Paying for College
Understanding Financial Aid, Scholarships, Loans & Savings Plans
The cost of college has risen at more than five times the rate of inflation during the last ten years. With tuition skyrocketing and more and more teens attending college, financial aid has become an important consideration for most families. To help you evaluate the available options, below is a brief outline of the various types of financial aid, different ways of saving for college expenses and available tax advantages.
Never assume that you will not quality for financial aid. Every college sets its own need-based financial aid levels, which may differ from the federal guidelines, so it is in your favor to apply for aid if it’s something you are interested in whether you think you will get it or not.
How is Need Calculated According to the Federal Formula?
In order to figure out how much aid a family will need, financial aid officers generally calculate a family's expected contribution by examining a family's adjusted gross income and its assets. The problem with this approach is that financial aid officers only look at money coming in and do not consider money going out. They do not look at liabilities or how much money a family has in their checking or savings account after all of the bills are paid. Each college has the option of setting its own need-based financial aid levels and it may calculate a family's expected contribution in its own manner.
Children's assets are assessed at a rate of 20% per year. Parent's assets are assessed at a tiered rate, with a top rate of 5.64%. This represents a difference in financial aid eligibility equal to 14.36% of the asset. These rates are assessed on the total value of the asset, including both principal and accumulated interest. However, due to their earnings, children typically pay taxes in the 15% tax bracket, while parents are typically taxed higher due to higher income. The tax savings for the child of 5% or 10% only applies to earnings, not principal. Therefore, if a family qualifies for need-based financial aid, it is usually beneficial for a child's college savings account to be in the parent's name instead of his own.
Not all parents' assets are considered when need is assessed. The law provides an allowance -- based on the age of the older parent -- which shelters a portion of the family's combined savings and investments. For example, a couple whose older spouse is 45 years of age, can shelter $40,000-45,000; a single parent, less than $20,000. In addition, money in qualified retirement plans, such as an IRA or 401(k), is not considered when need is calculated, however, the annual contribution is added back to the adjusted gross income and assessed accordingly (up to 47%). Also, the federal formula (but not the formulas used by many schools) ignores the value of the family's primary residence and the value of a family-owned and controlled small business with fewer than 100 full-time employees. There is no asset protection allowance for money in the child's name.
It is important to note that money in the child's name is legally the property of the child, so the child is free to spend it on whatever he wants when he reaches the age of majority. The following sections explain the various types of financial aid available and different ways parents can save for their children's education and how they can gain tax advantages.
Scholarships, Grants & Loans
Scholarships are a type of aid that does not have to be repaid. Scholarships are generally awarded to students with superior academic, artistic, or athletic achievement or those with specific backgrounds. Scholarships are also available for students interested in particular fields of study or who demonstrate financial need. Most colleges offer scholarships funded by alumni and friends of the college for students who meet specific, sometimes unusual, qualifications. For example, at one of the colleges featured on our website, an alumnus established scholarship for students who have shown an interest in Baroque music. It is also possible, albeit rare, for applicants to be offered full tuition scholarships. These scholarships are the most prestigious a college can offer and often require candidates to write additional essays or give a presentation.
One approach for finding scholarships is to use one of the free, online scholarship databases. Most of the online sites allow you to personalize your search so only those awards that match your background and/or credentials will be identified. Fee-based scholarship services exist and users have had mixed results. We recommend starting with the free searches and working from there.
Small local scholarships may not be listed in books or online. To find these scholarships, look for notices posted on bulletin boards at your high school, the public library, and outside the financial aid office at colleges and universities.
Grants are another form of financial aid that does not have to be repaid. Many times grants are awarded to students with significant financial need.
- Pell Grant Program - The largest grant program in the nation with more than 4 million students receiving grants each year. Pell Grants are awarded to students who have significant financial need. Eligibility is determined by the federal government's expected family contribution formula.
- Federal Supplemental Educational Opportunity Grant (FSEOG) - A grant designed to help lower income families make up the difference between the maximum of the Pell Grant and the total cost of a particular college. The FSEOG is funded by both the federal government and the individual college. It is administered by a college's financial aid office instead of by the federal government. The award amount ranges from $100-$4,000 per year depending on when a student applies for aid, his level of need, and the policies of the college's financial aid office. The federal portion of a student's FSEOG award cannot exceed 75% of the total amount awarded.
Many students and parents rely on loans to help finance college education. Federal loans offer low interest rates and do not require collateral on credit checks. Private loans are offered by private lenders to help cover the costs of college when a student has reached federal loan limits. Private loans typically have higher interest rates than federal loans but many offer more flexible repayment options.
Federal Student Loans
The federal loan for students is called the Stafford Loan and has two variations:
- Federal Family Education Loan Program (FFELP) - provides loans by private lenders such as banks and credit unions. FFELP loans are guaranteed against default by the federal government.
- Federal Direct Student Loan Program (FDSLP) - provides loans by the U.S. Government directly to students and is administered directly by the lending schools.
In addition, all Stafford Loans are either subsidized or unsubsidized:
- Subsidized Stafford Loans - the government pays the interest while the student is in college. To qualify for a subsidized loan, a student must demonstrate financial need.
- Unsubsidized Stafford Loans - the student pays the interest accrued during college six months have graduating. Deferring payments increases the size and overall cost of the loan.
The Perkins Loan is another type of student loan. This loan is awarded to students with significant financial need. Perkins Loans are campus-based loans for which the college acts as the lender using limited funds provided by the federal government. The school's financial aid office determines the size of each Perkins Loan up to the maximum. Borrowers may take up to 10 years to repay the loan, beginning nine months after they graduate, leave school, or fall below half-time student status. No interest accrues while the student is in school.
Loans for Parents
The federal Parent Loan for Undergraduate Students (PLUS) allows parents to borrow money to supplement costs not already covered by the student's financial aid package, up to the full cost of attendance. PLUS loans are either provided by private lenders or by the U.S. government and are the financial responsibility of the parents, not the student. Eligibility for PLUS loans is not based on need. Repayment begins 60 days after the money is advanced. The interest rate changes on July 1st every year and is capped at a maximum.
PLUS loans are often good for families with income less than $100,000 because the interest on the loans is tax deductible for married couples filing jointly. The interest deductions on PLUS loans phase out at $130,000. Higher income families may opt to take out a home-equity line or home equity loan instead of a PLUS loan because the interest is deductible (as long as you itemize deductions) regardless of income.
Private Loans (also known as Alternative Loans)
Private loans can help supplement the difference between the amount of financial assistance received and the cost of attending a particular college. Private loans typically have higher interest rates than federal loans but many offer more flexible repayment options. For example, many private lenders allow parents to defer repayment until after their child has graduated, an option very few PLUS loans or no home-equity loans offer.
Saving for College
With the cost of college continuing to rise, it is important that parents start saving for their children's education as early as possible. Saving for a child’s education works just like a 401(k) does: the earlier you start, the better because of the advantage of compounding interest. The example below that illustrates the huge implications of starting to save early:
Two families each have a child that is 4 years old. One family decides to start saving money immediately for their child's education. They save $100 per month from the time their child is 4 to when the child turns 18. The other family decides to wait to save for their daughter's education to the time she turns 9. That family saves $200 per month from the time their daughter is 10 until 18. Assuming that both families earn 8% interest per year on their investment, who has more money saved for college?
It may surprise you that the family who started saving earlier will have more money saved for college! The first family contributed a total of $16,800 over the 14 years and will have a more than $30,800. The other family contributed more money, $19,200, over the 9 years and will have a little more than $26,750 or $4,000 less than the family who contributed less money but started earlier.
Coverdell Education Savings Accounts (ESAs)
Coverdell IRAs were previously called Educational IRAs. Coverdell accounts are trusts created solely to pay the qualified education expenses of the student designated as the beneficiary of the trust. Coverdell accounts work in a similar manner as Roth IRAs in terms of tax treatment and contributions.
What are “qualified education expenses” for ESAs? The government defines qualified education expenses as primary, secondary, and post-secondary education expenses such as tuition, fees, tutoring, books, supplies, room and board, uniforms, and transportation. Computers for students enrolled in post-secondary institutions are allowed as a qualified expense only if they are required by the school.
- Availability - Most banks and financial intuitions can establish and administer Coverdell IRA accounts.
- Contributions - All contributions are paid with after-tax money and are not deductible. A maximum of $2,000 per beneficiary from all sources annually and contributions may be made until the beneficiary reaches the age of 18. Corporations, including tax exempt, may contribute to the account. All contributions must be in the form of cash.
- Withdrawals - Money in the account must be for qualified education expenses and used by the time the beneficiary reaches age 30.
- Income Considerations - Contributions are phased out for single tax filers with incomes between $95,000 and $110,000 or for married couples filing jointly with incomes between $190,000 and $220,000.
- Investment Options - Funds within a Coverdell IRA can be invested in stock, bonds, mutual funds, and most other investment vehicles. The account owner can manage the investments or hire someone else to manage the account. The account balance fluctuates with market and investment performance.
- Financial Aid Implications - Coverdell IRAs are exempt from federal taxation. Earnings accumulate on a tax-deferred basis. Qualified distributions are exempt from federal income tax. Non-qualified withdrawals are taxed as ordinary income at the donor's rate and subject to a 10% penalty. In addition, if the funds are not used by the beneficiary's 30th birthday, earnings will be taxed as ordinary income plus a 10% penalty.
- Coordination with 529 Plans - Contributions can be made to both a Coverdell IRA and a 529 plan in the same year but there will be gift tax implications if more than $12,000 total is given to a single beneficiary within the same calendar year.
Section 529 Plans or Qualified Tuition Programs (QTPs)
Section 529 plans, which are also known as Qualified Tuition Programs (QTP), are an excellent way to save for a child's college education because they have higher contribution limits and more favorable tax treatment than other investments. Section 529 plans have two variations:
- Prepaid Tuition Plans - These plans lock in future tuition rates at in-state public colleges at the current tuition rate. These plans are usually guaranteed by the state the beneficiary lives in. Contributions to these plans do not guarantee admission into any of the qualifying colleges.
- College Savings Plans - These plans are designed to pay for the beneficiary's education expenses. They differ from Prepaid tuition plans in a number of ways, most notably the funds can be used at any college, both in-state and out-of-state, and contribution limits are significantly higher than those of prepaid tuition plans.
What are “qualified education expenses” for a 529 plan? The government defines qualified education expenses for Section 529 plans as tuition, fees, books, supplies, room and board, and uniforms. Room and board expenses are limited to the actual school charges, as published by the institution, for students who live in campus housing or school-owned housing. Computers for students enrolled in post-secondary institutions are allowed as a qualified expense only if they are required by the school for enrollment or attendance.
Gift & Estate Planning Benefits - Section 529 plans are great estate planning tools, especially for grandparents. Section 529 plans have an accelerated gift option which allows individuals to make gifts over $12,000 per year ($24,000 for married couple) without incurring any gift taxes or using any of the individual's or couple's lifetime exclusion. The maximum gift over five years is $60,000 for individuals and $120,000 for married couples. For example, a student's grandparent's could gift him $25,000 one year, $25,000 the next year, and $10,000 the third year. The grandparents could not gift money in the fourth or fifth year to the same beneficiary without paying gift tax or using part of their lifetime exclusion. In addition, contributions to 529 plans are considered to be a complete gift and are immediately removed from the donor's taxable estate.
In addition, contributions to 529 plans are considered to be a complete gift and are immediately removed from the donor's taxable estate.
Prepaid Tuition Plans
College Savings Plans
College savings plans are accounts that can be owned by the parent, the student, a small business owned and controlled by the parents, or the guardian of a child. They operate similarly to a 401(k) in terms of tax treatment and contributions. However, college savings plans have even higher contribution limits and more favorable tax advantages than 401(k)s do. College savings plans do not place any restrictions on the choice of college.
- Contributions - Any individual or small business can contribute to a college savings plan. Each state sets its own contribution limits. Most states base their limit amount on their estimate of the money required for seven years of post-secondary education. That being said, contribution limits range from $145,000 to $305,000. The median contribution limit is $235,000.
- Withdrawals - Money in the account must be for qualified education expenses and used by the time the beneficiary reaches age 30. Qualified distributions are exempt from federal income tax. Non-qualified withdrawals are taxed as ordinary income at the donor's rate and subject to a 10% penalty. In addition, if the funds are not used by the beneficiary's 30th birthday, earnings will be taxed as ordinary income plus a 10% penalty.
- Income Considerations - There are no income restrictions.
- Investment Options - Investment options are limited to the options provided by the plan. Most plans offer numerous investment options ranging from aggressive (100% stocks) to conservative (inflation-protection money market accounts). The account balance fluctuates with market and investment performance. Be sure to check the expenses and sales charges associated with the account because they may be higher than the charges associated with investing the money yourself.
- Financial Aid Implications - College savings plans have a low impact on financial aid because the money is treated as an asset of the parent or guardian, whose assets are assessed at a much lower rate than the student's assets according to the government's financial aid need formula. However, for families who qualify for need-based financial aid, withdrawals in any given year in that exceed the EFC (expected family contribution – the minimum the federal government determines a family will pay at any college) will usually result in a dollar for dollar reduction of the college’s portion of aid! Time your withdrawals carefully.
- Income Tax Implications - Earnings accumulate on a tax-deferred basis. Qualified distributions are usually exempt from federal, state, and local income tax. Non-qualified withdrawals are taxed as ordinary income at the donor's rate and subject to a 10% penalty.
- Coordination with Coverdell IRAs - Contributions can be made to both a Coverdell IRA and a 529 plan in the same year but there will be gift tax implications if more than $12,000 total is given to a single beneficiary within the same calendar year.
As you can see, there are many different financial aid, scholarship, loans, and savings plans available to help students and parents pay for college. The “rules” are always changing, though, so we encourage you to contact a qualified financial planner and review government and college websites to ensure that you are receiving the most up-to-date advice on paying for college.