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Education Planning: When to start, what to do, and how to do it

At a glance:

One of the familiar images of the college graduate is the seemingly perpetual student loan that he or she never gets paid off. Another is the graduate who must take a second job to pay down a huge loan balance. One of the goals of education planning is to make these scenarios less likely or, at the least, not as lengthy.

There are many factors to study when you plan for higher education. That is why advisors suggest starting your plans early. It is important to understand the college cost environment in order to make sound educational choices for your or your child's educational needs—including, but not limited to, which ones are the best school choices.

Next, it is important to dispel the myths and misconceptions surrounding financial aid from other funding sources. Finally, you need to evaluate the myriad investing plans and strategies to minimize taxes, and maximize college cash flow when the time is right.

It's never too early to start saving for college. (Photo: AP Photo/Mel Evans)
It's never too early to start saving for college. (Photo: AP Photo/Mel Evans)

When to start education planning for your children

Many people put off planning for their children's educations until the kids are well into their teens. Often, they discover they've waited too long. With a late start, they have little time to accumulate the assets they need, and miss the chance to plan opportunities to maximize available financial aid. Ideally, the best time to begin planning for your children's education is the day you learn you're going to be a parent.

Things to consider

There are many factors to consider when planning for your child's education. These include whether you favor public, private, parochial, or home schooling, and how to pay for education. Many families even plan where to live by choosing which primary and secondary school districts their children will attend. Then there's higher education. College or trade schools?

Perhaps not all children should go to college, but all should be afforded the opportunity for a post-high school education so they may hone their skills to excel in the job market. There are many excellent post-high school programs for students who choose not to attend academic colleges.

How education is paid for

There are many ways to pay for education. The most common method in the United States is through taxation. Each state has its own rules for taxing residents to pay for public education. Private, parochial, and home schools don't receive public funds, so each family must pay for these out-of-pocket. While more governments are experimenting with education voucher plans to offset the cost of private education, at the time of this writing, they are not widely available. Financial aid is available for secondary and post-high school education, but there are rigid requirements to qualify for aid.

Make it part of your financial planning

With so many things to consider, your child's education should be a part of your overall financial planning. Not only do you have to consider how your child will be educated, but how you will pay for it, too. You also should consider how your plans will be achieved if your family income is diminished if you lose income due to layoff, accident, illness, or death.

When is the second best time to start planning for your child's education? Today.

What to know about the cost of education

Paying for college is not a one-shot, one-year affair. Parents and grandparents will have to think in terms of four years for a baccalaureate, six years or longer for a graduate or professional degree, and an eternity if they have seven bright students spaced two or three years apart.

Since you may be paying college bills for many years to come, it is essential to understand a bit more about the overall college cost environment.

Why tuition keeps rising

Tuition costs continue to outpace inflation. According to the College Board, average tuition and fees for four-year public colleges have increased at a rate over two times that of inflation. There are several reasons for the rapid increase in tuition:

  • Faculty salaries must be raised to attract new professors and to keep tenured ones from leaving.

  • Maintaining old buildings is very expensive.

  • Colleges must continually update technology to remain competitive.

  • The number of high school seniors is declining, so fixed costs are spread among fewer paying customers.

Despite this, colleges must compete for students because there aren't enough students to fill all the waiting ivy-covered halls. This competition is both fierce and expensive, with recruitment costs as high as $1,000 per freshman enrolled. Competition also allows parents and students to become more sophisticated shoppers. Many post-secondary schools may offer competitive financial aid packages to get students to attend their institutions.

College is an investment for a lifetime

One bit of good news is that college still pays. College is an investment for a lifetime. But does it create earning power? "The resounding answer is yes. Research shows that people with college degrees have more job choices and earn more money," according to the College Board.

For most, college is still affordable

College can be more affordable than most people think. According to the College Board, about half of full-time undergraduates attend a four-year college costing less than $12,000 per year for tuition and fees. The average 2019–2020 cost of tuition and fees for public schools for in-state students is about $10,440 per year. For out-of-state students, it is about $26,820. Private schools average a little over $36,880 per year for tuition and fees. Many of these higher-priced schools have grant aid available, making it easier to pay costs. Many who attend two-year colleges pay just a little over $4,000. At the extreme end of low cost, a few colleges charge no tuition or offer all students full tuition coverage through scholarships.

There is a lot of financial aid available

Furthermore, more people are eligible for financial aid than realize it. Many people who would easily qualify for need-based financial aid mistakenly believe that families with incomes over $35,000 are not eligible. According to the College Board, there is currently more than $185 billion of financial aid being awarded. To qualify, a family must pass a needs test that considers not only family income and assets but also the total cost of education for all family members as well. Families putting two or more family members through post-secondary education very often qualify for substantial financial aid despite "high" family income.

The cost of college keeps rising across the U.S. (Graphic: David Foster/Cashay)
The cost of college keeps rising across the U.S. (Graphic: David Foster/Cashay)

Although post-secondary education costs have risen dramatically, the cost of higher education is not out of reach for most families. There are several options available to make higher education possible. Apply for financial aid. Choose a school that is within your family budget (including financial aid). Also, plan early.

Of course, there is a wealth of tax incentives available to help you save on college expenses. Savingforcollege.com lists several here.

Financial aid misconceptions

Many families fail to get all the financial aid for which they are eligible simply because of myths and misconceptions about financial aid. These lead a family to believe that they do not qualify for financial aid, or send them searching for some arcane scholarship.

As a result, they spend time chasing myths rather than focusing on the main sources of financial aid: Uncle Sam, their home state, their college, and their employer.

Misconception: "I don't qualify for financial aid because I make too much money."

This could not be further from the truth. If you made too much money, you probably wouldn't need, want, or consider financial aid. However, most people do need financial aid to supplement the family budget for higher education. The fact is that the major factor in determining financial need is the actual cost of education for all family members. While family income and assets are factors, so are family living expenses, future retirement needs, and the current costs to educate family members.

Misconception: "You must complete your income tax return before applying for financial aid."

You will need the information from an IRS 1040 form to complete most financial aid forms, so gather that information in December. However, you may complete a financial aid form based on estimated tax information. Most colleges require the forms to be sent in no sooner than January 1, but by April, most of the grants and scholarships are gone. It is okay to file an "estimated" financial aid form; you will have an opportunity to amend it later.

If you do not prepare your own income tax returns, many tax professionals will be happy to help you prepare an estimate for financial aid applications.

Misconception: “Financial aid is a loan that must be repaid.”

Most need-based aid is in the form of student or parent loans. However, these loans do offer considerable financial advantages over other forms of borrowing. They usually have lower interest rates, and the interest may be deferred while the student is in school. That's free money; and repayment terms are usually more generous than those of other loans.

Some loans may also be "forgiven" if the student performs certain community service jobs upon graduation, such as teaching in a deprived area. Check the college financial aid office to learn more about these favorable provisions.

Need-based aid may include grants and scholarships. These are free money that does not have to be repaid. However, the student may be required to maintain certain academic grade-point levels. Grants and scholarships are awarded on a first-come, first-served basis, so it pays to apply for these early.

Students with financial need may also be able to get guaranteed work on or near the campus through the "work-study" program. These jobs may not be available to students who do not qualify for need-based aid. Akin to this are the military ROTC and reserves programs. For those inclined to serve in the military upon graduation, there are substantial financial benefits to signing up and having the government subsidize their education.

How to search for scholarships

Many people ask about the fortune in unclaimed scholarships that, they read, go to waste each year. It is true that some money does go unclaimed every year, but the basis for these extraordinary figures is primarily unused employee tuition remission benefits and not miscellaneous scholarships for which people have not applied. Before hiring a scholarship search firm, check out the education benefits offered by your employer or union.

For many people, looking for college money turns into a search for special scholarships; students are supposed to get these awards because they were born under a full moon and have a beauty mark below their left kneecap. Families should not stop looking for these awards; they should just make them their last priority. Remember, there is more money in being an informed consumer and taking charge of the financial aid process than in all the scholarship searches ever conducted!

Many computerized scholarship search firms have gone bankrupt or are under federal investigation for deceptive trade practices or mail fraud. The reason is simple: Their ads are full of empty promises. For a fee, they guarantee to find five awards for which the student is eligible. What they don't tell you is that this information is frequently outdated or inappropriate, or that it is information the family could get free from Uncle Sam.

If your education budget is tight, don't spend hundreds of dollars on searches you can perform free on your home computer, in the public library, or in the high school guidance office. If the time and effort spent on these endeavors were applied to a minimum wage job, the student would have more money to spend on education than he or she is likely to get from the search.

A final note

As you plan for higher education, you should seek out all financial resources available. Don't assume you won't qualify for financial aid. It only takes a few moments to complete the financial aid forms. It is important, however, to complete and send them in early. You can test your eligibility for free, as well as check out admission requirements and scholarships, on the College Board Website: www.collegeboard.org.

Determining the expected family contribution

Expected family contribution (EFC) is the amount of money a family should contribute toward education costs. Understanding how EFC is calculated is the key to your financial aid strategy.

There are currently two methods of calculating EFC: the method prescribed by Congress, called the federal methodology, and the institutional methodology. While both methods are similar, the institutional methodology includes certain income and assets not included in the federal method and tends to calculate a higher family contribution. The institutional methodology is often used by schools that make need-based aid available in addition to federal student aid.

What a student needs for the financial aid form

The student, not the parent, is responsible for completing a financial aid form. But the student may need the parent's financial information, depending on whether the student depends financially on that parent. The first part of a financial aid form asks questions to determine whether the student is dependent or independent. An independent student may omit questions about parents' income, assets, and taxes.

The financial aid form gathers information about the income, assets, and taxes of both student and parents. For a dependent student, EFC is the sum of four separate calculations, including the contributions from the following sources:

  • The parents' incomes

  • The parents' assets

  • The student's income

  • The student's assets

The calculations are not made on the form, but they are calculated by the agency that processes the financial aid form.

Contributions from parental income and parental assets

Contributions from parental income

Parental income includes taxable and non-taxable income from the year preceding the award year (last year's income if you plan to get financial aid this calendar year). The methodology automatically deducts an income protection allowance—money for food, rent, transportation, laundry, etc. The income protection allowance is adjusted for the number of family members and the number in school, and is based on a national average skewed just above the poverty level.

Federal and state income taxes, Social Security taxes, and an employment expense allowance (up to $4,000 if both parents work or if it is a single parent household) are subtracted from parental income to compute "available income." Available income is multiplied by a factor ranging from 22–47% (graduated upward on the amount of "available income") to determine the amount from income.

Contributions from parental assets

Parental assets include the value of stocks, bonds, savings accounts, and business assets as of the date the parents sign the form. To determine the amount from parental assets, an asset protection allowance—a sort of nest egg for the golden years based on the age of the older parent—is subtracted from the amount of parental assets, and the remainder is multiplied by approximately 6%.

Contributions from student income

Students add up all their income and subtract their federal, state, and Social Security taxes. They may also subtract an income protection allowance ($6,840 for 2020–21). The amount from student income is 50% of everything the student earns that is over that amount.

Contributions from student assets

Students add up all their assets, including savings, investments, and trust funds, but excluding retirement IRAs. The amount from student assets is multiplied by 20% or more.

The expected family contribution is calculated by adding these four amounts.

In families with more than one member attending post-secondary schools simultaneously, each student will have a separate family contribution amount consisting of a fraction of the parents' contribution from income and assets, plus the student's own contribution from income and assets. The parental contribution is divided by the number of family members in post-secondary school. This includes parents who may be students as well as children.

In single-parent families where parents are divorced or separated, students use the income and assets of the parent with whom they lived for the greater part of the calendar year preceding the year in which they enter post-secondary school. Where the parent has remarried, the step-parent's income and assets must also be included in the calculation, just as though he or she were a natural parent.

Independent student status in financial aid

Independent students include only their own income, assets, and those of their spouses (if married) on the financial aid forms to determine their expected family contributions. However, it is not easy to qualify for independent status.

The federal government has set strict guidelines for determining independent status. To qualify, a student must be able to answer "yes" to one or more of the following questions (list is not exhaustive):

  • Will you turn 24 during or before the year of attendance?

  • Are you a veteran of the US armed forces, or currently on active duty?

  • Are you a graduate or professional student?

  • Are you married?

  • Are you an orphan or a ward of the court?

  • Do you have legal dependents (other than a spouse)?

By answering "yes" to any of the above requirements, you are automatically considered independent for federal financial aid purposes. If you answered "no" to all of the questions above, you are considered dependent on your parents for financial aid, even if you don't live with them and they don't claim you on their tax return. Some schools may disregard independent status. Note that students may file an appeal with the college financial aid office if they believe they are fully independent of their parents' support.

Calculate your expected family contribution first

Financial planners recommend that you calculate your expected family contribution before completing financial aid forms. By determining your EFC early, you may be able to take advantage of financial planning strategies that will lower your EFC and generally improve your finances. You can perform the calculations free on the College Board Website.

Coverdell education savings accounts

The Coverdell education savings account (formerly the education IRA) is a tax-advantaged savings plan for post-secondary education. It is modeled on the standard IRA to give tax incentives to persons for saving for education.

Read more here.

529 Plans (qualified state tuition plans) and how they work

The states have tuition programs allowing families to save for a student's higher education (private colleges and universities now offer them too). These plans qualify for special tax treatment if the funds are used for qualified expenses at a post-secondary school that meets US Department of Education standards for student aid eligibility.

These plans are generally referred to as 529 plans for the tax code section that describes how they are treated for tax purposes. States offering such plans may also give favorable tax treatment for contributions, interest, dividends, and distributions from these plans. State tuition plans fall into two categories: pre-paid tuition plans and college savings plans.

How to buy pre-paid tuition plans

Pre-paid tuition plans allow participants to buy tomorrow's education at today's prices.

They may be purchased with a single lump sum or a series of payments. The state often guarantees that the pre-payments will cover the future cost of education at the state college. If the student chooses not to attend the state college, the state will make available the amount of money equivalent to the cost of the state education at maturity.

For example, imagine that a state university costs $8,000 per year today and you pre-pay two years ($16,000), to be redeemed in 8 years. In 8 years, the cost of two years at the state college goes to $24,000. The beneficiary has two years paid for. Should the student wish to attend a non-state school costing $30,000 for two years, the state typically has to rebate only $24,000 (the cost of the equivalent state college tuition).

Pre-paid tuition plans are not as popular today as they were a few years ago due to the phenomenal run-up in the investment markets that occurred in past years.

Savings plans

State college savings plans (also called "accumulation plans") have become more popular because of investment flexibility and the alluring possibility that, with investment skill and luck, proceeds may exceed the actual costs of education.

These plans have some tax incentives, too. While the contributions generally are not tax-deductible, the accumulation within the plans is tax-deferred until withdrawn. Even then, the accumulations may be tax-free if used for qualified educational expenses. Contributions to a plan may not exceed more than the amount necessary to provide for the qualified higher education expenses of the beneficiary (student). The contribution limits are often set by the plan administrator each year.

Taxes and penalties

There are no income taxes due on the value of these plans until the proceeds are distributed.

Then income tax is due only on the increased value of the plan over the contributed amount. The taxes are calculated at the beneficiary's rate, i.e., based on the student's income. Some states even waive income tax on funds used for qualified educational expenses. If funds are disbursed and not used for qualified education expenses, a 10 percent IRS penalty may be due unless the disbursement meets special requirements. The penalty may be waived if the refund of earnings is made because:

  • of the death or disability of the beneficiary.

  • the beneficiary received a scholarship for educational expenses.

Qualified higher educational expenses include tuition, fees, books, reasonable room and board, supplies, and equipment required for the beneficiary at an eligible educational institution. The student must be enrolled at least half time.

Transferring funds to other qualified state tuition programs

Amounts can be transferred to other qualified state tuition programs, and beneficiaries can be changed.

Amounts in a qualified state tuition program can be transferred tax-free to the qualified state tuition program of another beneficiary. The transfer must be completed within 60 days of the distribution, and the other beneficiary must be a family member of the beneficiary from whose program the transfer is made. The new beneficiary must be the existing beneficiary's spouse or one of the family members listed below:

  • Spouses

  • Sons and daughters

  • Adopted, step, and foster children

  • Brothers and sisters

  • Stepbrothers and stepsisters

  • Brothers-in-law and sisters-in-law

  • Fathers and mothers

  • Aunts and uncles

  • First cousins

529s vs Coverdells

Qualified state tuition plans are more popular than the Coverdell account because of the higher contribution limits and the ability to use qualified expenses as the basis for the Hope tax credit or lifetime learning credit.

No contributions can be made to a Coverdell on behalf of a beneficiary if any amount is contributed during the same year to a qualified state tuition program on behalf of the same beneficiary. Any amount contributed to the Coverdell will be treated as an excess contribution.

Summary of education planning

Planning for higher education has become more important now than ever. The costs of higher education have skyrocketed, outpacing inflation. Yet the the need for higher education has also become more important in order to succeed financially.

There are many myths and misconceptions about college costs, financial aid, and saving for college. In order to make the right decisions for your situation, you must dispel those myths and understand the college cost environment.

There are many ways to prepare financially for higher education. Preparation starts with a sound financial plan. This should be followed by an investment strategy that minimizes taxes while maximizing cash flow during the educational years. You should also explore the benefits and pitfalls of various education savings plans.

With planning and preparation, you can minimize the bite that paying for college may otherwise take out of your finances.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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