The Impact of Investing for College Costs
Many well-intentioned parents want to save for their children’s future educational expenses. The mistake that they often make, however, is putting money in accounts in the child’s name (in so-called custodial accounts) or saving outside retirement accounts in general. The more money you accumulate outside tax-sheltered retirement accounts, the more you will generally end up paying for college costs.
Under the current financial needs analysis used by most colleges and universities in awarding “financial aid” (that is, how much of their very high sticker price they will charge you), the value of your retirement plan is not considered to be an asset. Money that you save outside retirement accounts, including money in the child’s name, is counted as an asset and reduces eligibility for financial aid.
Also, be aware that your family’s assets, for purposes of financial aid determination, generally include equity in real estate and businesses you own. Although the federal financial aid analysis no longer counts equity in your primary residence as an asset, many private (independent) schools continue to ask parents for this information when they make their own financial aid determinations. Thus, paying down your home mortgage more quickly instead of funding retirement accounts can harm you financially. You may end up paying more for college costs and pay more in taxes.
Make it a priority to contribute to your retirement savings plan(s). If you instead save money in a nonretirement account for your children’s college expenses, you will pay higher taxes both on your current income and on the interest and growth of this money. In addition to paying higher taxes, you’ll be expected to pay a higher price for your child’s educational expenses.
If you’re sufficiently wealthy that you expect to pay for your children’s full educational costs without applying for financial aid, you can save some on taxes if you invest through custodial accounts. Prior to your child’s reaching age 19, the first $2,100 of interest and dividend income is taxed at your child’s income tax rate rather than yours. After age 19 (for full-time students, it’s those under the age of 24), all income that the investments in your child’s name generate is taxed at your child’s rate.
Paying for college
If the way in which the financial aid system works effectively encourages you to save in your own retirement accounts, how will you pay for your kid’s education expenses? Here are some ideas and resources:
- Home equity: You can borrow against your home at a relatively low interest rate, and the interest is generally tax-deductible.
- Company retirement plans: Some 401(k)s allow borrowing for educational costs.
- Student loans: Several financial aid programs allow you to borrow at reasonable interest rates. The Unsubsidized Stafford Loans and Parent Loans for Undergraduate Students (PLUS), for example, are available, even when your family isn’t deemed financially needy.
- Grants and scholarships: Grant programs are available through schools and the government, as well as through independent sources. Complete the Free Application for Federal Student Aid (FAFSA) application to apply for the federal government programs. Grants available through state government programs may require a separate application. Specific colleges and other private organizations — including employers, banks, credit unions, and community groups — also offer grants and scholarships.
- Work and save: Your child can work and save money during high school and college. In fact, if your child qualifies for financial aid, she’s generally expected to contribute a certain amount to education costs from employment (both during the school year and summer breaks) and from savings. Besides giving your gangly teen a stake in her own future, this training encourages sound personal financial management down the road.
Considering educational savings account options
You’ll hear about various accounts you can use to invest money for your kid’s future college costs. Tread carefully with these, especially because they can affect future financial aid.
The most popular of these accounts are qualified state tuition plans, also known as Section 529 plans. These plans offer a tax-advantaged way to save and invest more than $100,000 per child toward college costs. (Some states allow upward of $300,000 per student.) After you contribute to one of these state-based accounts, the invested funds grow without taxation. Withdrawals are also tax-free provided the funds are used to pay for qualifying higher-education costs (which include college, graduate school, and certain additional expenses of special-needs students). The schools need not be in the same state as the state administering the Section 529 plan.
Section 529 plan balances can harm your child’s financial aid chances. Thus, such accounts make the most sense for affluent families who are sure they won’t qualify for any type of financial aid. If you do opt for a 529 plan and intend to apply for financial aid, you should be the owner of the accounts (not your child) to maximize qualifying for financial aid.
Investing money earmarked for college
Diversified mutual funds and exchange-traded funds, which invest in stocks in the United States and internationally, as well as bonds, are ideal vehicles to use when you invest money earmarked for college. Be sure to choose funds that fit your tax situation if you invest your funds in nonretirement accounts.
When your child is young (preschool age), consider investing up to 80 percent of your investment money in stocks (diversified worldwide) with the remainder in bonds. Doing so can maximize the money’s growth potential without taking extraordinary risk. As your child makes his way through the later years of elementary school, you need to begin to make the mix more conservative. Scale back the stock percentage to 50 or 60 percent. Finally, in the years just before the child enters college, reduce the stock portion to no more than 20 percent or so.
Some 529s offer target-date-type funds that reduce the stock exposure as target college dates approach so you don’t have to make the adjustments yourself.