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April 25, 2012 at 08:00 PM
Faced with massive budget deficits, state legislators across the country are looking to chop college education funding to fill the gaps. The federal government will likely trim back aid as well. So, students and their families will have to start shouldering more of the costs themselves.
The above is likely high on your clients’ list of worries. Fortunately, college is still one of the smartest investments clients can make for their kids. This article identifies actions you can advise clients to take to put them on the right path.
Get an Early Start
Assuming tuition increases only by 5% per year in the future (that is, only about 2% faster than inflation), parents of a baby born today would have to save $385 each month in order to afford housing and tuition at the average state school. Putting off saving until age 5 bumps the value to $465. The required monthly amount grows to $780 if you don’t start saving until your kid is in middle school. These amounts are averages for public schools. Do you want to send Johnny to Yale? Then plan on putting $1,100 a month away starting the day you bring him back from the hospital. In other words, saving early and often is your best strategy for success.
Set Up a 529 Plan
These calculations assume a return on investments equal to 6% for each year before your child actually heads to college. Most people will earn much less than that amount if they save in a bank account. Fortunately, the government encourages saving for college with various tax-preferred college savings programs. Just a few years ago, there was an ongoing debate about the best program choice. However, recent changes in legislation have made for a fairly clear winner for the vast majority of households: the 529 plan.
One neat feature about a 529 plan is that you are not required to use it in your own state to receive the federal tax benefits. Evaluations of which 529 plan to use can be aided by using a website such as www.collegesavings.org. At Veritat Advisors, the firm I co-founded, we often recommend the Iowa 529 plan for many of our clients because of its small minimum required investment, low fees and good user experience. Some non-Iowa residents will forfeit the tax deduction against their own state income taxes; some other states, though, will still allow the deduction. But even if your state does not, your own state’s 529 plan might not be the best option if it has high fees.
Veritat’s own calculations reveal that a 529 plan with a low expense ratio will often more-than-offset a state tax savings for many households. So, be mindful of expenses as well as taxes.
After choosing a 529 plan, clients should follow a regular savings schedule. There are many online calculators to help them determine how much they need to save. However, some caution is in order. Besides making simple assumptions, these calculators fail to balance out your other life’s priorities, such as paying down debt, getting a house, affording retirement, and, oh, paying for your kid’s braces before he or she actually goes to college. That’s one reason why good financial advisors believe in comprehensive planning: You need to have a game plan that realistically balances your different life objectives since you cannot save for everything. Financial planning is not simply about figuring out how much to save and where to invest. It’s first about reflecting about what you really want to accomplish in life.
Moreover, clients need to invest their 529 savings wisely. They should not be seduced by larger projected returns — they come with more risk. Instead, suggest a “safety first” approach and make sure that the risk level of investments matches clients’ willingness to potentially fall short of their intended goal. Investment risk should also weigh clients’ future capacity to earn and save money in case things do go wrong.
Many 529 plans offer investment options that become more conservative automatically as college approaches. While these target-date funds seem simple enough, they are often still very risky, and some 529 plans indeed suffered large losses in 2008. Even if clients are in one of these funds, their investments should be revisited regularly.
Maximize Assistance
Despite the recent increase in average tuition and fees, the good news is that grants (“financial aid”) and federal tax benefits have grown fast enough during recent years to more-than-offset the higher costs for most families. The federal government alone subsidizes higher education to the tune of $200 billion per year. Although much less common, students who decide to work for the Peace Corps or other designated public or private organizations can also qualify for debt relief or even full forgiveness.
However, the bad news is that the government’s generosity, at both the federal and state levels, going forward is in serious decline in light of enormous budget deficits. Clients need to consider taking the following measures:
Pay off credit cards and mortgages. When determining financial aid, schools look at assets, not net worth (assets minus debt). So, if clients have some extra cash sitting around, then paying debt reduces their assets but not their net worth, making them better positioned to receive financial aid.
Avoid taking retirement distributions. Retirement assets are not counted when determining financial aid, so it’s desirable to keep money in retirement accounts as long as possible. Clients should only take the required minimum distributions when they have to do so. Fortunately, RMDs can be deferred until age 70.5, so that’s an unlikely concern for most parents.
Play the intergenerational trading game. In general, a student’s assets and income are penalized more heavily in financial aid calculations than the parents’ resources. The grandparents’ stuff is ignored altogether. So, clients should spend the student’s resources before their own. Moreover, while a 529 plan is counted as an asset for determining financial aid, it counts much less if it is held by the parent. Even better, have the child’s grandparents hold it so that it does not count at all.
Of course, if clients are really funding the grandparents’ 529 plan, then they have to limit annual contributions to avoid producing a gift tax, but that’s pretty easy to do.
Snag a Loan
Another option is to do the first two years at a local community college and then transfer to a regular four-year college. The average two-year program costs only $2,713 per year. To be sure, community colleges have garnered a bad rap in the past. Indeed, some academic studies have shown that students who start down this path typically don’t command as large of a future salary as those who start in a regular four-year college. However, these studies are often biased by “sample selection,” that is, the likelihood of lower-performing students to select a community college in the first place. In other words, they would have earned a lower income even if they had attended a regular four-year program from the get-go. Indeed, students who start in community colleges are generally 15% less likely to eventually graduate, and so they might be a different crowd altogether.