A four-year college education at a public school can cost $100,000 and a degree from a private school can be more than $200,000. A college education may be one of life's biggest expenses. The government has created a few tax deferred plans to help save for these college expenses. This article provides an overview of these plans as well as several other strategies to maximize your financial aid eligibility and reduce college expenses. There is more information on the value of a college education, rising college costs, and strategies to avoid student debt in chapter 10 of Become Loaded for Life.
Determining Financial Aid Eligibility
When applying to a U.S. college or university a student completes the Free Application for Federal Student Aid (FAFSA). The school uses the FAFSA along with federal income tax returns to assess a student’s eligibility for financial aid. The information is used to calculate a student’s Expected Family Contribution. The FAFSA draws from family income, from two years prior to starting school, not the previous year, so two years prior to applying for college is not the time to have a large increase in income, it will hurt your chances to qualify for student aid. Also, be advised that some of the more elite or selective colleges and universities (about 300 nationwide) also require the CSS Profile in addition to the FAFSA.
529 Qualified Tuition Plans
A 529-college savings plan, formally called a qualified tuition plan, is a tax-advantaged savings account. A 529 account is set up in a specific U.S. state and all states offer a plan. But, the account funds can be spent in any state, you are not limited only to schools in the same state as your plan. In addition to college and university level education, 529 funds can also pay for up to $10,000 in tuition for primary and secondary school (K-12).
Contributions to a 529 plan are not tax deductible, but future withdrawals, including any gains, are not subject to income tax if used for “qualified educational expenses” such as tuition, room and board, fees, books, and computers. The custodian of the account may change the beneficiary, so if your child is the beneficiary and gets a scholarship you can change the beneficiary to a different child or even yourself if you want to pursue a degree. There are no restrictions against relatives or friends contributing to a child's 529 plan. There are also some credit cards that offer cash back options for a 529 plan.
Funds in a 529 plan in the name of the student or their parents count as assets and will reduce need-based financial aid by a maximum of 5.64% of the value of the account. Hence, if you have $40,000 in a 529 plan the school may lower the student’s financial aid eligibility by $2,256. There are no annual contribution limits for 529 plans, but the plan's balance can't exceed the expected cost of the beneficiary's qualified higher education expenses. There are limits based on the State, ranging from $235,000 to $529,000 see the list here.
One benefit of a 529 plan is if you have wealthy relatives, they can contribute up to $75,000 ($150,000 from a couple) to a 529 plan. This contribution equates to five years' worth of tax-free gifts given in one year. However, this can only be done once every five years. A second benefit of 529 plans is that if you purchase real estate and the student beneficiary of the 529 plan is living in the property, the equivalent cost of on campus student housing is eligible for withdrawal from the 529 plan as a qualified education expense. Be sure to keep accurate records and withdraw only the appropriate amount of funds for the housing expense.
Risks with 529 Plans
There are a few risks with 529 accounts to consider. First, there is a potential that 529 plans will not retain their tax benefits in the future. Former President Barack Obama suggested eliminating the tax-free benefits of 529 college savings plans while he was in office. Similar proposals could occur again in the future.
Second, 529 plans and the financial aid process punishes savers. If you have two families at the same income level, but one saves in a 529 plan while the other buys luxury items, the family with a 529 plan may receive less financial aid. This results in a penalty for being smart with your money, but the value of having the resources to pay for college outweighs this risk.
Third, avoid having 529 plans in the name of a grandparent. Withdrawals from a grandparent's fund used for educational expenses are reported as untaxed student income for financial aid purposes. Instead of reducing the student’s financial aid eligibility at the 5.64% rate discussed above, it can reduce the amount of financial aid by 50% of the grandparent's payment. Hence, a grandparent’s payment of $5,000 from a 529 plan could reduce the student’s federal financial aid by $2,500. The preferred approach is to hold the plans in the name of the parent as the custodian.
529 Contributions and Withdrawals
529 contributions can be invested in stocks, bonds or other assets. As the money in the account grows the balance will consist of the original contributions and the gains from your investments. Withdrawals from your 529 account are in proportion to your contributions and gains. For example, if you have a $10,000 balance consisting of $7,500 in contributions and $2,500 in gains. A $1,000 withdrawal of $1,000 will be split as $750 in contributions (75%) and $250 in gains (25%). You must use the entire withdrawal amount for eligible educational expenses. Otherwise, the $250 in gains is subject to income tax and the 10% penalty. You cannot withdraw the contributions and leave only the gains to lower your account balance and improve your chances for financial aid in the two years prior to applying for college. This would be a clever strategy, but unfortunately, it is not permitted.
Alternatively, you can withdraw funds in your 529 account if you have eligible K-12 education tuition expenses prior to college. For example, if you can afford paying a $2,000 K-12 tuition expense out of pocket you can still withdraw $2,000 from your 529 plan without penalty. There are ways to invest the money which will shield it from being counted towards financial aid eligibility which are described below. The process reduces the balances in your account, as you are two years away from applying for college and completing the FAFSA.
Primary Residence and Family Business
For the purposes of assets under FAFSA, the equity of a primary residence and value of a family business (as long as your family owns at least 50% of the business and the business employs fewer than 100 full time employees) do not count as assets for eligibility for student aid. If you can move assets into your business or to pay down your mortgage on your primary residence you can shield them from being counted under the FAFSA. If you need the money for college expenses, you can always withdraw some of the equity from your house through a cash out refinance or by taking a home equity line of credit.
Retirement Accounts and Financial Aid
The money in retirement accounts like a 401(k) or a Roth IRA do not count in calculating the Expected Family Contribution for financial aid. However, any withdrawals from these accounts are counted as income for the year. Income listed on your federal tax return such as rental income, annuity payments, dividends from stock, interest from notes, income from a business, salaries, self-employment income and any taxable capital gains are all considered income in calculating financial aid eligibility.
Coverdell Education IRA
A Coverdell Education Savings account, commonly referred to as a Coverdell Education IRA is an investment account to pay for qualified education expenses. Qualified education expenses include tuition, room and board, mandatory fees, books, and computers. The contribution amounts are limited per year, currently $2,000 for 2022, and the student beneficiary must be under the age of 18 or else the contributions will face a 6% excise tax.
A student can have both a 529 plan and a Coverdell plan. Coverdell accounts are not designed for higher earners and once you reach a certain income level you can't contribute to a Coverdell. Like a Roth IRA, Coverdell contributions are not tax deductible, but any gains grow tax deferred and withdrawals, if used for qualified educational expenses, are tax free. One advantage of Coverdell accounts is the ability to make withdrawals for all qualified educational expenses for K-12 education. This is different from a 529 plan which only allows for up to $10,000 in withdrawals for K-12 tuition only. One caveat with these plans is that the student beneficiary of the Coverdell account can only use the funds if they are 30 years old or younger, so use the Coverdell funds for educational expenses before funds in a 529 plan.
Pre-Paid Tuition
There are a few other items worth mentioning related to saving for college. First is the existence of prepaid tuition programs to lock in the price of the education of a child now at a university or at all the universities within a state. Investigate the plans in the states that might be of interest to you but remember this option limits your choices to one or just a few schools.
Federal Income Tax Deductions
There are various tax deductions related to paying for college such as the American Opportunity Tax Credit which is worth $2,500. If your income is above $80,000 as single tax filer or above $160,000 as a joint filer you will be ineligible for this tax credit. Other older college-related tax credits include the Hope Scholarship and Lifetime Learning Credits. When you are completing your federal income taxes you will see these college related tax deductions. Also, it is sometimes possible to deduct some of the interest you paid on your student loans on your Federal income taxes. All these deductions are modified from time to time, but look for them at tax time if you had college related expenses for the year.
Student Loan Forgiveness
Certain jobs will repay your student loans as a benefit of employment. It can be advantageous to take student loans if you are going into a career that is likely to offer repayment assistance. I used student loans while in law school to buy real estate because the interest rates were lower than mortgage rates at the time. I paid for my tuition with money from my job and my employer repaid part of my student loan debts (essentially paying off my real estate debt).
In 2007 the Department of Education began offering individuals with federal student loans an income-driven repayment plan, in which a person with student loans would pay 10% of their discretionary income towards their student loans. If you work in the private sector you will be on this income-driven repayment plan for a 20 to 25-year period. However, depending on the original loan levels and payment rates, some borrowers will still have a significant loan balance which will then be forgiven. The important thing to know is that debt that is forgiven, including student loan debt, is deemed to be income for federal income tax purposes.
Military Benefits and Schools Abroad
The U.S. military has a number of programs to help members of the armed forces to get college education both while they are serving and after they complete their service. Starting in 1944 the G.I Bill began offering educational benefits to veterans with additional benefits added over the years. The military provides training opportunities to learn marketable job skills along with college education benefits for yourself or family members.
If you are seeking an adventurous experience with lower education costs consider looking overseas. There are excellent universities in Canada, Europe, Australia and New Zealand that provide degree programs for significantly less than most U.S. schools.
Using Real Estate for Educational Expenses
One approach to paying for college is to bypass the traditional education accounts and purchase a rental property soon after your child is born. If you use a 15-year note the property will be paid off when your child is ready to attend university. You have the option of selling the property or refinancing it to pull out cash to pay for their education. This strategy does not offer some of the tax benefits of other saving vehicles, but it does provide tremendous flexibility in how you use the money. As mentioned above, if you do have a 529 account and the student beneficiary of the account is living in the property, the equivalent cost of on campus student housing is eligible for withdrawal from the 529 plan as a qualified education expense.
