If you are a parent, you have thought about it, at least once: “Oh my, I need to start saving so my kids can go to college someday.” It is a natural instinct that we parents have, the instinct to take care of our offspring. But saving for college is not for the faint of heart. In some ways, it is simple – just set aside money, and you are done. However, there is really more strategy to it than that. Let’s examine all the Jedi skills that are involved with this task.
First, let me just say that the way the college funding system works right now is quite unfair. If you are careful and conservative with your finances, have a good emergency fund, don’t carry lots of debt, and save a bundle for your child’s college expenses, you will not fare well in the college financial aid department. Merit-based aid is different, of course. For our purposes here, however, we are only addressing need-based aid.
On the other hand, if you are not very good with your money, and you have racked up debt and have very little home equity and no college savings, you are considered to be at greater need for college funding. For years this has been a thorn in my side, the unfairness of this system. That said, let’s focus on working within the system as it stands, and figure out the best Jedi strategies for college saving. All these tips are based on how the financial aid system works right now. Who knows what changes will come to the system down the line? We can always correct course if substantial changes occur.
First and foremost, we recommend that people maximize all retirement savings vehicles before they even consider funding college savings vehicles of any sort. If your employer provides a plan that you can contribute to, maximize what you fund there, especially if there is an employer match. Also fund a Roth IRA to its maximum limit if you are eligible to do so. Why this focus on retirement savings? Because according to the financial aid formula, no retirement accounts are counted as being available to fund college. In addition, contributions to a Roth IRA could be withdrawn to pay for college expenses, if the need arises. Only the contributions work this way, however, and not the growth, which would be taxed and penalized if withdrawn prior to age 59.5. You may also be able to access your other retirement accounts with little to no penalty to fund college when the time comes.
If you find that you are maximizing all retirement vehicles you are eligible to fund, you can turn your thoughts to funding an actual account for college. In most cases, the best approach is to not open the account in your child’s name. Assets that the child owns are considered fully available to fund college expenses. A better approach is to have the money in the parent’s name.
In addition to qualifying for the maximum need-based aid possible, there is another reason for holding assets in the parent’s name. People tend to think fondly on the idea of opening an account for their children. They think, it will teach them about money! They will be responsible! But sadly, this is not always the outcome. Consider this scenario: You diligently set aside money in an account in Junior’s name every month from the start, invest it for growth, and by the time Junior is 18, the account is pretty large. (Just for a fun example, $100 per month invested from birth to age 18 at 7% growth would be worth over $43,000 at the magic age of 18!)
Sounds great, right? While some back patting should be in order considering how disciplined and steady you were in achieving this goal, you might have a very large problem now. In North Carolina, children become adults at age 18. What if Junior is now fresh out of high school, and has zero ambition to attend college? What if touring across America with his grunge band is what he aims to do? Well, legally that money is his, to do with as he pleases.
I jokingly (or maybe half-jokingly) tell people that a way around this problem is to never tell Junior that he has an account in his name. Then you can stall until he’s on the ‘right road’ to let him know he’s rich. A better and more appropriate strategy is to not fund it in his name from the start. If it is in your name, it is in your control, permanently.
A popular vehicle for funding college is the Section 529 College Savings Plan. Money contributed to a 529 plan grows tax-deferred, and it can be withdrawn tax-free for qualified education expenses. If the parent owns it, it is assessed by financial aid officers at a lower level than an asset owned by the child. Another alternative, and this is advanced Jedi training, have the grandparents own it. Then it is not counted at all as an asset available for college funding. (However, distributions the grandparents might take to help pay for college will count as student income, so Master-level Jedi techniques must be employed to avoid that. Those are beyond the scope of this article.)
The main objection some people have to funding a 529 plan is, “What if I fund it for years, and Junior never goes to college?” Well, that is unfortunate, but two strategies can then be deployed. The owner of the plan can change the beneficiary of the plan. So if you have other children or family members (including yourself) that might actually use the money for college or graduate school, you can simply change the beneficiary to the college-bound child and proceed on. Alternatively, you can withdraw the money for non-college expenses and just take the tax and penalty hit. Only the earnings in the plan, not the contributions, would be subject to a 10% penalty and would be taxed as income. My opinion is this is a pretty minor consideration, and I would err on the side of funding for college and not worry much about the “what if he doesn’t go to college” question.
All the rules for funding and taking distributions from 529 plans are easily found online. My goal here is to look at the bigger planning picture and provide some guidance that might best position you for financial aid. If your children are young, focus on saving for college, but do so by first maximizing your own retirement savings. Since you have no way to know what your income level might look like when college rolls around, it is better to be as prepared as possible with savings, despite the skewed financial aid system.
Now go forth and save, and may the Force be with you.
Dawn Starks is a CERTIFIED FINANCIAL PLANNER™ practitioner and financial advisor at Starks Financial Group, an independent firm. Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC. This article expresses the opinions of Dawn Starks and not necessarily those of Raymond James. You should discuss any tax or legal matters with the appropriate professional.
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Asheville, NC 28801