Paying for College (Morningstar)

The Short Answer

Ways to Pay for College If Your 529 Isn't Enough

By Karen Wallace | 11-24-15 | 06:00 AM | Email Article

Question: The amount we've saved in our child's 529 account will likely not cover the full cost of college. What are our options? Is there an order to tap other assets that makes the most sense?

Answer: There are many considerations, and the best strategy will, of course, depend on your individual situation. In addition to taking stock of the assets your family already has available to pay the bill in various college-savings accounts (529s, Coverdells, UGMA/UTMA accounts, and so on), you'll also want to assess whether your child might qualify for scholarships, grants, and credits.

Definitely do not skip the step of filling out and submitting a Free Application for Federal Student Aid, or FAFSA; schools use the information reported on the FAFSA to determine how much aid you qualify for. Also, remember to fill it out every year you plan to attend college. Bear in mind that colleges define "aid" more broadly than you or I might. Some of this aid will need to be paid back (such as loans), and some of it will not (such as grants and scholarships).

The amount of financial aid you are eligible to receive is based on your "financial need," which is the difference between the cost of attendance (determined by each school) and the expected family contribution (a measure of the family's financial strength, calculated according to a formula established by law). So, the lower your expected family contribution and/or the higher the cost of attendance at the school, the greater your financial need.

1) Grants and Scholarships
Grants and scholarships are among the most desirable forms of financial aid and should be considered first. Grants and scholarships, also sometimes referred to as "gift aid," are essentially free money--they are financial aid that doesn't have to be repaid. Grants are often need based, while scholarships are usually merit based. Do your research to find out which grants or scholarships you might be eligible for and what their application deadlines are. (One caveat, however: Per theDepartment of Education's website, you might have to pay back part or all of a grant in the event you withdraw from school before finishing an enrollment period such as a semester.)

2) The AOTC 
If you are eligible for the American Opportunity Tax Credit (AOTC), carve out $4,000 in college expenses to be paid with cash or loans ahead of all other sources of money, advises Mark Kantrowitz, a financial-aid expert. You can then use the AOTC to offset those expenses. The AOTC isn't available to everyone: Qualified taxpayers with modified adjusted gross incomes of $80,000 or less (or $160,000 or less for joint filers) qualify for the full credit. Taxpayers earning more than this may qualify for a partial credit, but a taxpayer whose MAGI is greater than $90,000 ($180,000 for joint filers) cannot claim the credit. For more on this, click here.

The reason that AOTC-eligible families should carve out $4,000 of tuition and textbook expenses each year that will be paid for with cash or loans is because the AOTC is worth more than the tax-free 529-plan distribution. The AOTC yields a dollar-for-dollar tax credit based on the first $2,000 of tuition and textbook expenses, then $0.25 on the dollar for the next $2,000). It's also important to remember that you can't use the same qualified higher-education expenses to justify two education tax benefits. For example, you can't use a tax-free distribution from a 529 plan to pay for tuition and textbook expenses that you also want to use to justify the AOTC.

3) Federal Student Loans
As a next step, Kantrowitz recommends figuring out how much of a gap you'll have beyond need-based aid and the 529-plan money, and whether some of it can be covered with Direct Subsidized Loans or Direct Unsubsidized Loans, which have low fixed interest rates and do not require a credit check.

One of the benefits of subsidized loans is that the U.S. Department of Education pays the interest for you if you're in school at least half-time and for a limited grace period after you leave school. This makes subsidized loans a better deal for the borrower than other types of loans, where interest begins to accrue immediately. In addition, subsidized loans have low fixed interest rates--the current rates are 4.29% on a Stafford loan for an undergrad and 5% on a Perkins loan.

Another option is unsubsidized Stafford loans, which are available to all students regardless of financial need. The unsubsidized federal Stafford loan has a fixed interest rate that is among the lowest available interest rates for unsecured debt (currently 4.29% for an undergrad) that is not based on the borrower's credit, Kantrowitz points out. Though the limits are higher than with subsidized Stafford loans, there are also limits to how much you can borrow with unsubsidized Stafford loans.

4) Spend Down Certain Types of Student-Owned Assets Before 529 Assets
In terms of drawing down different types of college-savings accounts, some important considerations have to do with how different assets are "counted" when calculating the expected family contribution. If possible, you should first spend down any assets that have a bigger impact on reducing the aid a student is eligible to receive.

For instance, if you have one, UGMA and UTMA accounts should be spent down before taking a qualified distribution from a 529 plan. The reason is that UGMA/UTMA assets are student owned and reduce financial-aid eligibility by a harsher 20% of the asset value. For this reason, Kantrowitz recommends spending the assets in UGMA/UTMA accounts down to zero before taking a qualified distribution from the 529 plan. Likewise, savings accounts, real estate, mutual funds, or stocks and bonds held in the student's name can also have a bigger impact in terms of reducing the aid a student is eligible to receive.

5) Spend 529-Plan Money to Fill In Any Remaining Gaps
Assets in a 529-plan account can also reduce aid eligibility, but not to the same extent that UGMA/UTMA and other types of student-owned assets can. If the 529-plan account is owned by a dependent student or the dependent student's custodial parent, it is reported as a parent asset on the FAFSA. In a worst-case scenario, this will reduce aid eligibility by up to 5.64% of the asset value, Kantrowitz said.

6) Federal Parent PLUS Loan
Another option is to use a federal Parent PLUS loan to address any remaining gaps that can't be covered by grants and scholarships, student loans, and 529 assets, Kantrowitz says. The PLUS loan has a fixed interest rate for the life of the loan (currently 6.84%), plus a loan fee.

Unlike with student loans, the Parent PLUS loan does depend on the borrower's credit history, but the credit check may not be as stringent as with some private loans. That said, Kantrowitz points out that borrowers with excellent credit may be able to qualify for a lower interest rate on a private loan than on the federal Parent PLUS loan. (Just be aware that if you sign up for a variable-rate loan, rates really have nowhere to go but up from here.)

Kantrowitz also points out that needing to borrow a Federal PLUS loan or a private student or parent loan may be a sign of overborrowing. Although taking on debt to finance college is unavoidable in many cases, there are some important considerations. In terms of students taking on debt, an oft-cited rule of thumb is that their total education debt should be less than their expected starting annual salary--otherwise, they will have trouble paying back that loan debt. Likewise, it's a good idea for parents to be conservative about how much debt they can comfortably take on, particularly as they near retirement and may have reduced incomes and fewer resources available to pay off the loans.

Karen Wallace is a senior editor with Morningstar.com.

Money for College - Dos and Don'ts (Morningstar)

Dos and Don'ts of College Savings

Knowing financial aid rules is key given the rising cost of higher education.

Morningstar, 04/27/2012


Investor Question: I'm worried about how we're ever going to afford college for our children. What can we do to increase their odds of getting financial aid in case we can't save enough?

Answer: For many families, the cost of college has become daunting. Tuition, fees, room, and board at a public four-year school currently run $17,131 per year on average (in-state), and $38,589 per year for a private four-year school, according to the College Board. During the past decade, in-state tuition and fees at public universities have increased on average 5.6 percentage points per year beyond the rate of inflation. No wonder, then, that many parents are losing sleep worrying about how they will be able to pay for their children's college education and how much help they can expect from financial aid.

But whether college is just around the corner or years down the road for the student, there are many steps parents can take to improve their odds of making it affordable, including qualifying for financial aid. Below are some ideas to help get them started. Keep in mind that some financial aid is need-based while some is not and that aid includes not just grants and scholarships, but also work-study programs and loans.

Do: Start Saving as Soon as Possible
Some parents worry that saving for college will negatively affect their student's chances for financial aid. But that's misguided, says college planning expert Mark Kantrowitz, publisher of FinAid, an online guide to college funding. "There's this perception that you'd be better off not saving anything," Kantrowitz says, "but the reality is most of the financial aid you're likely to get is going to be in the form of loans, which you're better off not having to pay."

Kantrowitz estimates that every dollar saved for college potentially reduces a student's borrowing costs by two. He suggests parents and students start saving for college as early as possible, noting that he started saving for his children to go to college before they were even born.

Kantrowitz likes 529 accounts as college-savings vehicles in part because of their tax deductibility (in some states), which he likens to "getting a discount on college costs." (You can visit Morningstar.com's 529 Plan Center here.)

Do: Apply for Any Scholarships for Which the Student Might Be Eligible

Applying for scholarships costs nothing but time, and the payoff could make a big difference in reducing out-of-pocket college costs. An obvious place for parents to start is by filling out the Free Application for Federal Student Aid, or FAFSA, the federal government's form for need-based grants, loans (both need-based and non-need-based), and work-study opportunities. Good online resources for scholarship searches include Fastweb and Scholarships.com. Kantrowitz says about one out of eight incoming freshmen at four-year colleges are on some kind of scholarship, with the average amount around $2,800 per student. "The students who win a lot of money are the ones who apply for every scholarship for which they are eligible," he says. One important tip when applying for scholarships: The more optional information provided, the better the odds of matching. For example, if a student or parent has had cancer, including that in the student's profile helps improve his or her chances of matching one of the many scholarships related to the disease.

Do: Have Kids Close Together in Age

Financial aid formulas are weighted heavily on parental income, and having multiple kids in college at the same time actually improves financial aid eligibility because it reduces the amount parents are expected to pay for each. This helps ease the burden on families having to pay two or more tuitions simultaneously. "Someone who has twins is going to get more aid than someone who has single children separated by four years," Kantrowitz says. Of course, it may be a little late to put this plan into action for most parents, but it also works if, say, a parent attends college at the same time as their child or children. Having an older child delay college to attend at the same time as a younger sibling also works.

Don't: Put Assets in the Student's Name

In financial aid calculations, assets belonging to parents have less of a negative impact than those belonging to students. So money in a 529 plan, which is considered the parents' property, counts less against financial aid than, say, money held in a custodial account such as a UGMA/UTMA, which is legally considered the student's property. One way around this problem is to spend down the student's assets before applying for aid. UGMA/UTMA funds can be used for a wide variety of qualifying expenses, so long as they are for the minor's benefit. Incidentally, money in a 529 opened by a grandparent on behalf of a student does not count against financial aid.

Don't: Count on the Student Getting a Full-Ride Scholarship

Expecting a child's academic or athletic brilliance to bail the parents out from having to pay for college? Think again. Fewer than 0.3% of students win full-ride scholarships or need-based full-ride grants, says Kantrowitz, whereas about two thirds of all undergraduates receive some kind of financial aid, including student loans.

Don't: Sell Assets the Year Before Applying for Aid

A common mistake parents make, Kantrowitz says, is to sell a large chunk of taxable investments to help pay for college the year before applying for aid. This might trigger capital gains that add to parental income and thus reduce financial aid eligibility. (Converting traditional IRA assets to a Roth can also add to taxable income, thereby hurting financial aid eligibility.) Keep in mind that students usually must reapply for financial aid each year, so holding off and waiting a year to sell might not help. It's best to plan ahead if possible by putting funds for college in a 529, where their impact on financial aid is reduced.


Other Financing Methods, With Caveats

Some parents opt to use their retirement accounts to help fund college costs. This has its advantages and disadvantages. The biggest advantage to this approach is that the 10% penalty for early withdrawals is waived if the money is used for qualified college expenses. Also, Roth IRA contributions might be withdrawn tax-free, though any earnings on those contributions are subject to regular income tax rates. All withdrawals from traditional IRAs are subject to regular income tax rates. The problem with this approach is that all IRA withdrawals, whether taxed or not, count as total parental income in financial aid calculations. So even though parents might save on taxes or penalties by doing this, they might also make it more difficult for the student to obtain need-based financial aid.

Borrowing from work-based retirement accounts, such as a 401(k) or 403(b) plan, is another option and does not affect need-based financial aid. However, the loan must be repaid within five years, and possibly immediately in the case of job loss. Parents might be eligible for hardship withdrawals, but those are subject to income taxes and penalties.