How can you properly fund your children’s education without draining your current cash flow? What should you do if they are a few years away from college and your education fund won’t be enough? How can you increase your chances of getting financial aid? What tax benefits might be available to you? This Financial Guide answers these questions.
With the costs of a college education rising every year, the keys to funding your child’s education are to plan early and invest shrewdly. However, there are steps you can take if you get a late start. Moreover, there are a number of effective techniques for increasing financial aid opportunities and reducing taxes.
According to the College Board, between 2013-14 and 2014-15, average published tuition and fee prices increased by 2.9 percent for in-state students in the public four-year sector, by 3.3 percent for out-of-state students in the public four-year sector and for in-district students at public two-year colleges, and by 3.7 percent at private nonprofit four-year institutions. These price increases are lower than the average annual increases in the past five years, the past 10 years, and the past 30 years. Despite this, college is still expensive and proper planning can lessen the financial squeeze considerably–especially if you start when your child is young.
Here are some guidelines–geared to parents whose children are no older than elementary school age–for funding your child’s education.
We cannot emphasize enough that getting an early start is basic to funding your child’s education. The earlier you start, the more you’ll benefit from the compounding of interest.
When should you start saving? This depends on how much you think your children’s education will cost. The best way is to start saving before they are born. The sooner you begin, the less money you will have to put away each year.
Example: Suppose you have one child, age six months, and you estimate that you’ll need $120,000 to finance his college education 18 years from now. If you start putting away money immediately, you’ll need to save $3,500 per year for 18 years (assuming an after-tax return of 7 percent). On the other hand, if you put off saving until the child is six years old, you’ll have to save almost double that amount every year for twelve years.
Another advantage of starting early is that you’ll have more flexibility when it comes to the type of investment you’ll use. You’ll be able to put at least part of your money in equities, which, although riskier in the short-run, are better able to outpace inflation than other investments after time.
How much will your child’s education cost? It depends on whether your child attends a private or state school. For the 2014-2015 school year the total expenses–tuition, fees, board, personal expenses, and books and supplies–for the average private college are about $42,419 per year and about $18,943 per year for the average in-state public college. However, these amounts are averages: the tuition, fees, and board for some private colleges can cost more than $60,000 per year whereas the costs for a state school can be kept under $10,000 per year. It should also be noted that in 2013-14 the average amount of aid for a full-time undergraduate student was about $14,180.
Don’t forget to add the costs of graduate or professional school to the amount your child will need.
Planning Aid: If you’re trying to estimate future costs, you can estimate that school costs will grow by about two percentage points above the inflation rate. To be on the safe side, we suggest you assume costs will grow by at least 7 percent per year.
As with any investment, you should choose those that will provide you with a good return and that meet your level of risk tolerance. The ones you choose should depend on when you start your savings plan-the mix of investments if you start when your child is a toddler should be different from those used if you start when your child is age 12.
Related Financial Guide: For a general overview of investing principles, please see the Financial Guide: INVESTMENT BASICS: What You Should Know.
The following are often recommended as investments suitable for education funds:
U.S. Government Bonds are also safe investments that offer a relatively higher return. If you use zero-coupon bonds for your child’s education, you can time the receipt of the proceeds to fall in the year when you need the money. A drawback of such bonds is that a sale before their maturity date could result in a loss on the investment. Further, the accrued interest is taxable even though you don’t receive it until maturity.
CDs are safe, but usually provide a lower return than the rate of inflation. The interest is taxable.
Municipal Bonds, if they are highly rated, can provide an acceptable return from the tax-free interest if you’re in the higher income tax brackets. Zero-coupon municipals can be timed to fall due when you need the funds and are useful if you begin saving later in the child’s life.
Tip: Be sure to convert the tax-free return quoted by sellers of such bonds into an equivalent taxable return. Otherwise, the quoted return may be misleading. The formula for converting tax-free returns into taxable returns is as follows:
Divide the tax-free return by 1.00 minus your top tax rate to determine the taxable-return equivalent. For example, if the return on municipal bonds is 5 percent and you are in the 30 percent tax bracket, the equivalent taxable return is 7.1 percent (5 percent divided by 70 percent).
Stocks contained in an appropriate mutual fund or portfolio can provide you with a higher yield at an acceptable risk level. Stock mutual funds can provide superior returns over the long term. Income and balanced funds can meet the investment needs of those who begin saving when the child is older.
Deferred Annuities provide you with tax deferral, but the yield may not be acceptable because of the relatively high cost of these investments. Further, amounts withdrawn before you reach age 59-1/2 may be subject to a 10 percent premature withdrawal penalty.
If you have insufficient savings for your child’s education when he or she is close to entering college, there are ways to generate additional funds both now and when your child is about to enter school:
Tip: Sources of student aid and education loans should be exhausted before other types of loans are used, since the former make better sense financially. In some cases, however, a home equity loan can be advantageous because of the deductibility of interest.
Here is a summary of the possible sources of financial aid. The types of aid and tax implications change frequently, so consult your financial advisor for specifics when you’re approaching the time to seek financial aid.
Grants, the best type of financial aid because they do not have to be paid back, are amounts awarded by governments, schools, and other organizations. Some grants are need-based and others are not.
Tip: Don’t assume that middle class families are ineligible for needs-based aid or loans. The assessment of whether a family qualifies as “in need” depends on the cost of the college and the size of the family.
Tip: Try negotiating with your preferred college for additional financial aid, especially if it offers less than a comparable college.
Loans may be need-based, and others are not. Here is a summary of loans:
Work-Study Programs. This is a program that is federally funded and based on the family’s financial need. The student works on-campus and receives partly subsidized pay. The receipt of work-study funds does not affect the level of “need” for purposes of need-based grants and loans.
To make a thorough investigation, you should fill out the financial aid application, which you can obtain from the school’s financial aid office. You will have to provide tax returns. The amount you are determined to be eligible for depends on your income, the size of your family, the number of family members currently attending college, and your assets.
Here are some strategies that may increase the amount of aid for which your family is eligible:
Example: If your child owns $1,000 worth of stock, the amount of aid for which he or she is eligible for is reduced by $350. On the other hand, the amount of aid is reduced by (effectively) only 5.6 percent of your assets and from 22 to 47 percent of your income.
As noted above, education funds should generally be kept in the parents’ names because of financial-aid considerations. However, in specific cases, it may be better to keep the investments in your child’s name since the tax rate on the income will be less than if they are held in your name. Professional advice should be sought in making this decision.
In the past, parents would invest in the child’s name in order to shift income to the lower-bracket child. However, the addition of the “kiddie tax” mostly put an end to that strategy. Now, investment income over $2,100 for 2015 ($2,000 in 2014) of children under the age of 19 (or 24 if a full-time student) is taxed at the parents’ rate. (This threshold is indexed annually for inflation.) Once the child reaches age 19, however, all income is taxed at the child’s rate. Of this $2,100, one-half probably won’t be taxed due to the availability of the standard deduction while the other half would be taxed at the child’s rate.
Note: These rules apply to unearned income. If a child has earned income, this amount is always taxed at the child’s rate. If you decide to invest in your child’s name, here are some tax strategies to consider:
Note: The Kiddie Tax does not apply if the earned income of a student over age 18 exceeds half of the child’s living expenses. Living expenses include food, housing, clothing, medical, dental, education and other necessary costs of support. Students over 18 are considered independent from their parents if they provide more than 50 percent of their own support.
Tip: Reporting the kiddie tax on the child’s return using the required Form 8615 calls for showing the parents’ taxable income. A parent reluctant to show that item to a teenager may instead report the child’s investment income of the parent’s return, on Form 8814. But this is not allowed, and the Form 8615 route must be followed, where the child has taxable earned income, as many teenagers would.