Saving for college is simple — if a financial advisor is possessed of a Kreskin-like ability to predict the future of the tax code, financial aid programs and investment returns while also correctly anticipating if, when and where a client's children will attend school.
For the ESP-challenged, though, the complexity and variables of prospective education costs are overwhelming. This is good news for advisors — but only for those who know enough to help their clients make sense of it all.
What follows is an action plan for managing college savings from the year of a child's birth to the midteen years. (Next month's column will discuss the years immediately preceding college through the post-graduation years.)
In one episode of the HBO series The Sopranos, Tony Soprano's girlfriend Svetlana says: “Russians always expect bad things to happen, and they are rarely disappointed.”
This quote has something to say about college investing: Plan for the worst. All the saving and planning in the world can be derailed by a single unanticipated tragedy. Before an advisor starts talking about saving and investing, he should take a number of steps to make sure the children's financial futures are protected.
Create a will
Most parents don't have one, and those clients who have taken the time to create one frequently neglect to update it. Attaching a trust to the will can ensure that any money left for orphaned children is spent in the manner intended by the parents.
The sensitive nature of this decision keeps many parents from completing the estate-planning process. Better to name someone than no one, but if clients can't get over this hurdle, skip it and move on to the other steps.
Address the issue of life insurance
Low- to moderate-income families should have at least a half-million dollars of term life insurance per child, per parent, with the term expiring when the child reaches her mid-20s. Wealthier families could pursue cash-value policies, taking comfort in the idea that while most financial aid offices don't count life insurance as an attachable asset, the families can still take a tax-free loan against the policy to pay for college expenses.
Max Out the Retirement Plans
Overstuffing 401ks and Roth IRAs should be the first investment priority of every parent, regardless of income and assets, for the simple reason that it's hard to get a “retirement loan.” Kids, on the other hand, can always borrow money to pay for college — or just not go at all.
An underfunded retirement plan means parents may have to work longer than they want to, at best. At the worst, a shortage of cash can spread poverty through multiple generations of a family.
A little now beats a lot tomorrow
Financial aid offices generally don't count retirement plan balances as part of the family's assets, but retirement plan contributions made while the child is attending college are added right back into the aid-reducing portion of the Expected Family Contribution.
For a quick tutorial on financial aid, check out the free calculators at finaid.org. They'll help advisors give families a more accurate picture of how much aid they might (or might not) get, and advisors will get a clearer view of their clients' personal financial picture.
Pay Off Consumer Debt
The interest isn't tax deductible, the rates can be astronomical and the only activity that doesn't generate an extra fee for the credit card company is opening the bill. If that's not enough incentive to whittle down charge-account balances, consider this: A family applying for financial aid with $50,000 in cash and $50,000 in credit card debt is considered to have $50,000 in available cash, to be added to the EFC. A family with no cash and no outstanding consumer debt has no money that can be added to the EFC.
Now We Can Talk 529s
College savings plans make great lead-ins to client conversations. But they're not for everyone, especially lower-income families with kids uncertain about attending college. That said, after the above steps are completed, turning to 529 plans makes sense — especially for high-net-worth families.
For the parents
The current benefits of 529 plans are well-documented. And since higher-income (and higher-taxed) parents are more likely to send their kids to higher-priced schools, the suitability of qualified state tuition plans rises right up the income scale. However, keep in mind that despite overwhelming public support for the concept, 529 accounts may someday be considered by financial aid offices to be student assets, rather than those of the parents. If that unlikely-but-possible nightmare scenario comes to fruition, 529 plan assets may drastically cut the financial aid available to many lower- and middle-income families.
Meet the grandparents
The older generation is probably wealthier and wiser than the parents and may even be more willing to help their grandchildren than they were their own kids. Best of all, assets in nonparental 529s currently count as a big fat zero on the financial aid application, at least until the withdrawals start. (More on how to finesse that problem next month.)
Playing Keep Away
Other than the miniscule tax benefits and the complete loss of parental control over the money, what's not to like about giving kids money through the Uniform Transfer to Minors Act? How about the UTMA's status as the worst place to put money for college, at least according to Harvard assistant professor Susan Dynarski. She calculates that putting a dollar into an UTMA account could cost a family $1.24 in taxes and lost financial aid. In other words, if the parents tear up the dollar instead of putting it into an UTMA, they'll save 24 cents.
If an advisor comes across benevolent parents and grandparents who have already made deposits into a minor's account, they need to deplete the accounts as fast as they legally can. Some acceptable expenses would seem to be braces, computers, sports, camp costs, a car and, of course, the added cost of insuring the teenage driver. (This last bill should quickly eat up all but the most enormous UTMA account balances.)
One other strategy that might pass the smell test: Once a child has legitimate earned income, take money out of the minor's account, and put it in a Roth IRA. Many financial aid offices don't count a child's retirement plan as an available asset, yet since the contributions can be withdrawn free of taxes and penalties, the accounts can offset college savings shortfalls.
Believe it or not, saving for college during the early years of a child's life is the easy part. In next month's column, we'll address how to guide parents of high school and college students through the torturous labyrinth of taxes, financial aid and investments, and still come out a hero.
Kevin McKinley is a CFP and vice president of investments at a regional brokerage and author of Make Your Kid a Millionaire — 11 Easy Ways Anyone Can Secure a Child's Financial Future.