College Savings Basics

Jian Fang Gu, MS
MU Graduate Student
&
Robert O. Weagley, PhD, CFP®

Many people look at a college degree as an investment. And, it is! The average college graduate earned 75% more than the average high school graduate, according to the U.S. Census Bureau (2006). Do you know, however, that a child born today will need approximately $100,000 for a four-year college education? WOW! How do you finance this investment in yourself or your children?

One option is to save. (Surprised?) Suppose one can earn 6% on one’s saving. If so, it would require a deposit of about $245 a month from birth until the child entered school to be able to pay for college. Of course, another option is to borrow money to pay for college and to repay the debt with higher earnings after graduation. Finally, you might find someone to help pay tuition. That is, seek student financial aid. In fact, 63% of all college undergraduates received some type of financial aid during the 2003-04 school year. This trend is increasing.

Most financial aid is provided by our federal and state governments. Colleges, scholarship organizations, civic organizations, and employers are also important sources for financial aid. Do not leave any stone unturned when you are looking for money to help you pay for your education.

From a student’s perspective, scholarship and grant aid are the ideal financial aid. Since they are pure subsidies, not requiring repayment, they are also known as “gift aid”. Education tax credits and deductions are also pure subsidies, although it often takes time for the savings to materialize, making them less effective in paying college expenses.

Financial aid also includes “self-help” aid in the form of interest-subsidized loans or work-study provided as a source of government assistance. A small amount of student aid comes from the Federal Work-Study Program (FWS) under which the Federal government provides funds to institutions to subsidize the wages paid to financially needy student workers. From the students’ perspective, however, they are simply receiving wages for services performed. Similarly, teaching and research assistantships, from which many graduate students benefit, are also a form of compensation. With respect to interest-subsidies, Stafford Loans and Perkins Loans provide the greatest benefits for students, since the government pays the interest while the student is in school but they do require the student to pay interest following school. Unsubsidized Stafford Loans and PLUS Loans, for parents of undergraduates and graduate students, carry a federal guarantee and a ceiling is legislatively placed on interest rates. In contrast to the above, private loans from lending institutions used to pay educational expenses, by contrast, do not carry any subsidy.

In the 2007-08 academic year, undergraduates received 17% of their financial aid from federal grants, 1% from work-study and 41% from federal loans. State, employer, and private grants combined to provide 14% of undergraduate aid.

The amount and type of financial aid offered to students is based on two factors: the student’s merit (academic, athletic, musical, etc.) and/or the student’s financial need. For undergraduates who are considered dependents, their eligibility for need-based aid is determined by their own and their parents’ financial circumstances.

There is another side to the coin: however. While many programs are seen as aiding college attendance, most programs convert from “aid” to student debt after graduation. Between the 2000-01 and 2006-07 academic years, an estimated 60% of bachelor’s degree recipients borrowed to fund their education. The average debt, in constant dollars, per borrower rose 18%, from $19,300 in 2000-01 to $22,700 in 20006-07 over this time period. Average debt per bachelor’s degree recipient, including those that did not borrow, increased from $10,600 to $12,400.

Saving for College

College is expensive. Given the large and increasing cost of a four-year college education, a child’s college tuition could be one of the largest expenditures a household ever makes. This is the financial challenge being faced by millions of families.

Although families may seek financial aid to finance their children’s college education and with most aid being in the form of debt, children could start out with substantial debt when they graduate. Saving now, therefore, for this future expenditure seems to be the best way to ensure children get the best education, while maintaining the greatest number of degrees of freedom to choose, following graduation.

Fortunately, American families with a desire to save for future college expenses have more options than before. Traditional investment options—savings accounts, taxable investment accounts, annuities, and U.S. Savings Bonds—are now joined by powerful new investment instruments including Section 529 college savings programs and Coverdell education savings accounts. Families saving and paying for college can take advantage of federal tax incentives that are offered by the federal government, as a subsidy to college expenses. The most popular types of college saving plans include the following:
· Qualified Tuition Programs (529 plans)
Educational savings plans known as 529 Plans are operated by states and some educational institutions. These plans are designed to help families set aside funds for future college costs. Within a 529 plan, earnings grow without being taxed and distributions are tax-free when used for qualified post-secondary education costs. 529 plans can be used to meet the costs of qualified colleges nationwide, although some restrictions apply. (For example, room and board is not a qualified educational expense.) More than 270 private colleges and universities have joined together in prepaid tuition plans that carry the same tax benefits as the state-sponsored 529 plans. These plans have grown in popularity in recent years and they held $110 billion in assets by the end of the second quarter in 2008. (Comment: We know this is quite a bit less today, than then.)
· Coverdell Education Savings Accounts
With a Coverdell Education Savings Account, earnings grow tax-free and distributions are tax-free when used for qualified post-secondary education costs. It may also be withdrawn tax-free for primary and secondary school expenses, if these expenses are prior to 2011.
· U.S. Savings Bonds
EE and I bonds purchased after 1989 by an individual who is age 24 or older may be redeemed tax-free when the bond owner or the bond owner’s spouse or dependent pays for college tuition and fees. In 2008, the tax exclusion is phased out for single income filers with income between $67,100 and $82,100 (between $100,650 and $130,650 for married couples, filing jointly). These income limits are indexed to increase each year.
· Individual Retirement Accounts
Early withdrawal penalties are waived when Roth IRAs and traditional IRAs are used to pay the qualified post-secondary education costs of the account holder, his/her spouse, children, or grandchildren. Regular income taxes are still payable on these withdrawals, however.
Clearly, higher education is a key to financial success and how we decide to pay for that education can greatly affect the economic value of that decision. Not everyone is the same, so no one method of saving for college is right for everyone. Our advice to you, however, is to not employ the ostrich method of sticking your head in the sand and pretending these costs are not there or that you’ll find a way to pay for them when you do pull your head out. On the other hand, we are often biased in our approach by our own personal experiences in life – we did it “one-way” and they can, too! We encourage you to think about how you will pay for college when it is your time to send a child to college or, most likely, when it is time for you to attend college. Make a well-informed, deliberate decision. Consider all the sources of funding for college and what you can do to have the most control over these decisions. Seek out more information, as tax policies and investments can change over time, and put together your plan for your, or a loved one’s, college education. Going to college is expensive….just not as expensive as not going to college….

References (check out these websites):
College Board. (2008). Trends in Student Aid 2008. Trends in Higher Education Series. Retrieved on November 17, 2008 from www.collegeboard.come/trends.
Kim, J. J. (2008). College Savers Stuck in Stocks as Market Falls. The Wall Street Journal, October 17, 2008.
Savingforcollege.com. Retrieved on November 17, 2008 from www.savingforcollege.com.

- Robert O. Weagley, Ph.D., CFP(r)
Chair, Personal Financial Planning
University of Missouri
Columbia, MO 65211