Financing college – with retirement not far behind
by Kate BavelockAt 47, this successful Hyannis businessman knows a bit about planning ahead. With three young children speeding toward college, he and his wife recently sat down to consider their financial future.
His company is doing quite well, but even so, $800,000 in projected college costs is a formidable – and frightening – prospect. So much so that they have decided to sell their attractive home and downsize.
“Not only is it our responsibility to assure our children’s future, but by the time they are out of college, we will be facing retirement,” he observed.
He’s far from alone. The baby boom generation is facing not only the twin pressures of college and retirement, but in many cases the extra responsibility of caring for elderly parents.
The challenge is made even more daunting because we live in Massachusetts. A recent study by the think tank MassINC found that private colleges in the region require 33 percent of a family’s income per student, while public universities take 21 percent. In addition, student debt has climbed more than 40 percent in the last 15 years.
For any parent and their financial adviser, planning and saving strategies are made especially difficult by widely swinging variables. Different colleges have different approaches to family need and financial aid.
“No matter how much you plan, it can blow up in your face. You don’t know what will happen. It’s a crapshoot,” said John Butler, a certified college planner and vice president of The Capital Group Inc. in Hyannis.
Despite the availability of college investment plans that grow tax-free, most families find that college sneaks up on them fast.
“Despite the best intentions, when you are supporting a young family, the mortgage and cost of living takes all your attention. Ninety-five percent of people are in that boat,” said Butler. “The reality is that most people are facing college costs for the first time when they are in their 40s to late 50s. So we meet with parents who are trying to fund retirement and finance a $40,000-a-year college education at the same time.”
Is there a single correct strategy to apply to these multiple goals? Do you focus on college at the expense of retirement? Do you tell your children that they can’t go to the college of their choice so you can secure your future in old age?
Opinions differ – depending on circumstances.
Butler said, “You have to put retirement savings first, no matter how obligated you feel to providing your child with a good education. You can borrow money for college. You can’t borrow money to retire.”
But another Cape-based company, College PayWay, which lends nationwide, operates under the theory that most families can manage a more balanced approach.
“Yes, retirement is a bigger nut to crack and should be the priority, but that doesn’t mean families shouldn’t plan and invest for both,” said Steven Yeh of College PayWay.
“For example, you could consider using a Roth IRA for college planning, because contributions to a Roth IRA can be accessed [without penalty[ and it will not be included in the Expected Family Contribution,” he said.
The Expected Family Contribution is how much money the U.S. Department of Education and the schools expect you and your family to contribute toward college costs. Factors include family size, the number of family members in college, family savings and current earnings.
“The EFC is a balancing act between a family’s current and future needs,” Yeh explained.
“Retirement assets coordinate very well with college needs since they are tax-advantaged if used for college costs and do not cause a loss in aid eligibility.”
Yeh also points out that families can use life insurance cash values to pay for school. “Again, these are not included in the EFC and can be accessed on a tax-favorable basis for either college or retirement planning,” he said. “The bottom line is there are options, and families need to determine which options fit with their lifestyle – and what they want or expect for their future into retirement.”
For Butler, the absolutely critical first step is for a family to understand what contribution colleges will expect from you, and what you can do to minimize that number.
He said some families decide to have a spouse with the lesser income quit his or her job to reduce income that counts toward the EFC. However, he cautions that the EFC formula has an intricacy that works against a family with one income. Under the formula, it’s better to have dad making $75,000 and mom making $5,000 than dad alone earning $80,000.
Another key concern is the value of your home and business. These are difficult numbers to pinpoint, especially business values. But overestimating by $100,000 could mean you lose $20,000 in financial aid for college.
Butler also sees some unfairness in the formula that penalizes savers. For example, students’ own savings are ‘taxed’ by the formula at 35 percent. If a student has worked and saved $1,000, she is expected to contribute $350 the first year of college.
“While we know there has to be some formula in place to manage the system, this formula is fraught with problems,” said Butler.
The good news is that there is significant flexibility in EFC strategies for self-employed parents and business owners. And on Cape Cod, that represents more than nine out of every 10 businesses. For example, hiring your child and putting that salary money directly into college savings has tax advantages and reduces your own income.
The value of college savings plans
Financial experts also hold differing opinions about the benefits of savings, particularly 529 plans that grow interest free for educational purposes.
A 529 plan is an especially good tool for grandparents because of its generous gift tax exclusion. Grandparents can gift up to $12,000 per year (or $24,000 if married and filing jointly) without incurring a federal gift tax, or they can elect to gift five years up front at $60,000 (or $120,000 if filing jointly)
Butler, however, sees two pitfalls to the 529. The better you are at savings, the more colleges expect you to pay. Moreover, 529s are not FDIC insured and are not very well understood.
“The 529s are pushed by Wall Street as a commission-driven product without appropriate analysis of a client’s needs,” said Butler. “I expect to see a lot of losses. It would be a much better strategy to put that money into your own retirement.”
College PayWay’s Yeh is more supportive of 529 plans. “We believe that 529s can be a good investment vehicle for families. Again, it depends on their personal financial position and what will work for them. 529 plans have been around for at least 10 years and have over $90 billion in assets under management. The fact that they aren’t FDIC insured isn’t what I would look at,” he said.
“With new regulations recently passed under the federal Deficit Reduction Act, money from an UTMA can be transferred to a 529 plan and be protected from the EFC,” he said.
UTMA stands for the Uniform Transfers to Minors Act and provides an alternative for structuring accounts owned by children. It allows someone to fund an account for a child, but limit that child’s access to the account until the child reaches the age of majority, usually between 18 and 21.
Maybe the best feature of 529 plans is the lack of annual income restrictions. As long as it is used for qualified expenses – college tuition, fees, room and board, books and supplies – they are tax-free.
A potential downside, however, is that they have to be managed, and investment selections may be limited. States that manage the plans can also switch administrators, which in turn can move your money into new investments. And management fees are usually higher than for traditional mutual funds.
Another option is the Coverdell education savings account, or ESA. Its biggest downside is that you can only contribute up to $2,000 a year per child. But that is less an issue for families with young children. Coverdells let you allocate proceeds not only for college, but also to pay for a private elementary or high school – and even other educational expenses, such as extended day programs, if required or provided by a school.
Coverdells also let you invest in diverse ways and on your own if you wish to avoid management expenses. College loan specialists point out that a Coverdell account not only is tax-free when used for education expenses, but there are none of the traps that exist with 529 plans. Most notably, the tax-free status of 529s will expire after 2010 unless Congress eventually acts to make withdrawals tax-free permanently.
Yeh cautioned that parents need not understand the complex EFC formula as much as they must appreciate what factors go into it. “Free, Web-based analyzer tools can provide a general sense of what you can expect to pay,” he said.
Originally published in the Sep/Oct 2006 issue of Cape Business.
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