Parent’s Finance Guide to a Child’s Education
Tips on Saving, Paying, and Borrowing
Determine the Expected Family Contribution (EFC) Toward College Costs
As a parent, how much you are expected to contribute toward your child’s college education is determined by the federal government. Their decision is based on information you provide in the Free Application for Federal Student Aid (FAFSA). In the application process, you are asked to provide information regarding both your finances and your child’s, including income and assets. You are also asked how many dependents you have and how many family members will be attending college at the same time. This information is analyzed to determine what you can contribute toward your child’s educational expenses, which is called the Expected Family Contribution, or EFC. The lower your EFC, the more grants and loans your child will be qualified to receive.
Prepare for College Costs by Pre-Paying Tuition
A number of colleges and universities participate in pre-paid tuition programs for future students. This is quite an advantage to parents who can invest money now and lock in the tuition rate for their children well in advance of when the children will be ready to attend. Some pre-paid tuition plans are managed at the state level, so you need to explore the options available to determine which is best for you. There is also the possibility that this financial move could provide a tax benefit to you, so you may want to ask a tax adviser for more information. Check with the college directly for more information.
Save for College
While many parents don’t heed this advice, the best way to prepare for college is to start saving money when your child is born. Since the cost of a college education increases each year, investing in a special college savings plan can help you stay ahead of the game by protecting you against inflation. There are special educational plans that provide a tax shelter for your funds until your future scholar runs off to college. Many states offer college savings opportunities, such as a Section 529 Education Savings Plan, that allow you to begin investing early. You can also start saving in your child’s name through the Coverdell Education Savings Account. This plan allows funds to be added until your child turns 18 and also provides tax benefits. To see which option is best for your family, talk to a tax adviser about the benefits and start saving no matter how old your child is.
Use a PLUS Loan to Pay For College
Your child will qualify for federal funds to pay for college; whether the loans are subsidized or unsubsidized depends on your financial situation. If you have demonstrated need, your child may qualify for subsidized federal loans or grant money (which doesn’t need to be paid back) to help defray the costs of attending college. If your child does not qualify for subsidized loans based on need, they will qualify for unsubsidized loans. However, these funds may not be enough. Many parents look for additional funding sources through loans such as the Parent Loan for Undergraduate Students (PLUS). The funds are disbursed directly through the U.S. Department of Education. You will be asked to fill out an application, and your credit history will be reviewed for any adverse activity (such as a default on previous debt), though you will not be subjected to a full credit check. If you don’t meet the minimum criteria, you may need an endorser for the loan. If you are denied a PLUS loan, your child may qualify for additional unsubsidized Direct Loan funds. For more information, visit: https://studentaid.ed.gov/sa/types/loans/plus
Use Your Home Equity for College Expenses
Don’t forget about the equity you have accumulated in your home over the years. You may actually find acquiring a home equity loan is a better option for you than accumulating student loan debt, because your home equity loan may qualify you for additional tax benefits.
Watch Out for Loan Scams
Navigating the financial aid process can seem daunting the first time you have to go through it. When an advertisement comes in the mail or a salesperson calls offering to do all the work for you, you may be tempted. Some ads even promise that your child will qualify for financial aid regardless of your credit history. What they all have in common, though, is that they want you to pay a fee for this service. Don’t let yourself be taken in by these offers. Applying for federal financial aid is free and qualifying for aid really depends on your financial situation. Some of these student loan scams take advantage of the uninformed and could end up destroying your credit history or your child’s. In addition, the student loans they offer you could leave you even further in debt, so do your research carefully.
Saving for college
There are many options for how to better prepare to pay for the costs of college. From Qualified Tuition Plans (or 529s), to Coverdell Education Savings Accounts, to U.S. Treasury Bonds, the range of ways in which to put away money for your or your child’s college education has greatly expanded during the last decade.
What’s key to remember is that the earlier you start planning (and saving), the better off you’ll be in the long run.
Qualified Tuition Plans (QTP or 529 Plans)
A QTP can take the form of a prepaid tuition plan or a savings plan. The prepaid tuition plan, administered by a state or a qualified school, allows parents to buy tuition at today’s prices for use in the future. QTP savings plans are available in many states-you don’t have to be a resident to participate. There is no yearly limit on contributions, although some plans have a lifetime limit. Interest earnings on these accounts are not taxed as they accumulate or when the money is withdrawn to help pay for college, as long as the distribution is less than the qualified education expenses.
There are two types of 529 plans: savings and prepaid. The savings plan lets you regularly contribute your own saving to the account. The accumulated savings may then be used by the student for any eligible college expense. Another great feature of the plan is that it may be used for any college and university in the United States. The prepaid plan, on the other hand, is more restrictive. Only 18 US states allow such a savings plan. It allows you to pay for college tuition at today’s rate for the future education of a student. However, you or the student must be the resident of the state that sponsors prepaid plan. The funds may be used in a private, out of state university as well.
Post high school education may be desired by many but it is not always affordable. It is important for a prospective college student and the parents to have a college savings plan. The 529 plan may allow a student to purchase tuition, room and board, books and other necessary equipment and supplies, for an accredited college or university, including a vocational school in the United States. The investment from the plan may further be used for studies in a college or university outside of the United States as well.
Coverdell Education Savings Accounts (ESAs)
Coverdell ESAs may be set up for beneficiaries under the age of 18, or those with special needs, to pay for their education expenses. Friends and family may deposit money into the account, but the total contributions for the year may not exceed $2,000. As with Qualified Tuition Plans, the earnings in Coverdell ESAs accumulate tax-free and are not taxed at the time of distribution unless the amount withdrawn exceeds eligible educational costs.
U.S. Treasury Savings Bonds
Savings bonds generally earn lower interest rates than other investments, but because they are fully backed by the federal government, their security is guaranteed. Generally, accumulated interest on bonds included in the government’s Education Bond Program is free from federal income tax (also state and local taxes) when used to pay qualifying educational costs. Bonds from the education program may be redeemed and rolled over into a Qualified Tuition Plan, with no tax on the interest earnings.
Custodial Accounts hold money and other assets until a named minor beneficiary reaches a certain age (usually 18 or 21), with a custodian managing the money until that time. Deposits to the account become the permanent property of the beneficiary. Interest earned on the account is taxed at the beneficiary’s rate and included on their tax return. Although similar to a trust, these accounts are preferred when the amounts involved are relatively small, and because they do not have the complicated legal structure of a trust (or the attorney’s fees!).
The Uniform Gift to Minors Act (UGMA) and Uniform Transfer to Minors Act (UTMA) are custodial accounts. UGMA covers cash and securities; UTMA covers these assets as well as real estate, intellectual properties and virtually all other assets.
Home Equity Loan and Home Equity Line of Credit (HELOC)
A Home Equity Loan is basically a second mortgage. Borrowers may receive up to the current value of their home minus the amount they owe on it (which equals the owner’s equity in the house). So, if the current value of the house is $200,000 and the amount outstanding on the original loan is $120,000, then the borrower could receive up to $80,000 in a Home Equity Loan. The loan amount will be reduced by fees and closing costs.
Interest rates for a Home Equity Loan are usually fixed over the life of the loan (from 10 to 15 years). Unlike Federal PLUS Loans, however, these loans have no deferment or forbearance privileges. That means that if the borrower fails to make the loan payments, the lender can take the house to recover its money.
A Home Equity Line of Credit (HELOC) is a revolving credit line with a maximum limit based on the borrower’s equity in their home. So, if the current value of the house is $200,000 and the amount outstanding on the original loan is $120,000, then the homeowner would have $80,000 as their maximum line of credit. Funds can be borrowed as needed, with interest charged only on the amounts used (like a credit card).
HELOCs have a variable interest rate, and may charge maintenance fees, inactivity fees or transaction fees. Some HELOCs require a balloon payment at the end of the loan term. Again, if the borrower fails to make the loan payments, the lender can take the house to recover their money.
Withdrawals from Retirement Accounts
Usually, if an Individual Retirement Account (IRA) account holder takes money from an IRA before the age of 59 and 1/2, the earnings portion of the withdrawal is subject to a 10% penalty. This penalty is waived, however, if the withdrawal is used to pay qualified education expenses. Remember that, generally speaking, the earnings portion of the money withdrawn will still be subject to income tax.
Saving on federal taxes through tax credits
In addition to financial aid, there is an indirect way to reduce the college bill through federal tax reductions. There are four tax breaks for college students and recent graduates. Some benefits have income and other restrictions. More information can be found in IRS Publication 970: Tax Benefits for Higher Education.
Student Loan Interest
Current college students paying interest on unsubsidized loans and graduates who are repaying their loans can claim a tax deduction of up to $2500 depending on your total income. There has been a ruling that interest paid on the parent PLUS loan also qualifies, but check with a tax expert before taking that deduction.
There are two tax credits available to help you get some money back on the cost of tuition: the American Opportunity Credit and the Lifetime Learning Tax Credit. Since they are both tax credits, you subtract the amount for which you are eligible right off your tax bill. You must choose which credit to take per qualifying student based on which is more beneficial for you.
- Lifetime Learning Credit: Maximum credit is worth up to $2,000 per return if the adjusted gross income of a family is $120,000 (if parents are married and filing jointly) or $60,000 (for singles). There’s no limit on the number of years you can qualify for this credit.
- American Opportunity Tax Credit: Maximum annual credit here is worth $2,500 and is available to individuals with an adjusted gross income below $80,000 or married couples who file jointly and earn less than $160,000. It’s only available for four years of education.
This is a deduction (not a credit), which can reduce taxable income by as much as $4,000 depending on your total income. This deduction may benefit students who do not qualify for either the American Opportunity or Lifetime Learning tax credits. You must decide whether to claim the tuition and fees tax deduction or claim the American Opportunity or Lifetime Learning Credit per qualifying student in the tax year.
Students who are required to move to take their first job qualify for a deduction for the cost of moving themselves and their possessions. More information can be found in IRS Form 3903. For questions on how to claim tax credits or take deductions on your college expenses, please visit www.irs.gov or speak with a tax professional.
Strategies in Times of Recession
Tuition is always difficult to afford. During a recession, these bills can feel like an insurmountable barrier between your child and their future. But there are things besides just cutting back on household expenses that can help you survive a bad economy and help you put your child through school.
Here’s just some of them:
- Revise your expectations about jobs during the school year. Have a discussion about the type of job your child needs to find while in school and how much money they need to contribute from that job. Be clear about expectations so everyone is on the same page.
- Talk to your child about finishing school faster. At the very least, they should finish in four years. To help motivate them to do so, remind them that scholarships often don’t renew after four years of schooling. Also, if you don’t want to be saddled with the responsibility of fifth-year tuition, tell them you won’t help pay if they don’t finish on time. If your child is truly motivated, and it’s still early in their education, ask them to take an extra class each semester. This could help them graduate a semester or an entire year early, meaning you save bundles.
- Look for other sources of money. The biggest one is always more scholarships. Your child should be applying throughout the year, every year. Scholarships are always available and they aren’t just for freshman. Ensure your child consistently checks in with the financial aid office and searches online for opportunities. Start with www.fastweb.com, cappex.com, and scholarships.com.
- Move more of the tuition burden to your child. When your child works a part-time job during college and still doesn’t earn enough to cover the gap between their tuition and the money you’re able to contribute to their cause, it might be time for your child to take out a student loan to cover the difference. They’ll have the responsibility of paying that debt back later, but the hope is that, with a degree behind them, they’ll be able to find a job. But be sure to compare student loans with SimpleTuition before borrowing, because we can save you thousands. It’s fast, easy, and free.
- Take advantage of your employer’s pre-tax savings. Often employers offer pre-tax plans that let you pay for things like transportation or medical expenses with income prior to taxes, which could save you a bundle of money throughout the year. There’s two benefits to this: the money you would have paid to taxes can now go toward tuition; and it lowers your taxable income, meaning your child might qualify for more federal aid.
Choose the right student loans, pay back less
If you’re like most students and parents facing a tuition bill, you’re going to need to borrow. That’s a pretty simple reality.
It does get complicated, however, because there are many different types of student and parent loans. Remember don’t make the mistake of borrowing private student loans before maximizing federal ones. Here’s a quick rule of thumb to help you figure out where to borrow.
Generally speaking*, a borrower should exhaust each of the following sources before moving on to the next one listed:
- Federal Perkins Loan (rarely available and dependent on need** but ask your school anyway)
- Federal Direct Loan
If further borrowing is necessary:
- If the parents are willing to borrow, then a fixed-rate, federal PLUS loan is a great option
- If the parents are not willing to borrow, then investigate private student loan options, but remember that a co-signer will almost definitely be required (might be that parent who wasn’t willing to borrow a PLUS loan)
Graduate / Professional Student
Generally speaking*, a borrower should exhaust each of the following sources before moving on to the next one listed:
- Federal Perkins Loan (rarely available and dependent on need**, but ask your school anyway)
- Federal Direct Loan
If further borrowing is necessary, choose between:
- Fixed-rate, federal GradPLUS Loan, or
- Private loan (the GradPLUS Loan will usually be the better option)
* Of course there are exceptions to these rules, so do your own homework and investigation. For example, some schools offer their own loans with lenient terms. There may also be state loans available to you with terms better than federal or private loans. Read your financial aid award letter. Ask your financial aid office. Learn about all your options. And always shop around.
** Perkins loans only represent 2% of all student loans each year and are generally awarded to lower-income students. Some schools don’t have access to Perkins loan money, even if you would have qualified by need (so don’t blame the school; availability of funds for Perkins loans has been established through a confusing political process that goes back decades).
Teaching your child financial responsibility
As the parent of a future college student, you have a lot to worry about already: from how you’ll handle the empty nest to paying tuition bills.
One huge and often unspoken subject between parents and their (almost) adult children is financial responsibility. But you have so many years they haven’t lived through yet, and so much knowledge. Use it to help your child understand how to manage money responsibly.
- Involve them in the payment process. Even if you have the money to cover the cost of tuition, your child shouldn’t get a free ride. Remind them of something very important: they need to help pay for their own education.
- Support them getting a job. A mantra of money: it’s easier to spend someone else’s cash. That means you probably shouldn’t just send your kid checks each month. Teaching your child financial responsibility begins with them earning their own money. So push them to get a job.
- Help them navigate the banking system. That means help them pick an account, preferably at a bank that has a presence on their campus. Teach them the differences between credit and debit and the dangers of debt. Remind them that credit cards have interest rates and debit cards are free.
- Don’t bail them out of every financial hardship. Lessons are sometimes difficult to swallow, but your child may need to learn them the hard way. If they decide not to work all semester but want to go on spring break anyway—well, tough luck kiddo. Maybe next year you should save more, plan better, or work. It’s not tough love, just tough money.
- Teach them the power of habitual saving. These days it’s easy. Paychecks can be directly deposited into checking accounts. The trick is keeping it there. The easiest way is asking your child to create a monthly budget.