3 Fundamental Lessons for Maximizing College Savings
By: Source: AARP Bulletin Today Date Posted: 2004-10-05 13:34:00-04:00
Saving for your child's or grandkid's college expenses requires a new kind of math. Indeed, different education-saving options, including popular Sect. 529 savings plans, all have their own tax and financial-aid implications.
Depending on how you sock away for college, financial-aid awards can suffer from 15 cents to $1.24 for each dollar saved. Better understanding of this math has steered some families away from saving specifically for college. [See Why Not to Save for Your Kids' College Years.]
But choosing not to save for college isn't for everybody, particularly for millions of parents and grandparents already socking away funds for junior's college. So choosing how you save is essential.
"Families with identical financial positions receive very different levels of aid, depending on whether they are savvy enough to steer their savings toward the right vehicles," says Susan Dynarski, a Harvard University researcher whose work has better revealed college saving/financial aid repercussions.
Consider these 3 tips to maximize your college savings:
- Don't save in a child's name. Uniform Transfer to Minors Act (UTMA) accounts and other traditional vehicles that put funds in kids' names are the worst ways to save for families also seeking financial aid. The reason: the Free Applications for Federal Student Aid (FAFSA) formula that helps to determine financial-aid awards puts much more weight on savings in a child's name (35% of the formula) than money saved in parents' names (5.64%).
Note: FAFSA does not count funds saved in their grandparents' names. But when grandparents pay college tuition from savings, the payment is included as a resource under FAFSA's formula thereafter. "Not good," says Alice Orzechowski, a Frederick, Md.-based accountant and author of 101 Tips for Maximizing College Financial Aid. "The workaround is to have grandparents pay off the student loans after the student graduates."
- Do save via home equity and traditional retirement savings plans in your name. FAFSA gathers detailed information on family income, assets and expenses, and FAFSA counts many resources—including income, non-retirement mutual fund/savings accounts and funds in education-savings vehicles—when determining financial-aid awards. However, certain assets aren't considered by FAFSA, including home equity, pensions and other retirement savings plans, life insurance and annuities.
With the FAFSA formula, Dynarski says, "Probably the best way to save is by paying down your mortgage, (as) home equity does not count at all in the federal aid formula." But the idea is that you ultimately might take a home-equity loan to cover college expenses not covered by financial aid, and this strategy won't suit you "if you would not be comfortable making home equity payments while the child is in college," Dynarski suggests.
Funds in traditional IRAs aren't considered by FAFSA, thereby making this another good way to save, particularly if it's unclear junior will go to college. What you lose in tax benefits, you gain in flexibility; if money is not pulled out for college, you keep it for retirement. But once IRA funds are tapped for education purposes, future aid requests can be cut by as much as 33 cents for each IRA dollar paid for college.
- Look to Sect. 529 savings plans and Coverdell education savings accounts (ESAs)—especially if you've maxed out contributions to retirement plans or if you're unlikely to qualify for financial aid because of income. Started in 2002, the Sect. 529 savings plans offer a tax-free way to let college savings grow (distributions for college expenses are also tax-free) and have higher funding limits and greater flexibility than other education savings vehicles. [See Sect. 529 Plans Offer Tax Incentive to Save for Grandkids' Education.]
Still, for every $1 saved in a Sect. 529 plan, financial aid is reduced by 15 cents upon withdrawal. Reports of high fees on some Sect. 529 plans and uncertain future of 529s' tax-free status (tax benefits end after 2010 unless Congress extends the provision) have spooked some families away from this option.
As for the Coverdell ESAs, FAFSA severely penalized ESA savings until recently. The federal government changed that, now treating ESAs the same as Sect. 529s. However, ESA contributions are limited to $2,000 annually and aren't tax-deductible, although distributions for educational expenses are tax-free.
Keep in mind that you'll pay penalties when Sect. 529 or ESA funds are not used for school.
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