College Funding Advisor Group: August 2009

College Panic
By Donald Jay Korn
August 1, 2009

Clients whose retirement plans have been disrupted by the current recession often have a logical solution: Work longer. If they can stay in the workforce a few more years, increase their savings and perhaps participate in a stock market recovery, they have a good chance of enjoying a comfortable retirement.

That choice is not practical for the parents of college-bound high school kids. Parents' college funds are down while economic turmoil may make it difficult to pay the steep costs of attending a dream college. Yet those parents can't tell their kids to stay in high school for a few more years until their 529 accounts regain lost ground.

At the same time, college prices continue to rise. Aggregate costs for public and private four-year colleges, comprising tuition, fees, room and board—but not books, transportation and other expenses—rose approximately 5% to 6% last year, on average. And it's hard not to imagine more increases coming. State schools will have to fight with other public agencies for dwindling funds; many private college endowments have taken serious hits. A few private schools, such as Reed College, have admitted that they're looking for students who can pay the entire tuition rather than hewing to their former need-blind admission policy.

As a result, many of your clients with teenage children may be feeling the college panic about now. They are looking at diminished net worths and an uncertain job market and economy—while their kids are plotting college tours. What can financial planners suggest to these clients? How can you help clients whose children are already in college and now find it difficult to pay the ongoing bills? There are many possible steps that parents can take, so advisors should be ready to offer sensible recommendations.

PLAN AHEAD

For starters, college planning should be done in advance whenever possible. Deborah Fox, who heads Fox College Funding in San Diego, says that preplanning can avoid a "whole family drama unfolding" about letting a child attend a university that's not affordable. "Worse yet," she adds, if a child already has applied and been accepted to an expensive school, "parents many times give in to their student due to the emotional component of the college choice. They don't want to prevent their child from attending his or her dream college."

Mary McGrath, executive vice president of Cozad Asset Management in Champaign, Ill., points out that the best time to start the conversation is when the child is around 15 or 16, in high school, but not yet ready to start applying. At that point, the family is thinking about college and has a reasonable idea of how much they can afford to spend. "Parents need to figure out their college budget ahead of time and then discuss it with their child before he or she applies," Fox says. "That way, colleges with the net cost above the predetermined budget can come off the list."

COST CONSCIOUS

As the above comments indicate, financial planning for higher education might begin with budget talks, which could lead to a discussion of target schools. Among colleges, there are huge cost differences.

According to the latest numbers from the College Board, for the 2008 to 2009 academic year, total charges at private universities averaged over $34,000, including about $9,000 for room and board. That's the average; at some private colleges, the total is close to $50,000 a year. If college costs continue to increase at a 5% to 6% annual pace, parents of today's 10th graders could pay $40,000 for their freshman year at an average private college, while an Ivy League education could start at $60,000 a year—transportation, books, pizza and dorm-room decor not included.

If clients are willing to send their kids elsewhere, costs can come down dramatically. At public universities, total costs for in-state residents averaged just over $14,000—more than half due to room and board. Clients who send their kids to a nearby state university, close enough to permit commuting from home, are looking at costs that average about $6,500 a year.

"Community colleges can be less expensive," McGrath says. "Students live at home, and the fees are lower. After two years at a community college, they can apply to a four-year school."
If a student is contemplating taking this route, a planner can earn parents' gratitude by filling them in on the agreements many four-year colleges have with two-year schools. Called articulation agreements, these pacts guarantee that the four-year college will accept credits earned at the two-year school. "It is important to know this in advance," McGrath says. "Many universities have 'partner' community colleges, where they agree on the courses accepted. Some even guarantee admission to certain majors if a student graduates from the community college with the appropriate courses and a certain grade point average. But don't assume that any courses at any community college will get you into the university you want."

Such a route through higher education can pay off beyond cost savings. "If a child wants to go to an elite college, admission as a freshman can be very competitive," says Ian Weinberg, CEO of Family Wealth & Pension Management in Woodbury, N.Y. "A child who goes to a community college and maintains a grade-point average at or near 4.0 may actually have an easier time getting admitted for the last two years of college."

What's more, those local college "A's" will remain on the student's record, according to McGrath, which may make it easier to get into graduate or professional school later. "It's the last school's name that is on the degree, not the community college where the student may have spent the first two years," she says.

McGrath says that some clients worry that their children will miss the college lifestyle experience if they spend two years at home. That may be true, but parents should know just how much they're paying in extra cost to support that lifestyle.

The lifestyle discussion may cut both ways. "We have counseled some of our clients that they will have to make real sacrifices to send their children to private school," says Michael Chasnoff, president of Truepoint Capital, a wealth advisory firm in Cincinnati. "Decisions such as vacations, cars and other lifestyle choices will need to be weighed as part of the college selection process."
A frank look at costs is desirable, for students as well as parents. After such a discussion, McGrath reports, one couple she works with told their son he could attend a pricey university only if he contributed half of the above-budget costs. "The son agreed, and he is now in a work-study program at the university, which reduces the parents' expenses," McGrath says.

LOOK FOR LOANS

Such work-study opportunities are included in many college aid packages, along with scholarships and loans. "Clients who send children to college should fill out the Free Application for Federal Student Aid (FAFSA) even if they don't expect any aid that's based on financial need," says Kal Chany, president of Campus Consultants, a financial aid counseling firm in New York.

U.S. Education Secretary Arne Duncan has said that he wants to simplify the FAFSA, which appears online as a 10-page PDF and asks as many as 153 questions. But the revised form may still be intimidating. Financial planners can play a vital role by helping clients with the paperwork. The FAFSA determines an "expected family contribution" (EFC), based on income and assets. If a school's total costs exceed the EFC, an aid package will be offered to the accepted students. Typically, the aid package is a combination of loans, work-study and grants.
By filling out the FAFSA, Chany says, a student becomes eligible for a Stafford loan, part of the federal loan program. These loans can be sliced into loans directly from the U.S. government (via participating colleges) and loans from private lenders, which have federal guarantees. They can then be diced into subsidized and unsubsidized loans.

"Most subsidized Stafford loans go to students with family incomes under $50,000, but some do go to families with higher incomes: almost 10% go to families with adjusted gross income over $100,000," says Mark Kantrowitz, publisher of FinAid.org. Subsidized Staffords have lower interest rates and somewhat gentler repayment terms than unsubsidized Staffords.

Still, unsubsidized Staffords-the loans that clients' children probably can expect-are appealing to many families, Kantrowitz says. The interest rate is fixed at 6.8%; even though the loans are made to students, there is no credit check, no collateral required and no need for a co-signer.
"Parents should have the student be responsible for taking out at least the maximum Stafford loan each year," Fox advises. For dependent students, the limits are $5,500 for freshmen, $6,500 for sophomores and $7,500 for upperclassmen. "Students who have some skin in the game view their education differently than do students with parents who cover all the expenses," she adds.

Students who take out the maximum Stafford loan each year will have total debt of $27,000 after four years. Assuming that interest accrues at a fixed 6.8% rate while the student is in college and that repayment is under the standard 10-year plan, Fox calculates that the payments would be about $300 a month, which may be affordable for college graduates earning a living.

"After graduation, parents can choose to pay off all or part of the student's Stafford debt as a graduation present," she adds. In the meantime, those loans will provide parents with some relief from having to use additional current income or spend down assets during the college years.

CLOSING THE GAP

Borrowing $27,000 over four years probably won't cover the full cost of attending college away from home. Clients who are willing to take on college debt can get PLUS loans, under another federal program. Parents can borrow amounts up to the full cost of college, minus any financial aid package.

PLUS loans, though, are not as attractive as Staffords. The fixed interest rates are higher (either 7.9% or 8.5%), and there is a credit check. "The credit check is not as stringent as it is for some other loans," Chany says.

Still, parents who have lost a home in a foreclosure or have been severely late with a debt payment will not get these loans; Kantrowitz says that PLUS loan denials appear to have increased in 2009. If a parent is denied a PLUS loan, the student can borrow slightly higher amounts via unsubsidized Staffords, just as independent students have the same higher Stafford ceilings.

Besides an interest rate that's higher than the rate for Staffords, PLUS loans have fees of 4%. An alternative for parents, suggested by Chasnoff, is to use home equity debt for higher education. "Interest rates are attractive," he says. "If a family has a reasonable amount of home equity, that could be a good choice." Bankrate.com puts the average interest rate on a home equity line of credit under 6%; the interest payments are more likely to be tax-deductible than the interest on a PLUS loan.

"Although some parents have discussed the possibility of withdrawing from their retirement accounts to pay for their children's college education, our analysis concludes that they would be better off using debt," Chasnoff says. "Loans are generally a better option, given the tax implications associated with retirement account distributions."

Even though there is no 10% early withdrawal penalty if a client uses an IRA to pay higher education expenses, it should still be considered a last resort—especially now that it could mean selling stocks near a market bottom (we hope). As McGrath puts it, "The last thing a parent should do is to tap his or her retirement account. You can borrow for college, but you can't borrow for retirement."

FIRST, AID

"Even with endowments down, many private universities have attempted to maintain financial aid to students," Kantrowitz says. "They may be cutting back elsewhere, and they might be reducing merit-based aid in order to maintain their need-based aid."

Some need-based aid might be available to financial planning clients in the current economy. "If the parents have experienced a significant change of circumstance (job loss, reduction in income, high medical bills, etc.), they can send a letter of explanation to the financial aid office to request reconsideration of their financial aid package," Fox says. "This year we have found colleges to be very responsive to families who have demonstrated a genuine need for additional help."

Moreover, families not considered "needy" may nevertheless qualify for financial aid-at the right school, one where the student will easily qualify for merit aid. "One of the best strategies for reducing higher education costs is to make sure the student applies to colleges where he or she falls within the top 20% to 25% of the applicant pool," Fox says. "Or, a school may be looking for a talent or a characteristic that student can provide. In those situations, students may be offered the best financial aid packages, even in tough times."

According to Fox, there are hundreds of private schools that will offer tuition discounts or scholarships of $5,000 or more to get the students they want. "This one strategy alone may allow parents to send their child to a private school where their student can actually graduate in four years and get taught by professors rather than teaching assistants, yet pay the same as (or even less than) the cost at a public university," she says.

MAKING COLLEGE LESS TAXING

The federal government also offers financial aid for higher education, including various tax breaks. Earlier this year, the American Recovery and Reinvestment Act of 2009 created an expanded version of the Hope Scholarship tax credit: the American Opportunity tax credit, now scheduled to expire after 2010.

The new credit can save taxpayers as much as $2,500 in tax, if they spend at least $4,000 in a calendar year on tuition, fees, books and materials for higher education. The credit is per student, so a client paying for two collegians this year or next can save up to $5,000 in tax. There is even a refund, up to $1,000 per student, if the parent owes less federal income tax than the credit would be worth.

The catch? This credit is subject to a phaseout for taxpayers with modified adjusted gross income between $160,000 and $180,000 for married couples filing jointly, or $80,000 and $90,000 for single taxpayers. Therefore, many clients won't qualify for this credit.
Nevertheless, clients with income below the thresholds will welcome a $2,500-per-student tax credit. "You can't claim the American Opportunity credit for expenses paid with withdrawals from a 529 plan," says Chany. "Parents may want to adjust 529 withdrawals so some college expenses are paid with other money, to allow the use of the new tax credit." This tax credit is dollar-for-dollar on the first $2,000 of expenses (and 25 cents on the dollar for the next $2,000 of expenses), so clients who qualify should pay at least $2,000 of college costs out of pocket to use the credit.

As Joe Hurley, founder of the Savingforcollege.com website (which has been acquired by Bankrate), notes, "the American Opportunity credit is available only to students enrolled at least half-time in a program leading to an undergraduate degree." Also, this credit is limited to expenses incurred in the first four years of a student's college education.

"For students who do not qualify for the American Opportunity credit, a Lifetime Learning tax credit provides a maximum annual credit of $2,000 for tuition and fees," Hurley says. "Keep in mind, however, that both tax credits operate more like rebates than discounts. They're not applied directly to tuition bills, but are instead made available once you've paid tuition." Again, the Lifetime Learning credit (which is 20 cents on the dollar) can't be applied to expenses paid with 529 withdrawals, so clients should be careful with 529 withdrawals if they intend to use either credit. Clients can use both in the same year, but not for the same student.

WAITING FOR THE REBOUND

As discussed above, some clients may have 529 college savings plans. "Many of those plans are age-based, so they switch from stocks to bonds as the child approaches college," Kantrowitz says. "In those plans, losses may not have been as steep as they were in the stock market last year." Nevertheless, a dreadful year for stock funds, combined with a poor year for many bond funds, has driven down the value of many clients' 529 accounts.

Clients with younger children can keep contributing and hope for a rebound. Parents of college and pre-college students, though, may have few options other than using 529 plan withdrawals to pay for higher education. "We have advised clients to pay for college from cash flow or from cash reserves. This delays liquidation of 529 assets as long as possible, allowing for a recovery," Chasnoff says. "However, clients should be mindful to reimburse themselves before the end of the calendar year in which the expenses were charged and incurred."

That is, a client might pay $20,000 out of pocket for college in 2009, leaving a 529 account in place in the hope of tax-free growth. Before the end of 2009, though, the client should withdraw the $20,000 from the 529 account if that client intends to pay for college with 529 funds. (If the client qualifies for the American Opportunity tax credit, he might withdraw only $16,000 from the 529 account and claim a $2,500 tax credit for the $4,000 net cost.)

And what if the market doesn't come back? If the client has other funds that can cover college bills without disrupting his or her financial plan, keep the money in the 529 as long as feasible, in hopes of future tax-free growth. In any case, clients should spend down their 529 funds if a child is finishing school and there is no younger sibling who could use the funds in the future.
Hurley suggests that parents of college-bound children realize losses in their taxable accounts to lock in tax benefits. The proceeds can be reinvested in 529 accounts so that any future gains from today's low levels can be withdrawn, tax-free, to pay for college later on-even, perhaps, in graduate school.

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