Financially Preparing For College

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In the prior post I showed you how the average American could save $780 per year on their cell phone bill. For a new mom and dad that is $1,560 each year, or $130 per month. This was only the most recent example of easily accessible money saving practices that have been reviewed on this blog. The reason that I spend so much energy devoted to improving and optimizing personal finances is for two reasons.

First, I do not plan on working forever, and the only definitive way that anyone can save enough money for retirement is by choosing to make daily intentional decisions to design their future. Second, I want to make sure that I do everything within my power to give my son his best chance at excelling physically, emotionally, spiritually, and financially. While I certainly do not plan on discussing each of these topics in this post, I do hope to write about each of them in the future. That being said, both of these reasons are related to one another in that by freeing myself little by little from the number one cause of stress in Americans’ lives, money, I am enabling myself to be a more present, involved, and engaged father in the life of my son.

Before we continue, let me reiterate that while I am a personal finance enthusiast, I am not your accountant, attorney, financial planner, or financial adviser, and nothing on this website is to be construed as coming from a professional. The information provided in this article is for informational purposes only, and nothing on this website is to be considered as professional advice. As such, I, the author, am not liable for any losses or damages related to actions or failure to act in any relation to the content on this website. If you need specific financial or tax advice, consult with a certified and licensed professional who specializes in your subject matter.

Let’s begin

Did you know that money in a qualified retirement account is not reported as an asset on the Free Application for Federal Student Aid (FAFSA)? Qualified retirement accounts include 401(k), 403(b), 457(b), Roth 401(k), Traditional IRA, Roth IRA, SEP, SARSEP, SIMPLE, Keogh, ESOP and pensions. This is fantastic, because it means that parents can prepare for their own financial futures without having their children slighted when it comes time to petition the Federal government for financial aid.

Additionally, it means that the $23,400 in seed money that you helped your child to contribute to a Roth IRA by the time that they are 18 years old, will not be expected to be used to pay for college expenses. However, pay attention parents! Did you realize that 529 college savings plans are not included on the list?

cost of college and 529 plans

Why you should not fund a 529 plan for your child

The SEC broadly defines 529 plans as tax-advantaged savings plans which are designed to encourage saving for future education costs. There are two general types of 529 plans, prepaid tuition plans and education savings plans. Although these accounts are both intended to help encourage saving for future educational costs, there can be substantial downsides in choosing to use either of these vehicles.

First, assets in a 529 plan, owned by the student or their parents, reduce need based aid by up to 5.64% of the asset’s value.

Well at least 5.64% is less than I would have paid in taxes had I not contributed the money to the 529 plan.

At the surface, this may seem like a legitimate point. However, let’s review the math! Assuming that the 529 plan has a balance of $30,000 when your child first applies for FAFSA, and assuming that the funds will be withdrawn equally over four years, the below table summarizes the reasonably assumed impact to their financial aid.

Year529 Plan BalanceExpected Loss of Financial Aid
1$30,000$30,000 x 5.64% = $1,692
2$22,500$22,500 x 5.64% = $1,269
3$15,000$15,000 x 5.64% = $846
4$7,500$7,500 x 5.64% = $423

In reality, the expected loss of financial aid renders an equivalent tax rate of 14.1% ($4,230 / $30,000).

Well, a 14.1% effective tax rate is still better than 22% or 24%!

Although I do not disagree with this statement, there are few Americans that pay this high of a tax rate. According to MarketWatch, nearly half of Americans do not pay any Federal income taxes, and according to the IRS, in 2015, the average American’s Federal income tax rate was 13.5%. Based on these findings, the perceived benefit of having a 529 plan does not stand its ground against intelligent scrutiny for the majority of Americans.

There is another element to understand about the utilization of a 529 plan. Specifically, what happens if your child decides that they do not want to complete a four year collegiate study. If withdrawals are made from the 529 plan and are not used for qualified higher education expenses, they will be subjected to the current state and federal income taxes at the time of withdrawal, plus there will be an additional 10% federal tax penalty on the account’s earnings.

This creates the risk of having to pay a higher tax rate in the future than you otherwise would have had to pay at the time you originally earned the income. This is a very legitimate prospect because it is reasonable to presume that the government will have no choice but to eventually raise tax rates in order to generate increased revenue to pay for its continued expenditures. This is not intended to be political in anyway, rather it is a common sense observation: one does not lower a deficit by continuing to spend larger amounts of money while collecting the same amount of revenue!

Also, given the fact that an increasingly popular political platform is free college tuition, having a 529 plan in 17 or 18 years could be rendered entirely obsolete.

What if a grandparent is the account holder of the 529 plan

Given that a 529 plan owned by a student or their parents lowers the financial aid that the student would otherwise receive, some clever readers may wonder if it is then better to have the 529 plan held in the name of grandma or grandpa. Well, although the 529 plan will not appear on the FAFSA as an asset of the student or their parents, all money that is withdrawn from a 529 plan to pay for a student’s tuition or other educational expenses must be reported on the next year’s financial aid forms as untaxed income to the student. This can reduce the amount of a student’s financial aid by 50 percent of the amount withdrawn from the plan.

For example, if a grandparent owned a 529 plan that contained $30,000, and $10,000 was withdrawn for one year of a student’s qualified education expenses, the withdrawal would likely increase the amount that the family is expected to pay for the next year of college by $5,000 ($10,000 x 50%). To state the seemingly obvious, if $30,000 is saved in a 529 plan which is owned by a grandparent, it should reasonably be expected that their grandchildren will receive $15,000 less in financial assistance than they otherwise would have received, effectively reducing the 529 plan’s expected value from $30,000 to $15,000. Yikes!

To summarize, no matter who owns the 529 plan, your child will receive less financial aid for being a recipient of the account’s funds, and for a significant majority of Americans, the implied effective tax rate of the financial aid reduction exceeds their Federal income tax rate. I understand that most of you are not relishing like I am in this wealth of exquisite information. However, as a new father, with student loan debt in the trillions, I am left wondering what steps should I be taking in order to help send my son to college if he decides that he wants to go.

Where does this lead us

A reasonable thought that some readers may be having is can a 529 plan be used to pay for student loans? Let me first explain the rationale behind this thought process. As discussed, if a grandparent is the account holder of the 529 plan instead of the child or parent, the account’s assets are not included in the FAFSA eligibility equation. Therefore, if a 529 plan could be used to pay for student loans, the logical conclusion would be to leave the 529 balance untouched until the student’s final year of college, when they will no longer need to apply for FAFSA, and then use the money to pay off the loans that were taken out during the student’s first years of college.

Unfortunately, 529 plans currently can not be used to repay student loans. However, earlier this year, a bill was introduced to allow an individual to use up to $10,000 from a 529 plan to pay back their student loans. If this bill manages to come to fruition, contributing $10,000 to a 529 plan held in my parents’ name will certainly be an option that my wife and I have to seriously consider. That being said, for reasons already explained, if the bill is passed and we do determine that we want to contribute to a 529 plan, we will not contribute above the amount that an individual can use to repay their student loans, and we would not access the funds until our son’s final year of college.

To further explain our decision we must review a powerful nuance of the FAFSA eligibility equation which I have not yet mentioned. Notably, the home in which you and your spouse live is not considered as an asset in FAFSA’s financial aid formula, which means that your home equity does not negatively impact your child’s federal financial aid eligibility. As a result, deciding to increase your home equity has a threefold benefit. First, by applying to your mortgage principal balance any money that you would have otherwise set aside in a 529 plan, you avoid having any unused money in the account. Second, as mentioned, you are able to build your assets without negatively impacting your child’s financial aid. Third, by paying down your mortgage’s principal balance more quickly, you reduce the amount of interest that you will pay over the life of the loan, and thereby enable yourself to save more money for your child’s future than you ever would have been able to by contributing an equal amount to a 529 plan.

In case you were wondering, it is time to Nerd out!

Many people fail to realize the incredible amount of interest that will be paid over the life of a 30 year mortgage. For example, using a simple loan amortization spreadsheet, you can see that a $250,000 loan, with a 5% interest rate, and a 30 year duration, will result in interest payments totaling $233,139.46. To be clear, this means that after 30 years, the $250,000 principal balance will be repaid along with $233,139.46 in interest payments, for a grand total of $483,139.46.

Alright New Dad, how is this relevant to financially preparing for my child’s college tuition?

Fair enough. Earlier, we assumed having $30,000 in college savings for our financial aid examples. According to Gary Sipos, the founder of College Cash Solutions, for a variety of reasons the average 529 plan returns only 3% annually. Therefore, to save $30,000 in 18 years would require saving approximately $103.67 for 216 months (12 months x 18 years). However, we noted that by saving this money in a 529 plan, your child’s financial aid would be dramatically, negatively impacted.

Therefore, what if instead the $103.67 was applied to your mortgage principal balance each month for 18 years? By paying an extra $103.67 for the same 216 months, the duration of the example mortgage will be reduced by 44 months. Therefore, since the original monthly payment for this loan was $1,342.05, you will have saved yourself $59,050.20 in future mortgage payments ($1,342.05 x 44 months)!

As a result, you will have saved $29,050.20 more than if you had simply contributed the same money to a 529 plan ($59,050.20 – $30,000). Additionally, do not fail to recall that due to the FAFSA financial aid eligibility equation, having $30,000 in a 529 plan would effectively reduce your child’s expected financial aid by $4,230, but potentially up to $15,000. Therefore, the entire realized benefit of this stealth decision results in additional savings of either $33,280.20 or $44,050.20 (The additional money saved plus the negated impact to FAFSA eligibility = $29,050.20 + $4,230 or $15,000)!

I understand that this may seem like a lot of math, but understanding it is very important, so go ahead and read the last three paragraphs one more time!

For your convenience, below is a table outlining the additional realized benefit for several loan amounts based upon the decision to pay an extra $103.67 to your mortgage principal each month for 18 years instead of saving the same amount in a 529 plan.

Loan AmountAdditional Realized Benefit
$350,000$34,354.16 / $45,124.16
$300,000$33,817.02 / $44,587.02
$250,000$33,280.20 / $44,050.20
$200,000$32,206.56 / $42,976.56
$150,000$30,596.10 / $41,366.10

(These values were calculated by multiplying the reduced number of monthly mortgage payments by the monthly payment amount, then subtracting $30,000 (the value of the alternative investment, the 529 plan), and then adding back $4,230 or $15,000 (the amount of financial aid that your child should reasonably expect to have lost if they had access to the 529 plan).

As you can see, each of these scenarios results in saving $30,000 to $45,000 more than contributing equally to a 529 plan. Further, since this money is not in a 529 plan, if in the next 17 or 18 years attending college becomes free or corporations begin emphasizing skills instead of requiring a college degree, or if your child decides to pursue a trade, you will be more advantageously positioned financially in order to help your child navigate the environment!

“Math has been a companion that helps me find order in chaos, and calm confidence in uncertainty. It is a creative art that lets me explore the possibilities and discover new ways of thinking that enrich all aspects of my life.”
Brett Woudenberg

P.S. Foreseeably, some of you may be thinking that you can not afford to save an additional $103.67 per month. However, as was referenced at the beginning of this article, not only have many personal finance optimizations been discussed on this blog that will save you multiple thousands of dollars per year, but also in a recent post a simple change was reviewed that would save the average American couple $130 per month on their cell phone bills. Therefore, it is nearly certain that you have no legitimate excuse to prevent you from saving an additional $103.67 per month!

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