Face it. Financial aid will probably not cover all college costs. So where can parents and students turn for help? Take a look at these strategies for financing college.
Whether college is around the corner or years down the track, it's not too late or too early to benefit from the various financing options available. Savings vehicles, tax breaks, and loan options can help families making the ultimate investment—a college education.
Saving Up for College
How you choose to save for college depends on the amount you can afford to save on a regular basis, your tolerance for risk, and the length of time before the student goes to college. Be sure to thoroughly investigate any savings vehicle before investing. Many of the options listed below come with limits on qualifying income and amounts that can be saved.
Coverdell Education Savings Account (ESA). An ESA allows post-tax investments until the student is 18. Earnings can be withdrawn tax-free when the student begins college, as long as withdrawals don't exceed qualified expenses. Although their annual investment limit is low compared to other college savings vehicles, ESAs make an excellent option for most families, especially when used in combination with other investments and if started early in the student's life.
529 College Saving Plan. A 529 savings plan is another investment option whose earnings are tax-free if used for qualified educational expenses. Annual investment limits are generous, allowing for substantial college savings. Each state has different rules, fees, and limitations for these accounts, so shop around.
529 Prepaid Tuition Plan. A 529 prepaid tuition plan is a savings account that allows contributors to pre-pay tuition and lock in a total tuition cost that is lower than they would otherwise pay. Some states offer these plans for in-state public colleges. A private college plan is available for over 270 private colleges. Students and families should be confident the student will attend an in-state college or a private college covered by a tuition plan. There are options, however, to transfer the assets to other schools or beneficiaries if the student's plans change.
Individual Retirement Account (IRA). Traditional and Roth IRAs are savings accounts intended for retirement, but account owners are also allowed to use them for qualified college expenses without penalty. Many people choose a Roth IRA for college saving because of its flexible rules for withdrawing money before retirement age, and because the earnings are generally tax-free. Those who have sufficient sources of retirement income from other investments may be interested in exploring the use of IRAs for college saving.
Custodial account. A custodial account is opened in the child's name and is governed by the Uniform Gift to Minors Act. Earnings up to a certain limit are taxed at the child's lower rate until age 18 or until age 24 if the child is a full-time student. The child assumes full control of the money at age 18. These accounts are less advantageous for college savings because they are counted as a student asset, thus reducing financial aid eligibility. Parents may not transfer the account to themselves, but they may transfer it to a 529 plan with no penalty.
Bank savings account. Everyone is familiar with old-fashioned bank savings accounts, which the government guarantees up to a certain limit. Unfortunately, such accounts don't earn much interest and may not be the best choice for a long-term college savings plan.
Savings bonds. The federal government allows tax-free interest on EE/E and Series I Savings Bonds when they are used for qualified college expenses. They are guaranteed by the U.S. government to earn a fixed amount or fixed rate of interest. Bonds historically yield a low rate of return. However, if purchased for a young child, they provide a safe, guaranteed return once college rolls around.
Life insurance. A variable life insurance policy can be used as a tax-deferred, long-term savings account. Funds can be used for any purpose, including college. Withdrawals are tax-free and the value of the policy is sheltered from financial need calculations. However, commission fees and premiums can significantly reduce investment gains. And if you change your mind, closing the account early in the child's life incurs serious penalty fees.
Borrowing for College
For many families, loans represent an important source of college funds. Loans can come from the government or from private lenders. Families should obtain federal loans before private loans. The federal loans have lower interest rates and fees than most private loans and are guaranteed by the government.
Federal education loans. The federal government offers several college loans, such as Stafford loans, which the government at least partially guarantees. They are easier to qualify for than other types of loans. If a student applies for and receives financial aid, at least some of the aid will likely include these loans. Federal interest rates are typically lower than rates offered by private lenders. A variety of reasonable repayment plans helps make repayment manageable.
Private borrowing. Private education loans are offered by private lenders, such as banks. Loan limits and interest rates are usually higher than for federal loans. Personal loans, such as loans using a home or other real estate as collateral, may also be used. These loans may make sense if financial aid and other resources don't cover all college expenses.
For more information on loans for college, see the article Borrowing Options for College.
Paying Tuition Over Time
Tuition payment plans offer short-term credit, so tuition can be paid over the school year rather than at registration. Usually a good credit history is needed to qualify for one of these plans. Either a private company or the college itself administers the plan and charges a service fee. In most cases, all tuition must be paid, even if the student drops out early.
Tax Savings from College Expenses
Using college expenses to save on taxes is another way to help pay for college. However, qualifying can be tricky. With the exception of the student loan interest deduction, the tax payer cannot claim more than one tax benefit for the same student in the same year. A tax break cannot be claimed for expenses already covered by scholarships or grants.
The American Opportunity credit. Through 2017, families can take the American Opportunity tax credit based on qualified expenses paid per student for each of the first four undergraduate years of college.
The Lifetime Learning credit. This tax credit is based on qualified expenses paid during the tax year for undergraduate, graduate, or professional instruction. Unlike the American Opportunity tax credit, graduate students and students attending school less than half-time are eligible.
The student loan interest deduction. This tax deduction reduces taxable income based on qualified tuition and fees paid with a student loan during the tax year.
The tuition and fees deduction. This tax deduction reduces taxable income based on qualified tuition and fees paid during the tax year.
For more information on qualified expenses, tax saving limits, and income limits, see the article Tax Breaks for College.
Investing from birth to age six. According to many college financial advisors, parents investing from the time of a child's birth until age six should focus on both stocks and bonds. Investing in a combination of riskier "aggressive" and "growth" funds is okay at this early stage.
Investing from age 7 to 13. When the student is 7 to 13 years of age, switch to less aggressive investments, such as conservative index funds or Treasury Bills and all types of bonds. Five-year Certificates of Deposit are recommended. Also, consider investing in state prepaid tuition and college savings plans.
Investing from age 14 to college. When the student is 14 years old, switch to even safer investments such as Series EE/E U.S. Savings Bonds. They don't produce much growth, but they are safe and usually completely tax-free if used for qualified educational expenses. This is also a good time to start investigating the various financial aid options that can help cover college expenses.
Be Careful About Who Owns the Investment
In the past, parents often placed college investments in the child's name to take advantage of the child's lower tax rate. But due to changes to the tax law, annual investment income over $1,900 is taxed at the parents' rate if the investments are held by children under age 19 or by full-time students under age 24. (Gains from 529 accounts, Coverdell Education Savings Accounts, and some bonds are not taxed if used for eligible college expenses no matter who owns the account.)
Another consideration is how the government counts assets when calculating financial aid. When the government figures what a family should pay for college, the assets belonging to dependent students count nearly four times more than assets belonging to their parents. Plus, a generous portion of parental assets are entirely excluded from the calculation, depending on the older parent's age. That means that saving in a parent's name is likely to be more advantageous than saving in the student's name. One benefit of owning a 529 account is that it is considered a parent asset, even if it is owned by a student.
If You Haven't Started
Have you and your family been thinking more about which college to attend than about how to finance your education? If so, it's time to get down to the business of paying for it. Even if the student is starting college in less than two years, some of these financing options may still be useful. Be sure to look at other articles on borrowing and saving in CollegeData's Pay Your Way section.
Before You Go Further
These methods have been used successfully by many families, but they may not be relevant in your case, so seek the advice of an experienced college financial advisor—perhaps your accountant or financial planner—to help you choose the optimal investments.
Note: Financial information provided on this site is of a general nature and may not apply to your situation. Contact a financial or tax advisor before acting on such information.