Your Child's Education: How To Finance It

With the costs of a college education rising every year, the keys to funding your child's education are to plan early and invest shrewdly. However, there are steps you can take if you get a late start. Moreover, there are a number of effective techniques for increasing financial aid opportunities and reducing taxes. Here are some guidelines for funding your child's education that are geared to parents whose children are no older than elementary school age.

Start Saving Early

College is expensive, and proper planning can lessen the financial squeeze considerably - especially if you start when your child is young. Getting an early start on saving is basic to funding your child's education. The earlier you start, the more you'll benefit from the compounding of interest.

Planning Aid: For an estimate of the amount of money you would have at the time your child enters college if you begin saving now, see the Financial Calculator: College Savings Calculator.

When should you start saving? This depends on how much you think your children's education will cost. The best way is to start saving before they are born. The sooner you begin, the less money you will have to put away each year.

Suppose you have one child, age six months, and you estimate that you'll need $120,000 to finance his college education 18 years from now. If you start putting away money immediately, you'll need to save $3,500 per year for 18 years (assuming an after-tax return of seven percent). On the other hand, if you put off saving until the child is six years old, you'll have to save almost double that amount every year for twelve years.

Another advantage of starting early is that you'll have more flexibility when it comes to the type of investment you'll use. You'll be able to put at least part of your money in equities, which, although riskier in the short-run, are better able to outpace inflation than other investments after time.

Find Out How Much You'll Need To Save

How much will your child's education cost? It depends on whether your child attends a private or state school. According to the College Board, for the 2022-23 school year, the total expenses - tuition, fees, board, personal expenses, and books and supplies - for the average four-year private college are about $57,570 per year and about $27,940 per year for the average four-year in-state public college. However, these amounts are averages: the tuition, fees, and board for some private colleges can exceed $80,000 per year whereas the costs for a state school can often be kept under $10,000 per year. It should also be noted that in 2022-23 the average amount of grant aid for a full-time undergraduate student was about $8,690 and $24,770 for four-year public and private schools, respectively. More than 75 percent of full-time students at four-year colleges and universities receive grant aid to help pay for college.

Planning Aid: Use College Search, a database of over 3,200 two-and four-year colleges, to find and select the best colleges for your child.

Planning Aid: If you're trying to estimate future costs, you can estimate that school costs will grow by about two percentage points above the inflation rate. To be on the safe side, we suggest you assume costs will grow by at least 4 percent per year. For the most recent increases, refer to Trends in College Pricing.

Choose Your Investments

As with any investment, you should choose those that will provide you with a good return and that meet your level of risk tolerance. The ones you choose should depend on when you start your savings plan-the mix of investments if you start when your child is a toddler should be different from those used if you start when your child is age 12.

Related Financial Guide: For a general overview of investing principles, please see the Financial Guide: INVESTMENT BASICS: What You Should Know.

The following are often recommended as investments suitable for education funds:

- Series EE Bonds are extremely safe investments. For tax treatment of redemption proceeds used for college, please see the Financial Guide: HIGHER EDUCATION COSTS: How To Get The Best Tax Treatment.

- U.S. Government Bonds are also safe investments that offer a relatively higher return. If you use zero-coupon bonds for your child's education, you can time the receipt of the proceeds to fall in the year when you need the money. A drawback of such bonds is that a sale before their maturity date could result in a loss on the investment. Further, the accrued interest is taxable even though you don't receive it until maturity.

- CDs are safe, but usually provide a lower return than the rate of inflation. The interest is taxable.

- Municipal Bonds, if they are highly rated, can provide an acceptable return from the tax-free interest if you're in the higher income tax brackets. Zero-coupon municipals can be timed to fall due when you need the funds and are useful if you begin saving later in the child's life.

Be sure to convert the tax-free return quoted by sellers of such bonds into an equivalent taxable return. Otherwise, the quoted return may be misleading. The formula for converting tax-free returns into taxable returns is as follows:

Divide the tax-free return by 1.00 minus your top tax rate to determine the taxable return equivalent. For example, if the return on municipal bonds is 5 percent and you are in the 30 percent tax bracket, the equivalent taxable return is 7.1 percent (5 percent divided by 70 percent).

- Stocks contained in an appropriate mutual fund or portfolio can provide you with a higher yield at an acceptable risk level. Stock mutual funds can provide superior returns over the long term. Income and balanced funds can meet the investment needs of those who begin saving when the child is older.

- Deferred Annuities provide you with tax deferral, but the yield may not be acceptable because of the relatively high cost of these investments. Further, amounts withdrawn before you reach age 59-1/2 may be subject to a 10 percent premature withdrawal penalty.

Related Financial Guide: For further information on investing in annuities, please see the Financial Guide: ANNUITIES: How They Work And When You Should Use Them.

If You're Caught Short

If you have insufficient savings for your child's education when he or she is close to entering college, there are ways to generate additional funds both now and when your child is about to enter school:

- You can start saving as much as possible during the remaining years. However, unless your income level is high enough to support an extremely stringent savings plan, you will probably fall short of the amount you need.

- You can take on a part-time job. However, this will raise your income for purposes of determining whether you are eligible for certain types of student aid. In addition, your child may be able to take on part-time or summer jobs.

- You can tap your assets by taking out a home equity loan or a personal loan, selling assets or borrowing from a 401(k) plan.

- You (or your child) can apply for various types of student aid and education loans (discussed below and in Info Sources).

Sources of Student Aid and Financial Aid

Grants are the best type of financial aid because they do not have to be paid back and can be awarded by governments, schools, and other organizations. Some grants are need-based, while others are not. These grants include:

- Federal Pell Grant Program (need-based)

- State education department grants

- Private organization scholarships

- School-provided aid and scholarships (both need-based and non-need-based)

- Military scholarships for Reserves, National Guard, or Reserve Officers Training Corps

It's important to note that middle-class families may still qualify for need-based aid or loans, depending on the cost of the college and the family's size. Employers may also provide subsidies for education.

Loans

Loans can be need-based or not. Here is an overview of different types of loans:

- Stafford loans (formerly guaranteed student loans) are federally guaranteed and subsidized low-interest loans made by local lenders and the federal government. Subsidized loans are need-based, but an unsubsidized version is also available.

- Perkins loans are provided by the federal government and administered by schools. They are need-based and can be inquired about at school aid offices.

- Parent loans for undergraduate students (PLUS) and supplemental loans for students are federally guaranteed loans by local lenders to parents, not students. Information can be obtained at college aid offices or by calling 800-333-4636.

- Some schools may provide their own student loans.

Work-Study Programs

This program is federally funded and based on the family's financial need. Students work on-campus and receive partly subsidized pay. Receiving work-study funds does not affect the level of "need" for purposes of need-based grants and loans.

To thoroughly investigate financial aid opportunities, you should fill out the financial aid application, which you can obtain from the school's financial aid office. You will have to provide tax returns, and the amount you are eligible for depends on your income, family size, the number of family members currently attending college, and your assets.

Planning Techniques to Increase Financial Aid

Here are some strategies to potentially increase the amount of aid your family is eligible for:

1. Avoid Putting Assets in Your Child's Name: Generally, education funds should be kept in the parents' names to avoid negatively impacting aid eligibility. Investments in a child's name can reduce aid by a significant percentage.

2. Reduce Your Income: Income for financial aid purposes is usually determined based on your previous year's income tax situation. To reduce your taxable income in the years immediately before and during college, consider deferring capital gains, selling losing investments, reducing business income, avoiding distributions from retirement plans or IRAs, and paying taxes during the year in the form of estimated payments.

3. Detail Financial Hardships: If you have financial hardships, clearly explain them in the financial aid application. Financial aid officers may be able to assist in explaining hardships.

4. Consider Independence: If feasible, have your child become independent. In this case, your income is not considered when determining your child's aid eligibility.

Reducing Taxes for Education Expenses

While education funds should generally be kept in the parents' names for financial aid purposes, there are cases where keeping investments in your child's name might lead to lower tax rates on income. Professional advice should be sought when making this decision.

In the past, parents invested in their child's name to shift income to the lower-bracket child. However, the "kiddie tax" rules have changed. Now, investment income over $2,500 for children under 19 (or 24 if a full-time student) is taxed at the parents' rate. Consider these tax strategies:

- Shift just enough assets to create $2,500 in taxable income for an under-19 child.

- Buy U.S. Savings Bonds in the child's name scheduled to mature after they reach age 19.

- Invest in equities with potential for appreciation and minimal income during the child's under-19 years.

- Employ your child in a family business, as earned income is not subject to the "kiddie tax."

There are also various tax incentives that may be available for education expenses.

For further information and assistance, consult your financial advisor.

Government and Non-Profit Agencies

U.S. Department of Education (for information on financial aid): 1-800-USA-LEARN (1-800-872-5327)