Invest in your child's greatness

Physician's Money Digest, September 2005, Volume 12, Issue 13

If nothing else, college costsare consistent—consistently rising, that is. According to a report bythe College Board, "Trends in College Pricing 2004,"the average tuition for undergraduates attending a4-year private university rose 6% last year, to$20,082. Undergraduates attending a four-year publicuniversity rose 10.5%, or $5132 per year.

That trend of rising college costs has resulted in yetanother trend: increased borrowing and rising debt."The debt levels of students as a whole are continuingto rise every year," explains Jon Hayward, businessdevelopment manager for Chela Education Financing,a San Francisco-based student loan provider. "Andunfortunately, the federal programs don't keep pacewith the rising costs at the institutions."

Part of the problem, says Ellen Frishberg, directorof student financial services at Johns HopkinsUniversity, is that students are coming through the systemwith parents who still have undergraduate orgraduate school debt of their own. "Parents tell usthat they can't borrow for their kids because they'restill paying off their own student loans," Frishbergexplains. "We're afraid we're going to see the samething happen with the current generation of collegestudents when they start having children."

Forgoing a college education, however, does notmake economic sense. The College Board reports thatbachelor's degree recipients earn over 60% more onaverage than individuals with only a high schooldiploma. Factored over a lifetime, the gap in earningspotential between a high school diploma and a bachelor'sdegree can exceed $1 million. As a result,Hayward says, it is increasingly important that studentsand parents understand their options and obligationsassociated with the debt they're assuming, andhow to best manage that debt.

Planning Ahead

Certainly one of the most efficient ways to finance acollege education is to save in advance, and 529 collegesavings plans are one of the more popular options."Depending on the state in which you live, your contributionsto the plan may not be tax-deductible, butall of your earnings are," explains Pam Little, editor-in-chief of WomensWallStreet.com. "Thatmeans that if you start contributing when yourchild is young and you earn thousands of dollarsby the time your child is ready for college, you canwithdraw all of those earnings without paying adime in taxes."

There are two types of 529 savings plans: statesavings plans and prepaid tuition plans. Though statesavings plans and prepaid tuition plans share thesame federal tax advantages, there are important differencesbetween them.

According to "The ABC's of 529 Plans," state savingsplans let you save money for college in an individualinvestment account. These plans are run bythe states, which typically designate an experiencedfinancial institution to manage their plan. However,you can't hand pick your own investments as youwould with a Coverdell Education Savings Account(ESA), custodial account, or trust. Instead, you typicallychoose one or more portfolios offered by theplan—the underlying investments of which are exclusivelychosen and managed by the plan's professionalmoney manager. After this, you simply decidewhen, and how much, to contribute. When it's timefor your child to go to college, the beneficiary of youraccount can use the funds at any college in this countryand abroad, provided the school is accredited bythe Department of Education.

A prepaid tuition plan lets you prepay tuitionexpenses now for use in the future. The advantagehere, says Doug Brown, CEO of Independent 529Plans, is that you take inflation and investment riskoff the table. In exchange for your up-front cash payment,or series of payments, the plan promises tocover a predetermined amount of future tuitionexpenses at a particular college in the plan.

However, if your child elects to attend a schoolthat isn't participating in the prepaid plan, you'll typicallyreceive a lesser amount to cover expensesaccording to a predetermined formula. That factor,Little says, is a concern. "The last thing you want todo is force a child to fit into a situation that they justdon't fit into," Little explains. "It's difficult to makea commitment to a school, and once you make thatcommitment there's no changing your mind."

Regardless of which 529 option you employ, thereare two caveats to keep in mind. The first is that the2001 act that made qualified withdrawals from a529 plan tax-free at the federal level will expire onDec. 31, 2010. Unless Congress extends the law, afterDec. 31, 2010, the federal tax treatment of 529 planswill revert to the law in effect prior to Jan. 1, 2002,meaning that qualified withdrawals are taxed at thebeneficiary's rate.

In addition, if the money is not used to pay for collegeor other educational expenses, you will have topay income tax on the amount of money you end upwithdrawing, plus a penalty.

Savings and Loan Options

Of course, 529 savings plans are not the onlyvehicle available for financing a college education.Coverdell ESAs are another popular option. Theyfunction similar to an IRA, and thus have similarrestrictions. For example, monies deposited in anESA accumulate on a tax-deferred basis, and withdrawalsused to pay for education expenses areincome tax-free. However, contributions are limitedto $2000 a year, and married couples earningmore than $220,000 a year or individuals earningmore than $110,000 a year are unable to contribute.Money in an ESA is also counted as the child's assetwhen calculating eligibility for student aid.

For families that have not planned in advance—and according to Frishberg, there are many—borrowinghas grown exponentially as a means offinancing college. "We think that most of our familiespay by borrowing from the equity in theirhomes," Frishberg says. "It happens to be one of themost tax-advantaged ways you can borrow. Theproblem is that by the time most people get their kidsto school they're tapped out on their home equity sothey have to look for alternatives."

Two popular options are parent (Plus) loans, andstudent loans, such as a Stafford loan. Both are variablerate loans that are tied to the 90-day Treasurybill index that is reset once annually in July, and bothhave interest rate caps. But that's generally where thesimilarities of the loans end.

Stafford loans are a student's responsibility. Theyhave a nice feature, Hayward explains, in that thestudent does not pay back the loan until they havegraduated. There is an option where students canmake interest-only payments while in school, butmost defer those payments until after graduation. Inmost cases, however, Stafford loans cover a smallportion of tuition and college costs, and studentsmust resort to private, credit-based loans to make upthe difference. The majority of these private loans, ifnot all of them, have no cap and therefore offer nointerest rate protection.

On the other hand, "Plus loans can be taken outup to the entire cost of attending college, which isdefined by the school as everything the studentwould need to attend their classes," Hayward says.However, Plus loans generally require that parentsbegin repaying the loans within 60 days of the finalloan disbursement.

Financial Aid Myths

When it comes to information about financial aid,the College Board suggests that you should notbelieve everything you hear. Literally billions of dollarsin financial aid is available to those who need it,yet lots of misinformation clouds the facts about whattype of aid is available and who is eligible.

The College Board reports that from 2002 to2003, student financial aid rose to a record level ofmore than $105 billion. Most aid is awarded throughlow-interest loans, or institutional or other grants,and is based on financial need. College financial aidadministrators often take into account not onlyincome but expenses like home mortgage costs andother financial factors.

"It all starts with the FAFSA (Free Application forFederal Student Aid) form," Hayward says. "A lot ofparents that we meet that already have children inschool haven't even started that process because theydon't think they qualify. Even though you might be ahigh-income earner, your child might still qualify forsome of the loan programs. Everyone should at leastexplore those options."

Hayward stresses that it's important to understand the various deadlines that schools have withrespect to financial aid monies, whether they'reloans or scholarships. In many cases, these moniesare available on a first-come, first-serve basis. Ifyou miss the deadline or you're late in applying,even though you might have qualified for aid, youcould be out of luck.

Do Your Homework

Financial aid is linked to a family's financial status,but scholarships are not. Unfortunately, there aremany scholarships left unclaimed every year."There's some staggering statistic out there about thenumber of scholarships that go unused every yearbecause people don't know they exist," Little says."And what better project for a high school student todo than to research the Internet to track down scholarshipsthat he or she may qualify for?"

Many students hear about scholarships locally,through their church or other organizations theirparents belong to. There are also several nationalscholarship databases available to search, includingCollegeBoard.com and Scholarships.com, and mostdatabases are free. If a site is charging a fee, Frishbergsays, don't bother to apply.

Chela Education Financing also makes available aCD-ROM, "A Parent's Guide to Paying for College2005-2006," that walks parents and studentsthrough the entire financial process, including how tofill out the FAFSA.

It's also critical to gather information on theschools being considered by your child to make certainthere's a good fit. Much information is availableon a college's Web site, and Frishberg suggests youand your child arm yourselves with information andquestions in advance of a college visit.

"It's also important for students to let the admissionsoffice know they're there," Frishberg suggests."Don't just wander around. Go in, fill out acard, and let them know you're present because itshows you're interested and allows the school tostay in touch with you."

If you're looking for an off-the-record assessmentof a particular college, you might want to considerschool-specific insider guides that are available fromCollege Prowler (www.collegeprowler.com). Eachbook covers a particular university and is written bystudents at that school. The books cover everythingfrom academics, dining, and dorms to diversity, safety,and local atmosphere.