is that the grantor cannot gift again to the same individual for the next four years.

One additional benefit of doing it this way is pointed out by Dave Emery of Univest National Bank & Trust Co., in Doylestown, Pennsylvania. If the 529 is opened by the grandparent, those assets do not get included in the financial aid form filed by the family, so they won’t count against the student’s ability to qualify for financial aid.

Marc Schindler, of Pivot Point Advisors in Bellaire, Texas, offers another wrinkle on 529s: using UPromise ( or Little Grad ( to help fund them via rebates on items purchased. Aunts, uncles, other relatives, and even friends can help. Freshman Fund ( “lets parents and other donors contribute online to any 529 plan.”

Objections to 529 plans include not just the loss of control over assets–there’s a limited range of investment products to choose from within them, many of which lost money over the downturn–but also the facts that 529 money can only be used for education, can’t be withdrawn without penalty for any other purpose, and often carries heavy fees. Schilling also points out that many of the funds within 529s have been subject to style drift as managers become more aggressive in pursuing returns. That brings us to her favorite investment vehicle, shared by planner Stan Richelson of Scarsdale Investment Group Ltd. in Blue Bell, Pennsylvania: bonds.

Bonds. Zero Coupon Bonds

It’s not just any bonds that Schilling and Richelson like, it’s municipal bonds especially. Says Richelson, “People like to fool themselves and make believe: ‘I’ll invest in equities and what’s going to happen is that the equities are going to go up in value…just when the kid needs the money.’ It’s a ‘Hail, Mary’ pass. The 529 plans lost money.” Instead, Richelson says, “We like to buy zero coupon bonds and muni bonds, tax free, which come due in the years when your child is going to start college. So that accomplishes two things: one, you know exactly how much money you’re going to have, and two, all the gain on the money is not subject to tax.”

Schilling concurs, pointing out that grandparents who want to fund children’s education via gifting should consider zero coupon bonds–”municipals if taxes are an issue due to the phantom income”–instead of cash, since “it would provide more than $13,000 and often close to double that amount in 18-21 years as purchase prices vary.”

Richelson’s book, Bonds: The Unbeaten Path to Secure Investment Growth, from Bloomberg Press, offers a case study on the use of bonds in planning for college expenses.

Jobs and Property

Brian Pon of Financial Connections Group in Corte Madera, California, and Thomas Scanlon of Borgida & Co., P.C., Manchester, Connecticut, also suggest that parents consider hiring their children. Pon points out that this way they can use the tax law to their advantage. If the children are under 18, you won’t have to pay Social Security or Medicare taxes for them. “You can hire them to do low-level tasks,” he says, “like shredding, or filing if your filing system is easy enough…you’re deducting their wages at your tax rate, and they’re paying [taxes on them] at their rate.”

Scanlon explains in more detail that parents must either have a sole proprietorship unincorporated business, a single member limited liability company (LLC), a spouse general partnership (made up only of two spouses), or an LLC made up only of husband and wife. The children, however, must be treated as the parents would treat any other employee: if they keep time cards, the child must have a time card. And they must actually work.

For parents who are incorporated, Kahler advocates paying an employed child’s wages into a Roth IRA. That way the money can be used tax free for qualified expenses that include fees, books, supplies, and equipment. He adds, “if the student is at least a half-time student, room and board are qualified higher education expenses.”

Then there’s real property. Kahler says, “Buy a house in the city where the child will go to college, which will eventually be the property they occupy. Have them rent out rooms to friends to help offset housing expenses.” Planner Cheney has another idea. “For clients who own income property or own the office building for their business, I like to recommend that they own the property in an LLC or family limited partnership, and gift interest in that entity to their kids (or grandkids) at $13,000 per spouse, the current annual gift exemption, each year.” This, he says, transfers ownership to the children without gift taxes, and each year the portion of rental income to the children will increase. Once the children are 18 “and kiddy taxes are…out of the picture, and they need to pay tuition, they will have a substantial income stream that faces a significantly lower effective tax rate than [that of] the parents, and the income can be used for tuition, room, and board.”

Be Vigilant

When clients just aren’t financially oriented, sometimes even advisors can’t solve the situation. Blain tells of a client couple who divorced. They had a 529, but it was in the ex-wife’s control, and she “never had worked and was not organized financially.” She kept pestering her ex-husband to pay for college. “There was a big debate,” says Blain. But the kids “kept going to Dad and saying, ‘We’re not getting any money for tuition.’” The father ended up “paying twice for college; fortunately, it was a state school.” Both kids have now graduated, he says, and the mother never has spent the 529 money. She “just never called or filled out the paperwork to get money from the plan…it’s one of the reasons we’re cautious [on 529s].” “She’ll either have to wait till grandchildren come to transfer it, or use it herself–or she’ll have to pay tax and penalties to take it out.”

Marlene Y. Satter is a freelance journalist and former Investment Advisor staff editor who can be reached at [email protected].


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