Junior might be a toddler now, but sooner than you think he’ll need some form of higher education, and that doesn’t come cheap.
You’ve just welcomed a new child into the family? Congratulations! Time to start saving for college.
That’s no joke. As the cost of higher education keeps rising, the best way to prepare is to put aside money as soon as you can. You don’t want to saddle your youngster 20 years from now with mountains of debt just when she or he has that diploma and is heading out to take on the world.
Fortunately, there are tools to help — both sources for practical advice as well as financial instruments that help you save while giving you some tax benefits for doing so.
And if college isn’t so far away for that youngster, you want to get started even faster.
It’s wonderful to imagine that Junior will get a free ride to Harvard on the strength of her brilliant intellect (or an athletic scholarship thanks to her brilliant soccer goaltending). But just as you don’t plan for retirement by buying lottery tickets, you don’t want to depend on luck to cover the cost of college.
There are other forms of financial aid besides academic or athletic scholarships, but most are based on need. The federal government is the largest single source of financial aid through a variety of grants and loan programs. To qualify, you’ll have to complete a standard form that discloses not just your annual income but the assets you and your child own: the Free Application for Federal Student Aid — FAFSA for short.
So Step One is to go to www.fafsa.ed.gov to get a general idea of what you will be expected to contribute toward the child’s college education. The younger your children are, of course, the more likely it is that specific requirements might change by the time they reach college age.
For now, though, here are some basic rules of thumb:
The larger your asset pool, the larger your family’s expected financial contribution — EFC for short.
The equity in your home is not counted as an asset on the FAFSA application. (Other scholarship programs might include it, though, so you’ll need to be prepared for that possibility.)
Generally, your child’s assets count more than yours — so it’s wise to keep more of your assets in your name.
A business at least 50 percent owned and controlled by your family and employing fewer than 100 full-time employees (or the equivalent) does not count as an asset on the FAFSA (see fafsa.ed.gov/help/fotw44eF4c.htm).
Investment holdings such as mutual funds in a tax-sheltered retirement account also do not count as an asset — but other investments that aren’t part of a retirement plan do count.
SAVE VIA 529 PLAN
The single most useful instrument to help you save for college is the Section 529 plan. Created in 1996 as part of the U.S. Internal Revenue Code, these accounts let you save for college on behalf of your child — or grandchild, if that’s your stage in life — while providing tax advantages along the way.
Almost every state has at least one Section 529 plan (some have two or more). An excellent clearinghouse for information on Section 529 plans is at www.SavingforCollege.com. There you can look up plans in each state and see rankings that compare their investment performance.
The money you pay into a Section 529 plan is not tax deductible, but the earnings in the plan are tax-free, and if you spend the money on college education or the equivalent, you won’t pay federal income taxes on it when you withdraw it.
On the other hand, if the money goes to nonqualified expenses, the earnings will be taxed upon withdrawal. Not only that, but there will also be a 10 percent tax penalty on top of that.
But what if your child doesn’t want to go to college — or does get that rare free ride? No worries. You can switch the plan beneficiary to another child — one of your other children or a grandchild, for example.
As a general rule, a state’s Section 529 plans don’t limit your child to going to school only in that state. They also don’t limit you only to a public institution.
You also don’t have to choose one of the plans in your home state. As SavingforCollege.com points out, you can live in one state, choose a Section 529 plan from another state, and use the plan to fund your child’s college education in a third state.
More than 30 states give their own taxpayers a tax break on contributions to the plans in their state. If you aren’t a resident of the state whose Section 529 plan you pick, you probably won’t get that advantage. You’ll want to consider whether the trade-off is worth it considering the investment performance of various plans.
Remember, your assets are treated differently than your children’s assets when it comes to evaluating how much financial aid they will be eligible for.
In calculating the expected family contribution, only 5.64 percent of a parent’s assets are counted. That’s true even if you’ve actually named the child as the beneficiary of the plan — you’re still in control.
By contrast, the same calculations count 20 percent of assets that the child holds directly, such as through a custodial account to which she or he gains control upon reaching legal age. To preserve your options for financial aid, keep your assets under your control; don’t pass them on to your child.
That also ensures you control what the money is spent on.
Student income, by the way, is counted at an even higher rate — 50 percent. And that leads to another wrinkle. Remember the part about grandparents being able to open a Section 529 plan for their grandchildren? When that happens, everyone needs to think strategically about when those funds are distributed.
That’s because the money from the plan the grandparents set up gets treated as income for the student when it’s withdrawn. So the child’s financial aid eligibility is reduced by the equivalent of half of that amount.
The solution? Have the grandparents’ contribution kick in for the last year of college when it won’t have any effect on future financial aid eligibility.
The last piece of advice here is more philosophical than anything else: Decide early what you expect your children to do when it comes to saving for college.
Will your children work while still in high school? If so, will you require them to save at least a portion of those earnings for college?
Then make it clear what the rules of the road are, and stick to your plan.
It’s well known that the jobs of the future will depend more and more on education beyond high school, whether through a four-year degree or through some alternative forms of training.
So when the time comes for your children to take that next step, there’s no better gift you can give than to make sure they can focus on their studies instead of having to worry about how they, or you, will pay for them.