Strategies for paying

18 September 2019

Persistence comes in handy when you’re looking for ways to meet college costs.

There’s little question that 529 plans and Coverdell education savings accounts (ESAs) deserve the positive attention they receive. But they’re not the only way to pay for college. Parents were successful in finding ways to foot tuition bills long before these plans were introduced, and some of those methods still merit investigation.

Several of these approaches, like taking a home equity loan, involve long-term commitments and a level of risk you’ll have to consider carefully. But it pays to know about the choices you have, since one of them may just be the solution you’re looking for.

What’s not smart

One of the conflicts you may wrestle with is whether to use the money you’ve invested for retirement to pay for your child’s education. Most financial advisers think it’s a bad idea because it may leave you short of income later on. But if it makes the difference between your child’s going to school or not, you may consider a loan from your employer’s plan — if the plan allows loans — or a withdrawal from your IRA.

The loan isn’t income, so there’s no tax. But if you leave your job before repaying the full amount, the balance will be considered an early withdrawal, subject to tax and penalty if you’re younger than 59½.

If you take money from your traditional IRA, you’ll owe income tax on the amount you withdraw, though not a prepayment penalty. That’s because paying college expenses is considered one of the legitimate reasons for early withdrawal. You can withdraw contributions you made to a Roth IRA without owing tax or a penalty, but you will reduce your retirement savings by that amount.

Where there’s opportunity

Once you actually start paying tuition, you may qualify for a American Opportunity Tax Credit or Lifetime Learning tax credit. Get more information from IRS Publication 970.

Giving gifts to minors

If you want to give your child — or any minor — substantial financial gifts, you can set up a custodial account. You or a person you select controls the account until the child reaches majority, which can be 18, 21, or 25 depending on the state where the account is set up and the type of account it is. It doesn’t cost anything to set up an account and the only fees are trading costs when you buy or sell securities and the fees attached to mutual funds you own.

Custodial accounts fall under either the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfer to Minors Act (UTMA) and are generally known by those acronyms. The major difference is that UTMA contribution rules are more flexible.

You can contribute as much or as little as you like to an UGMA or UTMA account, though annual gifts over $ 16,000 (or $32,000 if you and your spouse make a joint gift) are potentially taxable to the giver. You can invest the assets as you see fit, but any income or capital gains tax that’s due is calculated at the owner, or beneficiary’s, rate. If those amounts exceed the exempt amount that Congress sets for the year, the balance will be taxed at the owner’s parents’ rate.

Take a second look

Custodial accounts may work well as college savings plans because you have enormous discretion over how to invest the assets. The more confident you are about choosing a diversified portfolio, the more attractive this approach may seem.

However, UGMAs and UTMAs also have some potential drawbacks.

  • If the beneficiary applies for financial aid, she or he will be expected to contribute up to 20% of the balance each year in keeping with the standard formula
  • When the beneficiary reaches majority, she or he has the right to assume control of the account
  • Any earnings are taxable, unlike earnings in a 529 or ESA

Home Equity Loans

Your biggest ace in the hole when it comes to paying for college may be the equity you’ve built up in your home. That’s because you can usually borrow more cheaply with a home equity loan than with any personal loan. That’s because the interest rate may be lower than the rate on either a federal PLUS loan or a loan from your bank or credit union.

If you bought your home when your child was small, the original mortgage may be nearly paid off.

That makes it easier to arrange an equity loan. And writing a check to the lender every month won’t come as such a financial shock since you’ve been making mortgage payments all along.

Home equity loans are not a perfect solution, though. First, the money has to be paid back, usually starting immediately. And, if for some reason you default, or fail to pay back your loan, you run the very real risk of losing your home.

Degrees for less

If you’re looking for other ways to save money on college costs, you might consider encouraging your child to consider an accelerated program:

  • Some colleges offer credit for high school advanced placement courses, which could mean finishing a degree a semester, or even two, early
  • Some colleges offer three-year programs that move students through their required courses more quickly
  • Credits earned at local colleges during summer school may count toward graduation and can reduce the number of semesters required
  • Two years at a community or junior college before transferring to a four-year college or university will help lower the total cost of a degree

A bond deal

Baccalaureate bonds are something else to keep an eye out for. Some states issue special tax-exempt zero-coupon bonds, usually sold in small denominations so you can build up a portfolio of them on your own investment schedule.

Because the bonds mature on a specific date, you can time them so you’ll have cash on hand every semester or every year. Some of them provide an extra bonus if you use the money to pay tuition at an in-state school. But if you sell these bonds before they mature, you stand a good chance of losing money, as well as depleting funds you’ll need for college.

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This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.

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