How to Pay College Bills Not Covered by Financial Aid
January 18, 2017Worried about paying college bills? Considering that the average balance in a 529 college savings plan is only $21,000, it’s no surprise that one of the most frequently asked questions we get at Financial Finesse is, “How should I pay for my kids’ college?” Here are some ideas, along with the benefits and pitfalls of each.
529 College Savings Plans
529 plans have become the most popular way for parents to save for future college expenses due to the tax advantages of both tax-free growth (as long as funds are used for qualified expenses) and in some cases, state income tax deductions for contributions.
Pros: They offer tax advantages, ease of saving, and have less of an effect on financial aid than savings in the child’s name.
Cons: They must be used for qualified education expenses to avoid a 10% penalty plus taxation of withdrawals. Funds held in a grandparent’s or other non-parent’s name are treated as income in the year distributed, which can affect future years’ applications for aid.
UTMA/UGMA Custodial Accounts or Other Savings in Your Child’s Name
Any account in your child’s name, even their own savings from summer jobs, will have the greatest impact on the availability of aid. If these assets are intended to be spent on college anyway, consider transferring them into a 529 plan to reduce the impact. Otherwise, spend what you’re going to spend from these accounts first to lower that impact.
Pros: Any capital gains from the sale of investments are treated as income to your child instead of you (beware kiddie tax rules though) and funds can also be used for things like a new laptop for school or eventually, your child’s first home or wedding.
Cons: 20% of the value is counted in aid formulas, potentially reducing the amount offered to your child. Once your child reaches the age of majority in the state where they are going to school, they’ll have unfettered access to the funds.
Taxable Investment Accounts
Any investments you own outside of retirement accounts are included in the financial aid formula and should be spent before dipping into retirement savings. If you have to sell investments for a gain, consider gifting them to your child first so that they could potentially pay a lower capital gains rate than you would. Doing this right before your child enters college, but after you’ve counted it as your asset on the FAFSA, nets the best benefit in terms of how it affects financial aid as the income won’t come into play until your child’s junior year package. However, if your investments are at a loss, keep them in your name to reap the benefit of up to $3,000 per year of capital losses.
Pros: There are possible tax benefits but no early withdrawal penalty.
Cons: Taxable gains could affect future aid offerings.
Home Equity
As long as interest rates stay low and you are able to deduct any interest paid on a home equity loan or line of credit, you may consider tapping this source if it’s available rather than having your child take out higher rate student loans. Of course you’ll be on the hook to pay it off even if your kid drops out mid-semester, but that’s a different kind of planning conversation to have with your child.
Pros: They have relatively low interest rates and there’s a potential income tax deduction for interest.
Cons: Your home is now collateral for your child’s education whether they graduate or not.
401(k) Loan
Rather than requesting a hardship withdrawal from your 401(k), which would incur income taxes and possibly an early withdrawal penalty if you’re under age 59 ½, borrowing from your 401(k) may be an option worth considering.
Pros: There’s no credit check, you pay yourself back the interest, and they generally have lower interest rates than student loans.
Cons: Your plan most likely limits the amount you can borrow to the lesser of $50,000 or 50% of your vested account value and you typically have to pay it back in 5 years or less. If you leave your job, you may also be on the hook for any balance due or risk negative tax consequences.
IRAs
Traditional and Roth IRAs allow penalty-free early withdrawals for qualified education expenses, although you’d still have to pay taxes on any traditional IRA withdrawals and any growth in your Roth IRA.
Pros: You don’t have to pay it back and there are no penalties for early withdrawal. Roth IRAs also let you withdraw up to the total amount of contributions without any tax consequences, so you could leave any growth in the account to continue growing for your retirement.
Cons: You can’t pay the money back as you’re still limited to annual contribution limits and most likely, you will have to pay income taxes on withdrawals unless you’re just using your Roth IRA contributions.
Student Loans
At the end of the day, you may need to ask yourself if you should even be contributing much at all, particularly if doing so would compromise your ability to retire at a reasonable age. As our CEO Liz Davidson likes to say, they don’t give out loans for retirement and you can’t “work through” it either. I also like to remind parents that sacrificing retirement so that your child can graduate debt-free may be a great way to negate the possibility that they’ll end up back at home sleeping on your couch, but it could mean that one day you’ll find yourself sleeping on THEIR couch.
Student loans are there for a reason (and no, they’re not “financial aid,”) and have provisions in place to account for the fact that your child may not be earning a ton of money right out of school or they may face difficulty in finding a job after graduation. Help your child reduce these chances by helping them choose a lucrative major. Then consider this college funding plan that many of my friends are choosing for their own children: they plan to fund about half of their kids’ educations on a semester-by-semester basis and expect their child to fund the other half either through working, loans, work-study programs or whatever means work for their student. This method worked to keep them motivated to do well and graduate on time and the hope is that it will serve the same purpose for their children.
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