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YOUR CHILD'S COLLEGE EDUCATION:
How To Finance It
|How can you properly fund your childrens education without draining your
current cash flow? What should you do if they are a few years away from college and your
education fund wont be enough? How can you increase your chances of getting
financial aid? What tax benefits might be available to you? This Financial Guide answers
TABLE OF CONTENTS
Savings And Investment Strategies
If You're Caught Short
Sources Of Financial Aid
How To Reduce Taxes
With the costs of a college education rising every year, the keys to funding your
childs 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.
The thought of funding your childs educationthe cost of which has grown at
about 6% a yearcan be staggering. However, 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 childs education.
Start Saving Early
We cannot emphasize enough that getting an early start is basic to funding your
childs education. The earlier you start, the more youll benefit from the
compounding of interest.
|Planning Aid: For an estimate of the amount of money you would have
at the time your child enters college if you begin saving now, see the Financial
Calculator: College Savings Calculator.
When should you start saving? This depends on how much you think your childrens
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 youll need $120,000 to finance his college education 18 years from
now. If you start putting away money immediately, youll need to save $3,500 per year
for 18 years (assuming an after-tax return of 7%) . On the other hand, if you put off
saving until the child is six years old, youll have to save almost double that
amount every year for twelve years.
Another advantage of starting early is that youll have more flexibility when it
comes to the type of investment youll use. Youll 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.
Find Out How Much Youll Need To Save
How much will your childs education cost? It depends on whether your child
attends a private or state school. In the late-90s, the total expenses--tuition, fees,
board, personal expenses, and books and supplies--for the average private college are
about $21,000 per year and about $10,000 per year for the average public college.
However, these amounts are averages: the tuition, fees, and board for some private
colleges can cost more than $25,000 per year, whereas the costs for a state school can be
kept under $10,000 per year.
|Planning Aid: To find and select the best college's) for your child
from a database of over 3,200 two-and four-year colleges, see College Search.
Dont forget to add the costs of graduate or professional school to the amount
your child will need.
|Planning Aid: If youre 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% per year. For the most recent increases, refer to Average Increases In
College Tuition And Fees From 1998 To 1999.
Choose Your Investments
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
you start your savings planthe 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.
The following are often recommended as investments suitable for education funds:
Series EE Bonds are extremely safe investments. For tax treatment of redemption proceeds used for college, please see the Financial Guide: HIGHER EDUCATION COSTS: How To Get The Best Tax Treatment.
U.S. Government Bonds are also safe investments that offer a
relatively higher return. If you use zero-coupon bonds, 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 dont 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 youre 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 childs 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% and you are in the 30% tax
bracket, the equivalent taxable return is 7.1% (5% divided by 70%).
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% premature
If you have insufficient savings for your childs 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:
- You can start saving as much as possible during the remaining years. However, unless
your income level is high enough to support an extremely stringent savings plan, you will
probably fall short of the amount you need.
- You can take on a part-time job. However, this will raise your income for purposes of
determining whether you are eligible for certain types of student aid. In addition, your
child may be able to take on part-time or summer jobs
- You can tap your assets by taking out a home equity loan or a personal loan, selling
assets or borrowing from a 401(k) plan.
|Planning Aid: If you are planning on borrowing for your
childs education, see the Financial Calculator Parent Debt
Calculator to get some insight as to your capacity to take on additional debt
and the Parent Loan
Repayment Calculator for help in estimating your
- You (or your child) can apply for various types of student aid and education loans
(discussed below and in InfoSources).
||Related FG: For further information on Equity
Loans, please see the Financial Guide: HOME
EQUITY LOANS: How To Shop For The One That's
Best For You.
||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 youre 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.
- Pell grants are federal aid based on need.
|TIP: Dont 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.
- State education departments may make grants available. Inquiries should be made of the
state agency. Employers may provide subsidies.
- Private organizations may provide scholarships. Inquiries should be made at schools.
- Most schools provide aid and scholarships, both needs-based and non-needs-based.
- Military scholarships are available to those who enlist in the Reserves, National Guard,
or Reserve Officers Training Corps. Inquiries should be made at the branch of service.
|TIP: Try negotiating with
your preferred college for additional financial aid, especially if it offers less than a
Loans may be need-based, and others are not. Here is a summary of loans:
- Stafford loans (formerly guaranteed student loans) are federally guaranteed and
subsidized low-interest loans made by local lenders and the federal government. They are
needs-based for subsidized loans; however an unsubsidized version is also available.
- Perkins loans are provided by the federal government and administered by schools. They
are needs-based. Inquiries should be made at school aid offices.
- Parent loans for undergraduate students (PLUS) and supplemental loans for students are
federally guaranteed loans by local lenders to parents, not students. Inquiries should be
made at college aid offices or by calling 800-333-4636.
- Schools themselves may provide student loans. Inquiries should be made at the school.
Work-Study Programs. This is a program that is federally funded and based
on the familys 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 schools 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
There are a number of techniques that you can use to try to increase the amount of
financial aid or to reduce tax on the income being accumulated.
How To Increase The Amount Of Financial Aid
Here are some strategies that may increase the amount of aid for which your family is
1. Try to avoid putting assets in your childs name. As
a general rule, education funds should be kept in the parents names, since
investments in a childs name can impact negatively on aid eligibility. For example,
the rules for determining financial aid decrease the amount of aid for which a child is
eligible by 35% of assets the child owns and by 50% of the childs income.
|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% of your assets and from 22 to 47%
of your income.
2. Reduce your income. Income for financial aid purposes is
generally determined based upon your previous years income tax situation. Therefore,
in the years immediately prior to and during college, try to reduce your taxable income.
Some ways to do this include:
- Defer capital gains.
- Sell losing investments.
- Reduce the income from your business. If you are the owner of your own business, you may
be able to reduce your taxable income by taking a lower salary, deferring bonuses, etc.
- Avoid distributions from retirement plans or IRAs in these years.
- Pay your federal and state taxes during the year in the form of estimated payments
rather than waiting until April 15 of the following year.
- Since a portion of discretionary assets is included in the familys expected
contribution from income, reduce discretionary assets by paying off credit cards and other
- Take advantage of vehicles which defer income, such as 401(k) plans, other retirement
plans or annuities.
3. Detail your financial hardships. If you have any financial hardships,
let the deciding authorities know (via the statement of financial need) exactly what they
are, if they are not clear on the application. The financial aid officer may be able to
assist you in explaining hardships.
4. Have your child become independent (if feasible). In this case, your
income is not considered in determining how much aid your child will be eligible for.
Students are considered independent if they:
- Are at least 24 years old by the end of the year for which they are applying for aid,
- Are veterans,
- Have dependents other than their spouse,
- Are wards of the court or both parents are deceased,
- Are graduate or professional students or
- Are married and are not claimed as dependents on their parents returns.
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 childs 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
In the past, parents would invest
in the childs 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 $1,600 for 2005 (the same as
for 2004) of children under the age of 14 is taxed at the parents
rate. (This threshold is indexed annually for inflation.) Once the child
reaches age 14, however, all income is taxed at the childs rate.
Of this $1,600, one-half probably wont be taxed due to the availability
of the standard deduction while the other half would be taxed at the childs
||Note: These rules apply to
unearned income. If a child has earned income, this amount is always taxed at the
childs rate. If you decide to invest in your childs name, here are some tax
strategies to consider:
- You can shift just enough assets to create $1,600 in taxable income
to an under-14 child.
- You can buy U.S. Savings Bonds (in the childs name) scheduled
to mature after your child reaches age 14.
||Caution: Buying in the childs name forfeits tax relief otherwise available where bonds are redeemed to pay college expenses.
- You can invest in equities that pay small dividends but have a lot
of potential for appreciation. The income earned when your child is
under 14 will be minimal, and the growth in the stocks will occur over
the long term.
- You can, under The Uniform Gifts/Transfers to Minors Acts, establish
a custodianship for your child. Gifts to children under these acts are
irrevocable, so you run the risk that your child will use the money
for non-educational purposes once he or she reaches the age of majoritya
determining negative factor for many parents.
- You can set up a trust for your child.
- If you own a family business, you can employ your child in the business.
Earned income is not subject to the "kiddie-tax," and is deductible
by the business if the child is performing a legitimate function. Additionally,
if your business is a sole proprietorship and your child is under 18,
then he or she will not pay social security taxes on the income.
There are also a number of tax incentives that you might be able to
take advantage of. Please see the Financial Guide: HIGHER EDUCATION COSTS: How To Get The Best Tax Treatment.
by month suggestions and ideas to improve your financial life.
Books and Other Publications
- The College Boards College Cost Book (available through high school
guidance counselors or libraries).
- The ACTs College Planning/Search Book (available through high school
guidance counselors or libraries).
- Guide To Scholarships And Fellowships For Math And Science
Students (Prentice Hall, 800-643-5506)
College Student's Guide to Merit and Other No-Need Funding:
Reference Service Press.
The Student Access Guide to Paying for College
(Random House, 800-733-300, cost:
Dont Miss Out: The Ambitious Students Guide to Financial Aid (Octameron
Associates, 703-836-5480, Cost: about $7). (Octameron has other titles relating to college
admissions and financing available.)
Government And Non-Profit Agencies
- U.S. Department of Education (for information on financial aid): 800-433-7327