It's five years before your child trots off to college. That may not seem like much time to maneuver your finances, but there's actually a lot you can do to better position yourself to pay for tuition, room and board, fees, and books.
But you have to do some homework—and make sure you involve your children in the planning process, as they will likely be responsible for at least some of the costs down the road. Before your child starts touring college campuses, make sure you research the financial aid system and the costs of college and that you understand your loan options. Also, it's important to make sure you save adequately and invest properly during the remaining years between now and when your child sets off for college.
"The most important step for preparing for college for both parents and students is to start saving money," said Andrew Schrage, co-owner of Money Crashers, a popular personal finance Web site. "If possible, start saving even earlier than five years before entering college."
Here are five steps you can take before your child starts college.
1. Finesse financial aid.
With the cost of a college education increasing at a rate of 3.7% for private schools, as well as 2.9% for public universities for the 2014–15 school year,1 it's more important than ever to understand the financial-aid process and how to potentially improve your eligibility.
In particular, the federal government program Free Application for Federal Student Aid (FAFSA), which is used by many families to apply for aid, has some factors that you may use to your advantage a few years before your child enters college.
FAFSA calculates your expected family contribution, or EFC, as the amount of money that the parents and student together should pay toward college expenses, based on the cost of attending a particular school. The higher the EFC, the less financial aid you can expect to receive, and vice versa. But keep in mind that it is up to the school to distribute financial aid for each student as it sees fit. Just because you receive a low EFC doesn’t mean that you will have to pay only that amount toward college.
Here's an example of a hypothetical expected family contribution calculation:2
As this example shows, when there are two students in college at the same time, the entering student has a lower EFC than if there were only one student in college. You can also see that student assets/income are taken into consideration to help pay for college.
"Paying down all credit card debt and other consumer debt will reduce assets and improve chances of more federal financial aid," said Schrage. "Assets in the student's name count more than those in the parents' name when determining the Expected Family Contribution, which will reduce the amount of aid available."
Consider spending down custodial accounts in the child's name, and consider adding any surplus monies to retirement accounts in the parents’ name, thus improving a family's chances for more federal financial aid, because these accounts aren't taken into account for the EFC.
Understand college costs
It's important for families to understand the true college costs that they will face (Read Viewpoints: "How much college can you afford?"). The average annual total for tuition, fees, and room and board for an in-state public four year college was $24,061 for the 2015–16 tuition year. The average total for tuition, fees, and room and board for a private four-year college was $47,831 for the 2015–16 tuition year.3
A recent Fidelity study on families' preparedness for college found that, on average, families intend to pay 70% of their children's college costs.4
In reality, few families pay the full sticker price for college. In view of this, colleges have been required to provide a “net price calculator” on their Web sites to provide a rough estimate of what the costs for prospective students are, after grants, financial aid, and certain expenses are taken into account.
"Fidelity suggests performing a dry run with the College Board EFC calculator—even five years before you complete your first FAFSA application—in order to obtain a ballpark EFC figure and get a sense of what family financial data is required to participate in the financial-aid evaluation process," says Ribika Mohapatra, a director of financial solutions with Strategic Advisers, Inc., at Fidelity Investments. Then, once you're closer to deciding on which schools to apply for, use the college’s net price calculator.
2. Get familiar with grants, scholarships, and loans.
Your financial-aid award may consist of a combination of grants and scholarships (money you don't have to pay back) and loans (which must be paid back). As the chart below shows, the largest piece of undergraduate aid (40%) comes from federal loans, consisting mainly of two loan types—Stafford loans (subsidized and unsubsidized) and PLUS loans. The average undergraduate aid per full-time equivalent student totaled $14,210 in the 2014–15 school year, including $8,170 in grant aid from all sources, and $4,800 in federal loans.5
Federal Pell grants—up to a maximum of $5,815 for 2016-17 academic year—are awarded based on financial need, as determined through the FAFSA. Colleges and universities award grants based on financial need, merit, or both. State grants vary in amount and are usually need-based awards. Private grants are based on a variety of factors, including background, associations, achievements, interests, and need.
Awarded by the federal government, institutions, states, and private sources, scholarships may be based on different factors such as merit, need, diversity, interests, or cultural background, to name a few.
It is a good idea to research the different types of grants and scholarships available to your child or loved one, to make sure you're utilizing any source of funds you don't have to pay back. To look for scholarships, search fastweb.com and finaid.org.
While your student may or may not qualify for grants or scholarships, there are a variety of loans available to help foot looming tuition bills. Read the Viewpoints Student loan guide for a broad description of what is available.
Probably the most attractive loans are subsidized Stafford loans. These are federal government loans available to any student who meets the FAFSA eligibility requirement and who typically has an unmet financial need after Pell grants and other financial aid are factored in. Typically, they are offered at set amounts for each school year—from $5,500 for the first year up to $7,500 in the third year and beyond—with a lifetime limit of $31,000.
Also to be considered are unsubsidized Stafford loans and private education loans, which you may apply for regardless of financial need. With unsubsidized Stafford loans, the interest on the loan begins accruing immediately. However, the student may defer payments until six months after he or she leaves school.
Parents may borrow for college through PLUS loans, which allow you to defer repayment until six months after the student leaves school, although the interest begins to accrue as soon as the loan is dispersed. Borrowing limits are high, so parents with good credit histories may borrow up to the full cost of the student's education, less any aid the student has received.
3. Revisit how you've invested your child's college savings.
As you prepare for college, take a good look at the investment portfolio within your college savings, and make sure it still makes sense. After all, your savings goals are beginning to shift from growing your savings to getting ready to use them to pay your college bill. In fact, many people don't understand the need to reduce the proportion of their equity investments—and thus their risk—in their college savings portfolio as college approaches.
"As college gets closer, it’s important to review your investments and consider shifting to a less aggressive mix than perhaps seemed reasonable 10 years before college," says Keith Bernhardt, vice president of college planning at Fidelity Investments. "Big swings in savings due to market volatility can be disruptive to your plans, while going too conservative may not give you the opportunity to keep pace with tuition inflation. An age-based investment strategy, such as the age-based investment portfolios in the Fidelity-managed 529 college savings plans, takes this into account by investing in an appropriate mix of assets based on when the student is expecting to enter college. Investments in these portfolios shift from equity to fixed income as the college-entry date gets closer."
Professional portfolio managers handle the asset allocation based on the target date of when the student is expected to begin college. As the portfolio approaches the target date, the allocation shifts over time to reach 20% equities, 50% bonds, and 30% short-term investments within a few years of when the child enters college. The chart below shows how the Fidelity-managed 529 college savings plans manage risk over time.
The federal income-tax-free advantage granted to 529 college savings plans for qualified distributions can be significant. Distributions from 529 college savings plans can be used to pay for qualified higher education expenses (tuition, fees, books, supplies, and equipment required for enrollment at accredited institutions). In addition, the distribution may also be used toward room and board, so long as the beneficiary of the plan is attending the school at least half-time.
A 529 college savings plan may offer added estate planning benefits as well. “Any contributions made to a 529 college savings plan are considered ‘completed gifts’ for estate tax purposes, so they come out of your taxable estate, even though the account remains under your control,” Bernhardt says.
Most 529 college savings plans have lifetime contribution limits of $275,000 or more per beneficiary, and age limits on contributions or withdrawals. You are typically allowed to give an individual up to $14,000 a year ($28,000 per married couple filing jointly) and stay within annual gift tax exclusions, but with a 529 college savings plan, the gift amount can potentially be much higher. For example, you could give $70,000 per beneficiary (or $140,000 per married couple filing jointly) in a single year and treat it as though you were giving that lump sum over a five-year period. This approach can help an investor potentially make very large 529 plan contributions in a short period of time without exceeding gift tax exclusions. Of course, additional contributions to the plan during those same five years would result in going over the gift tax exclusions and result in additional tax filing work.6
But, say you are risk averse and don't want to invest in equities. "You might consider purchasing U.S. savings bonds, which would earn more than cash over five years," Mohapatra says. Not only are savings bonds safe (they are backed by the U.S. government), but you and a spouse can each purchase up to $30,000 of certain types of bonds and defer federal taxes on any interest earned until you redeem the bonds. Depending on your income, you may be able to exclude the interest from your federal taxes if you use the bonds for qualified educational purposes. Talk to your tax adviser for the best approach for your unique situation.
Also, it’s important to keep in mind that your education savings plan is just that—a savings plan. No matter how much you tweak the investments within your 529 plan, it all comes down to how much savings go into your plan. You may want to revisit your goals as your situation evolves. Look at the schools you and your child are considering, and make sure you’re saving enough to pay for them.
4. Research colleges together.
Some of the greatest missed opportunities begin by not having the right conversations between you and your child when you start planning for college. The Fidelity College Savings Indicator study7 found that 79% of families with older children (age 15+) who had these conversations took action to address how those issues would affect earning potential, job prospects, and future student loan debt. Below is a list of suggested topics parent should have with their college-bound children.
Having conversations with your child about which school he or she would like to attend, the child’s interests, and what you are willing to contribute, are good starting points. Colleges and universities may be pretty strategic about awarding financial aid, so if it is determined that you do qualify for financial aid, you may be eligible for a better package if your child has a background or interests that match a particular school's criteria. Here's where doing college research several years out may be beneficial. If you know what studies, sports, arts groups, or extracurricular activities your college of choice deems attractive, your child may want to start engaging in those same studies and activities in high school in order to potentially garner a better financial-aid package.
“If families commit to saving, planning, and talking about college priorities early, they are better prepared to meet college costs and help their children avoid significant student debt in the future,” said Bernhardt.
5. Consider working with a trusted adviser.
“The best strategy to take here is to consult with a financial adviser before making any financial moves, in order to maximize the amount of federal financial aid, especially if your assets are significant,” said Schrage.
An expert adviser can help you evaluate your family's income, assets, and liabilities, and suggest actions that may allow you to enhance your financial-aid eligibility. For example, having sufficient life insurance and disability insurance to help provide income to cover school and living expenses in the event of an illness or accident can be an enormous help, both for the child and for the parents.
These discussions are more successful when they are conducted well in advance of your child's financial-aid application deadline. This way, there is plenty of time to consider your adviser's suggestions and take appropriate action.
But be careful when selecting college planning advisers, and also keep a look out for financial aid scams and fraud. Make sure that the college adviser has you and your child’s interests in mind, and not the adviser’s own. For a list of professional organizations, see FinAid.org.
"Paying for college is such a balancing act, trying to make your savings, taxes, income, and financial aid work to your advantage," Mohapatra says. So it helps to work with advisers with college planning expertise, who may be able to help you avoid any potential pitfalls.