College Funding: Four Ways to Save for College
Updated: Nov 8, 2020
1. Don’t Do Anything
Strangely, this is a form of savings. Here’s why: If you don’t save, you’ll probably have to borrow; and, borrowing, assuming you intend to repay, is nothing more than deferred saving.
2. Specific College-Savings Vehicles
Sponsored by states, “529s” (named after the IRS-enabling section) are the most popular
method of college savings. More than 10 million 529 accounts have been opened. Any investment growth is tax-free -- assuming the money is used for “qualified higher education expenses”. Your investment contribution may also be deductible from income on your state tax return. There are two types of 529 investments:
Pre-Paid 529s:These simply guarantee you future tuition at today’s price. For example, if you’re a Pennsylvania state resident, you can purchase one year’s undergraduate tuition at Penn State University, main campus 2020 - 2021 rates: $23,418 and $39,457 for out-of-state students. The graduate tuition has been risen by 1.84% for Pennsylvania residents and increased by 1.88% for out-of-state rates from the previous year.
Even if your son or daughter is 14 years away from college, in 14 years, you will own the equivalent of one year of tuition at Penn State. The funds can be applied to any college’s tuition bill. The risk of investing your money well enough to cover future tuition increases is assumed by the sponsoring state (or an agency created by the state). Pre-paids are a safe, conservative way to save for college.
Only 18 states offer prepaid plans; investments are generally limited to state residents. In the long run, stock market investments have historically increased at a greater rate of return than the inflation rate of college tuition. However, in the period from 2000 to 2010, pre-paid 529 returns significantly exceeded the return on the benchmark S&P 500. Mutual Fund 529s: Nearly every state offers a mutual fund-type 529 investment. These plans do not guarantee future tuition and are subject to market risk. Families may be able to invest (1) directly in investments managed by a mutual fund company selected by the state; (2) through a financial advisor affiliated with a state-selected fund manager; (3) or, both. Many investment options exist; some states offer age-based portfolios and other variations designed to allow you to invest according to your own risk tolerance. Coverdell Education Savings Accounts: If you have a modified adjusted gross income of less than $110,000 ($220,000 for couples filing a joint tax return), you may be able to contribute to a Coverdell ESA tax free, up to $2,000 per beneficiary per year in almost any investment (except life insurance). As with 529s, Coverdell account withdrawals are tax-free if used for qualified education expenses -- at any eligible institutions, kindergarten thru graduate school. 3. Other Investments Many people don’t want to tie up their assets in college-specific investments. Their logic is simple: Tax issues, other cash requirements, liquidity and so forth weigh against segregating college savings in a separate “bucket.” These folks may prefer, for example, to fund college costs by selling a losing mutual fund or by refinancing their home with the deductible interest. 4. Cash-Value Life Insurance Most financial advisors recommend a variety of cash-value life insurance strategies (whole life, indexed universal life, etc.) for two reasons: (a) Certain types have guaranteed returns, so the cash value grows and isn’t wholly dependent on the fluctuations of the stock market; and, (b) borrowing from the cash value to fund college costs can done at very, very favorable interest rates as a tax-free event. Unlike other investments, the cash value of the policy is not included in financial aid calculations derived from the FAFSA form. Plus, there’s a death benefit – which every parent should have as part of a college savings plan. The use of cash-value life insurance as a college funding vehicle is often recommended for grandparents as an “intergenerational funding” method.
How To Shelter Assets on the FAFSA Form
Student and parent assets can affect the student’s chances of getting grants and other need-based financial aid. There are, however, several steps you can take to reduce the impact of assets on eligibility for need-based aid.
Sometimes families want to shelter assets on the Free Application for Federal Student Aid (FAFSA) to increase eligibility for need-based financial aid. Sometimes they want to preserve assets for future use for something other than higher education, such as down payment on a house or starting a business. There are four main methods of sheltering assets on the FAFSA:
Reportable vs. Non-Reportable Assets
Strategic Positioning of Assets
Simplified Needs Test
Spend Assets Strategically
Assets must be reported on the FAFSA as of the date the FAFSA is filed. In practical terms, this usually requires reporting the net worth of the asset as of the most recent bank and brokerage account statements. However, you can make last-minute changes in your assets before filing the FAFSA, so long as you keep a dated printout from each account’s website showing the account balance after the change in assets. Reportable vs. Non-Reportable Assets Some types of assets must be reported on the FAFSA, while other types of assets are not reported on the FAFSA. Shifting an asset from a reportable category to a non-reportable category can help shelter the asset on the FAFSA.
Reportable and non-reportable assets are illustrated in this table.
One of the most common mistakes on the FAFSA is to report retirement plans and net home equity as investments. These are non-reportable assets. It is also important to distinguish assets from income. Money in a qualified retirement plan is ignored as an asset, but contributions to and distributions from a qualified retirement plan during the base year count as income on the FAFSA. Some of the income may be taxable and some may be untaxed income, but both have the same impact on eligibility for need-based aid. Even a tax-free return of contributions from a Roth IRA counts as income on the FAFSA. Shifting an asset from a reportable to a non-reportable status may sometimes lead to income, such as realizing capital gains when an investment is sold. Generally, it is best for this to occur prior to the base year, so that it doesn’t artificially inflate income.
There may also be limits on the ability to use a non-reportable asset to shelter money on the FAFSA. For example, qualified retirement plans are usually subject to annual contribution limits, so it may take several years to shelter a lot of money. On the other hand, contributions to an annuity may allow the family to shelter more money more quickly. Trust funds often backfire. Trust funds are reportable as an asset, even if access to the principal is restricted. The main exception is when a court placed involuntary restrictions on access to principal, such as to pay for future medical expenses of an accident victim. If the restrictions came from the grantor who established the trust, the restrictions are considered voluntary. Another exception is when ownership of a trust is being contested, such as a testamentary trust where the estate has not yet been settled. As soon as the dispute is resolved, however, the trust is a reportable asset. Note that loan proceeds count as an asset if the money is unspent as of the date the FAFSA is filed. Only loans that are secured by a reportable asset are treated as reducing the net worth of the asset. For example, the net worth of a brokerage account is reduced by the amount of any margin loans against the brokerage account. Any mortgages on the family home are ignored on the FAFSA because the family home is not a reportable asset.
But, if the family owns a reportable asset, such as a vacation home or rental property, any mortgages that are secured by this investment real estate will reduce the net worth of the asset. However, if the family used a mortgage on the family home to buy a vacation home, that mortgage does not reduce the net worth of the vacation home because it is not secured by the vacation home. A good strategy for sheltering assets is to use them to pay down debt. Using assets to pay off credit card balances, auto loans and mortgages can not only make the money disappear, but it also represents good financial planning sense. If you’re paying a much higher interest rate on your credit cards than you’re earning on your bank account, you will save money by paying off the high-rate debt since you will be paying less interest. Parents should also consider accelerating necessary expenses. For example, it is better to replace the roof on the family home before filing the FAFSA than soon afterward. Necessary expenses may include maintenance items as well as replacing a car or other equipment that is near the end of its normal life. Although businesses are treated more favorably than investments on the FAFSA, rental properties are normally considered investments, not businesses, unless they are part of a formally recognized business that provides additional services (e.g., maid service at a hotel). A vacation home is considered an investment, even if you rent it out for part of the year. Intentions for the use of money don’t matter. For example, if you sell your home and intend to use the proceeds to buy a new home, you must still report the proceeds as an asset until you are legally committed to buying the new home. Similarly, intending to use the money to pay for retirement does not matter, not even if you are already over retirement age. Assets owned by a younger sibling are not reported on your FAFSA, but may be reported on the CSS/Financial Aid PROFILE form. However, money in a 529 college savings plan, prepaid tuition plan or Coverdell education savings account is reported as a parent asset if the parent or the child is the account owner. Shifting assets to a sibling may have limited utility in sheltering it from need analysis unless the sibling will not be going to college (e.g., a special needs trust). 529 college savings plans, prepaid tuition plans and Coverdell education savings accounts are not reported as an asset on the FAFSA if they are owned by someone other than the student or the custodial parent, such as a grandparent, aunt, uncle, cousin, older sibling or non-custodial parent. However, any distributions from such a plan must be reported as untaxed income to the beneficiary on the subsequent year’s FAFSA.