The next time one of your clients is passing out cigars to celebrate the birth of a baby, tell him that if he wants to educate that bouncing bundle of joy at an in-state public school, he should begin saving at least $300 per month — right away.
And those willing and wealthy enough to pay for four years of school at a private institution should plan on setting aside twice that amount, assuming you can earn them 8 percent on the money year in and year out.
If only that's all there were to the process. Although saving money is certainly a big part of paying for higher education expenses, there are many smaller moves that can make any money accumulated for college go farther and last longer. Here are 10 innovative strategies to get your clients more bang for their higher education bucks, presented in chronological order:
- The first dollars shouldn't be saved …
They should be spent preparing for worst-case scenarios. First, disability insurance should be considered to help offset an interruption in income that could be caused by an injury to a working parent.
Even more important is life insurance (preferably term) on the lives of both parents, kept in force until the last child is out of college. And at least a few hundred dollars should be set aside to pay a lawyer to establish a will for the clients' assets, and select guardians for the children.
- Money for children's education shouldn't be saved in the children's names
Benevolent parents and grandparents sensibly conclude that if they are setting aside money for a child's college education, it should be set up in the child's name, with an adult (usually the parent) as the custodian of the funds.
These folks mean well, but they're usually wrong. Yes, families do get a small tax break on income, interest, and dividends earned on investments held in accounts in the child's name. But the advantage only qualifies on a certain amount of each year's unearned income ($1,700 in 2007). Worse, most colleges will demand 35 percent of any money held in the child's name to help pay for tuition before they award financial aid.
And finally, when the kid hits adulthood (an age determined only chronologically, not by maturity), the money is his to do with it what he pleases.
- Don't give savings bonds to children
Not because the kids won't like them (that's a foregone conclusion), but rather because of the way in which tax breaks can apply to savings bonds used for qualified higher education expenses.
The tax exemption on redemption only applies to bonds that are owned by the child's parents, and only for people at or below adjusted gross income levels at the time of redemption. No one knows what those levels will be at in the future (to say nothing of what the parents' income will be at the time). Plus, only tuition and fees are deemed “qualified” higher expenses — not room and board.
Combine these restrictions with an interest rate that usually barely rivals that offered by a savings account, and it's understandable why these boring bonds don't get much attention when it comes to saving for college. Still, it's hard to dissuade some grandparents from choosing savings bonds as symbols of the love they have for grandchildren. But take heart — previously purchased bonds can be rolled into 529 college savings accounts tax free, as long as the above parameters are met.
- Many parents shouldn't use 529s to save for college
Despite my affection for college savings plans in general, it's usually better for lower- and middle-income parents to put money in Roth IRAs first, before redirecting dollars to 529s.
First, the kids can borrow money to go to college, but as of yet, there is no financial institution generous enough to offer a “retirement loan.” Second, when calculating financial aid packages, some institutions may require more money to be paid up from 529 accounts than they would otherwise request from retirement accounts.
And woe to parents who recognize a shortfall in retirement savings just as they are sending their kids off to college. Many schools' financial aid formulas figure money going into at-work retirement plans and IRAs at the time of enrollment could just as well be turned toward college costs, and will therefore count those dollars into the expected family contribution.
Parents should also know that since contributions to a Roth IRA can be taken back out at any time, for any reason, with no taxes or penalties, the non-earnings portion of the account should be available to pay for future college expenses.
- 529 penalties aren't that penalizing
Some parents who can afford to save money in 529 plans still shy away from the vehicles because non-qualified withdrawals can be hit with both taxes and penalties. They're worried that their kids either won't go to college, or that the money will be needed for more urgent, yet unforeseen, expenses.
The fear is fair. But before they go scurrying away from your office, show your clients just how “bad” the taxes and penalties might be if the money is taken out for some purpose other than qualified expenses.
Let's say you have parents of an eight-year-old who may or may not be “college material.” They can afford to put aside $500 per month. Your hypothetical investment strategy earns them a hypothetical annual return of 7 percent per year for 10 years.
Upon junior's graduation from high school, assume the balance of the account has reached about $86,000. Instead of going to college, though, the child wants to open a falafel stand — and his parents want to use the money in the 529 account to get him started.
How bad will they get nicked? The contribution portion of the 529 plan totals $60,000, so income taxes and the 10 percent penalty will only apply to the $26,000 above that amount. Even if the combined income tax bracket and penalty reaches 45 percent, they'll still be left with $71,700.
And that amount might be even bigger if the parents can “gift” the account to the child, whose subsequent non-qualified withdrawals from the 529 would likely be hit at a much lower tax-bracket rate.
- Get conservative well before college starts
Ideally, you will help families begin saving for college in growth-oriented accounts, started years before the money will actually be needed. But assuming the extra risk pays an extra reward, you may want to scale back the allocation before the child's junior year in high school.
If the money is outside a tax-sheltered college savings account, selling at this time can prevent any realized capital gains from artificially inflating the family's perceived wealth, and correspondingly reducing financial aid they would otherwise receive.
Also, moving to a less-aggressive portfolio mix a few years before college can help avoid a market meltdown that could wipe out a year's worth of higher education expenses — or more.
- Use non-retirement assets to pay off consumer debt
There are two advantages to this step: One is the potentially large gap between the interest cost of the debt, and the potential earnings on the invested assets. The second is that most financial aid formulas add a portion of the assets into the expected family contribution, but don't give any credit for the amount of consumer debt outstanding.
That means a family with $50,000 in a mutual fund, and an equal amount in outstanding car loans and credit card balances, could be asked to contribute several thousand dollars before any aid is awarded.
But sliding the assets over to cover the debt will rightfully depict the family as having little attachable money, and could increase the final financial aid package awarded.
Note, though, if your clients choose to zero out their assets, they should also consider maintaining an untapped home equity line of credit that can be drawn upon for emergencies — educational or otherwise.
- Borrow money you may not need
Clients who have the wherewithal to write a check for college costs will be a little perturbed by this suggestion. And in a purely mathematical evaluation, it's probably a better idea to pay expenses out of pocket, if possible.
But consider this scenario: Your clients have set aside $60,000 to pay for their child's four years of college. However, a financial emergency arises after the kid matriculates but well before she graduates, forcing the funds to be diverted to more pressing needs.
Just wait until then to borrow the money, right? Well, what if the lenders' purse strings have tightened in the meantime, or the money crisis the family is suffering also makes them less attractive borrowers?
Pre-emptive borrowing is even more attractive if the parents or students can get subsidized loans — some of which offer below-market rates, tax-deductible interest, or the ability to delay repayment until the child leaves college.
- Tap accounts intelligently
If there is money invested in the child's name, that money should fund the initial college costs before any parental contributions are kicked in. Draining the kid's account could lead to more financial aid in later years, and prevent an erstwhile student from using the money to pursue an unapproved alternative to college.
But some parents may be wise to delay tapping 529 accounts until the child's junior or senior years. Forcing the child to beg and borrow enough to pay for the initial years of school puts some of his proverbial skin in the game, and may provide motivation to stay on track.
And if an unmotivated student drops out of college, the money leftover in his 529 account can be transferred to other family members' education accounts.
- A student's job is to go to class
Many of us hark back fondly to the backbreaking jobs we had in college. And there is certainly some intrinsic value in learning to juggle work and schoolwork, or establishing experience and connections in a particular field.
But when viewed purely through a financial prism, the cost of working while attending college can be an extremely expensive mistake. Especially if the hours spent at work cause the student to take more than four years to graduate.
When colleges calculate the expected family contribution, student earnings can rank near the top in terms of money the schools want before any financial aid is awarded. Much worse, though, is if the student's time lost to work has to be made up with a fifth year in college. Say your clients have a child who is attending a school that costs a total of $15,000 per year, and upon graduation will get a starting salary of $35,000.
If she needs a fifth year to get her degree, the cost is not only the $15,000 spent on college, but also the $35,000 worth of salary she lost. Which means the fifth year in school could have a gross cost of $60,000 — the same amount as the total cost of years one through four.
The Birth Is The Easy Part
Having a child is a frightening, exhilarating, and expensive proposition for your clients. But it's even more so to get the kid into and out of college with a degree, as well as to find the money to pay for it.
If your clients knew what they were getting into, they'd wait until the child is wearing a cap and gown before they started passing out the celebratory cigars.
Writer's BIO: Kevin McKinley CFP is a Vice President-Private Wealth Management at Robert W. Baird & Co., and the author of the book Make Your Kid a Millionaire (Simon & Schuster). You can reach him at [email protected]