Start Now, Save Big On College Financing

By Mitch Swanda, USAA Financial Planning Services

Winter 2004-05

For military parents of young children, funding a college education can easily fall to the bottom of the to-do list. After all, when you're clipping commissary coupons for diapers, it's tough to put money toward something the kids won't need for many years. But starting a college fund early can help parents receive one of the best deals ever, saving them thousands of dollars in the long run.

In the 2003-2004 academic year, the average cost of tuition, room and board at a four-year public institution was $10,636, according to The College Board, a not-for-profit education services organization. At private universities, the average cost was more than double, at $26,854 for a single year. What's more daunting is that college costs are rising at double the overall rate of inflation, meaning 2004 will seem like the good ol' days by the time today's toddlers leave for college.

The staggering price may make some parents rethink the value of a college education, but the costs associated with not going to college are likely to be much greater. In fact, The College Board reports that median annual earnings for college grads are about 60 percent higher than earnings for those with only a high school diploma.

Despite the horror stories of rising costs, most families have the ability to make college affordable through proper investment planning and an understanding of the options for financial aid. Here are a few key points parents should consider:

Jump Start Your Savings

The greatest ally of a long-term investor is time. The earlier you start saving for college, the more you and your child benefit from compounding interest, which can add up exponentially over the years and dramatically reduce the amount you need to contribute to the account.

As a hypothetical example, assume that four years of college will cost $100,000 when your newborn becomes a freshman in 18 years. If you start building an education fund in the child's first year and earn an average seven percent annual return, you'll need to put away $2,784 annually, or $232 per month, for 18 years to reach your goal. By the start of the freshman year, your $50,112 investment has turned into $100,000. But if you put off the college fund until your child is in first grade (age 6), you'll have to nearly double your contributions for the next 12 years ($5,340 annually, or $445 per month) to meet the same $100,000 goal.

Beyond the marvel of compounding interest, starting early can provide flexibility for parents who need to start small and increase their contributions over time. Having time on your side also means that you may be better able to weather the ups and downs of the financial markets, making it possible to put a larger portion of the money in stocks, which are higher-risk but offer higher earnings potential.

Once you've made the resolution to start saving, the next step is choosing an investment vehicle that will help your money grow and hopefully provide income tax advantages. For the novice investor, the array of options available can be both encouraging and confusing:

Coverdell Education Savings Accounts (CESA). Formerly known as an "Education IRA," the CESA is a tax-deferred account that allows parents to contribute up to $2,000 per year for each child under 18 years of age (the age limits do not apply to a beneficiary with "special needs"). The proceeds may be distributed tax-free for educational expenses, but they must be fully distributed before the child reaches age 30. An additional advantage of the CESA is that the savings aren't just for college. The money can also be used for qualified school-related expenses from kindergarten through high school.

529 Plans. So called because the tax benefits are derived from Section 529 of the Internal Revenue Code, state-sponsored 529 plans are usually categorized as either "college savings plans" or "prepaid tuition plans." College savings plans, typically the more popular of the two 529 options, offer investment choices ranging from aggressive to conservative, depending upon the account owner's risk tolerance. Contributions are made with after-tax dollars, but the earnings grow tax-free and distributions can be made tax and penalty-free for qualified higher education expenses, which can provide a substantial savings boost over the years.

Prepaid tuition plans, the other type of 529 plan, allow you to lock in today's tuition rates at a state school by starting tuition payments now and earning a rate of return designed to match the state's expected rate of tuition inflation. However, these plans don't usually offer the same opportunity for high growth as college savings plans, and some states have closed their prepaid plans for new accounts.

The CESA and 529 college savings plans are similar in that they are both considered assets of the parents, which can work to the child's advantage when applying for financial aid. Also, both plans allow contributions from almost anyone, so grandparents and others may contribute if they wish.

In contrast, 529 college savings plans allow much higher contribution limits than CESAs. And only qualified college expenses (tuition, fees, books, etc.) - not K-12 expenses - qualify for penalty-free withdrawals from a 529.

UTMA/UGMA Accounts. Another savings option some parents and grandparents consider is a custodial account established through the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). The account is established in the child's name, but the donor controls the assets until the child reaches adulthood (18-21 depending on the state). At that point, the child has the legal right to use the money how he or she sees fit - be it for college tuition or outfitting a rock band - a rule that makes some parents uncomfortable. In some circumstances, UTMA/UGMA accounts can be used to gain tax advantages, but if the primary purpose of the account is to save for college and you're hoping to receive financial aid, most parents would be wise to carefully consider a CESA or 529 plan before choosing a UTMA/UGMA account.

U.S. Savings Bonds. Parents also may look to U.S. Series EE Savings Bonds, on which interest is tax-free when the bonds are redeemed. However, for 2005, if your income is more than $91,750 for married filing jointly, or $60,750 for single or head of household, the tax benefits of savings bonds are phased out, making them a less attractive choice for college savings.

Financial Aid Can Ease Funding Gap

Even with the best intentions, some parents find that saving enough for college is simply not possible due to other financial obligations and priorities, such as retirement, paying down debt and building an emergency savings fund. To make up the shortfall in college funding, many families turn to loans, grants and scholarships offered by the government, universities, or other private organizations.

Most financial aid programs are based on the student's need, so it pays to plan in advance to help your child's chances of qualifying for aid. The planning begins as soon as you open a college savings account. While some parents are tempted to put the account in the child's name for tax purposes, the savings are usually eliminated if the child is unable to qualify for aid due to the substantial assets in his or her name. In most cases, establishing the account in your own name or a grandparent's name is the best bet.

At least two years before your child enters college, conduct a self-evaluation of your financial standing to determine how you might make adjustments to qualify for as much financial assistance as possible. It's during this time that aid officials determine a student's eligibility, so minimizing your income through tax deductions and avoiding large capital gains can help. For information on financial aid options and qualification requirements, visit the U.S. Department of Education website at www.ed.gov.

When federal funds aren't available and interest rates are low, a home equity loan or line of credit can be an alternative to financial aid.

The Military Connection

Whether taking advantage of their parents' military service or donning a uniform themselves, many high school graduates can benefit from a generous range of scholarships and programs related to the Armed Forces.

Scholarships are offered service-wide, such as the Retired Officer's Scholarship Program, or by a specific unit, such as the First Cavalry Division Association. Students also may obtain full or partial college funding by enrolling in military academies or the ROTC, and still others may choose to delay a college education and save money by serving on active military duty.

Most people agree that the prospect of paying for college can be daunting. But thanks to the enormous range of funding options for families from all walks of life, college is not a luxury available only to the affluent. With advance planning and disciplined saving, you can worry less about the finances and more about helping with the homework.

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Mitch Swanda served six years on active duty in the U.S. Navy and is a salaried Certified Financial Planner™ practitioner with USAA Financial Planning Services, one of the USAA family of companies. USAA is a diversified insurance and financial services organization that has served the military community since 1922.

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Beware Of Financial Aid Scams

Unfortunately, as in most industries, there are scams in the college financial aid area that intentionally prey on unsuspecting consumers. Be suspicious of grants, scholarships or other financial aid programs with these characteristics:

Fees charged to file an application, apply for or receive an award.
"Guarantees" you will receive an award or a certain amount of aid.
No telephone number is listed; only a box number address.
Excessive hype or overstated claims about the percentage of successful recipients.

Never reveal your bank account number or credit card numbers on a scholarship application. Many such scams are just fronts for cleaning out your bank account.

Source: USAA Educational Foundation, a non-profit organization whose mission is to help consumers make informed decisions by providing information on financial management, safety concerns and significant life events. To order a free booklet, "Financing College," visit www.usaaedfoundation.org.

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