Ready for College? – timing & planning finances

All college applicants that need a loan, scholarship or a grant must complete a financial-aid application. The process isn’t solely for those who have low enough income to qualify for aid. If you would  like to be considered for the 2017 education financial process you will need to complete the “Free Application for Federal Student Aid” or FAFSA (www.fafsa.gov). The process begins again on October 1, 2016.

Ideally, you will work closely with someone that is immersed in this process and aware of the 2015 changes enacted by President Obama. These changes will sync the timing of funding with college decisions for the 2017-2018 academic year. Though this timing is for federal financial calculations, individual institutions agreed to match up with the process for the 2017 school year. Even so, always double check with the specific college that is under consideration.

The process will now be based on 2015 year-end taxes (even if extended) for the 2017-18 school-year. There will no longer be estimating and re-adjusting as in past years. Parents and working students are encouraged to file taxes by the summer and to defer income (as much as possible) during college funding years.

Controlling the recognition of income (for both parent and student) will make it easier for students to obtain loans that have reasonable terms of repayment. In some cases, it is not possible and other ways of paying for higher education will be needed. Year-end tax planning should have a high priority starting two years before the intended college start.

So how does the 529 College Savings Plan affect your ability to receive loans or aid from the FAFSA system?  If the 529 plan is owned by the parent or dependent student it is an asset in the application (FAFSA) process, BUT qualifying distributions are not counted as income (i.e., tax free). Though grandparent owned 529 are not counted as part of the FAFSA calculation, distributions to pay for a student’s education does count as child’s income (but it is tax-free). The best way to handle grandparents’ distributions from 529 plans for students is to hold back distributing from grandparents until the last two years of a student’s college education.  So, keep in mind, it is best to take 529 distributions (from parent and student owned 529s) during the first two years and grandparent funded 529 during the last two years.

Though 529 plans are useful if your child has more than three years to go before college, they are not really effective as a short-term strategy. If you’ve little money saved and your child is to attend college within 3 years you need to consider other strategies. Consider paying the tuition yourself directly – you are allowed without tax consequences (but also no tax benefit) to pay for  higher education tuition costs directly without triggering gift tax (gift tax is triggered if you gift more than $14K in 2016). These tax-free gifts will not count as a student asset or income for financial aid purposes. This strategy works well for grandparents who can pay directly for a grandchild’s tuition and/or provide annually a gift towards expenses not exceeding the limit that year (limit of $14K in 2016).

Another strategy often quoted is gifting of appreciated assets which can be a double-edged sword since it can cause a student’s income/assets to exceed the FAFSA limits and result in the loss of access to loans or aid awards. We recommend close and careful monitoring and it is best if these tactics are reserved for the last two years of college so that there is little to no impact on the FAFSA annual calculation.

Sometimes parents have purchased Uniform Gifts to Minors Act (UGMA)/ or Uniform Transfers to Minors Act (UTMA) assets since they can be used for pre and post college funding, BUT these accounts are considered part of a student’s assets in the FAFSA application and have a significant impact on the availability of loans or aid. We recommend transferring to a 529 account, BUT this is not always a good strategy since it triggers capital gains taxes. The best strategy is to spend the account two years prior to college. These accounts have a much looser definition of how they must be used. Any expense that benefits the child other than those that a parent is required to pay are permitted. Ways we’ve seen these accounts used include: summer camp, highschool tuition, an electronic device (laptop or Smartphone) and academic tutoring.

The most important take away is that you must plan for a college account distribution two years before your student will attend college. The new rules do simplify the application process but it also means that your tax planning needs to be ahead of the student’s decision on higher education.

Finally, (like any complex financial decision) college planning can frankly add a level of discomfort and conflict to the family. But, it can also provide an opportunity. The experience, if inclusive, can be part of a shared life experience, an educational moment, and an opportunity to fulfill your goals. It is a chance to learn how to make financial decisions and feel good about them.

Stay connected with your financial advisor and discuss how to best deploy your available resources to benefit both you and the student.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com

A Closer Look at Funding College Education

College costs continue to rise at a fast pace (5%). For the 2014-15 year tuition plus room and board averaged $43K for private four-year colleges; $33K for out-of-state public colleges; and $19K per-year for in-state public four-year colleges. These numbers are higher for private university programs in California.

When parents, students, relatives or other benefactors ask us how they can help fund a college education we normally outline three conventional ways and also suggest two other ways. The conventional ways are to use a 529 plan (either college savings or pre-paid tuition), a Coverdell Educational Savings Account (ESA), and a Uniform Trust for Minors (either UTMA or UGMA). To cover the non-qualifying expenses we recommend a taxable brokerage account. Finally, once a child has their own earnings (however small) we also recommend a Roth IRA since it can grow tax free. Even so, the most common plan is the 529 plan because it has the highest contributions and no earning limits.

You are mistaken if you think that paying for college is as simple as just buying a tax advantage plan (such as 529 college savings plan) and letting it grow. If you want simplicity you’ll forgo any tax advantage. The complexity arises when you distribute the money to pay for the various types of college expenses.

College expenses can be paid directly to the institution, to the beneficiary student, or to the owner of the 529 plan. The best way is to pay the institution directly but often tracking these types of payments can be difficult. The more common way is to send the money directly to the beneficiary (student) but there would need to be assurances that the payment goes towards “qualifying” expenses or tax reporting penalties and taxes may apply. Last is to distribute the money to the owners (parents, grandparents, or other benefactors). In this scenario, the owners will need to keep records to demonstrate that each distribution has matching beneficiary (student) qualifying expenses.

So, here are some tips to consider when you are ready to pay for college from a 529 plan:

The key to distributing from a 529 plan is that the educational expense must be “qualifying”. To be eligible to withdraw from a college savings 529 plan without incurring the 10% penalty and taxes the beneficiary (student) must be enrolled in a qualified institution. Traditional qualifying expenses include tuition, “qualifying” room and board and expenses directly linked to course requirements. If not qualified the penalty plus taxes on the gain will apply.

We need to be clear that paying off educational loans is not considered a “qualified higher-education expense”. Also be clear that the list of “qualifying” expenses gets continually updated, albeit rather slowly. Only this year are they willing to approve computers as part of “qualifying” educational expense (but do first check that it applies to your plan).

New 529 rules may finally eliminate the penalties if funds are returned to the 529 plan within 60 days (this happens when a student is forced to unexpectedly drop out of college and no longer qualifies to draw from the 529 plan).

Additional issues arise if the child actually qualifies for financial aid. A student with financial aid needs to be particularly careful when they access any nonparental funded 529 plan. The non-parent 529 plans are not part of a student’s financial aid application until the first distribution is made. We recommend that any non-parental 529 be accessed last. If not, a student’s income will be increased by the distribution and will affect the next year’s financial aid by as much as 20%. Parental 529 plans, on the other hand, impact aid by just over 5.5%.

If there are remaining assets in the 529 when the beneficiary ends their education (undergrad and graduate school) then parents need to transfer the named beneficiary to a close relative (who still needs college education funds) or they may transfer ownership to the student if they are likely to be in a lower tax bracket (but they can’t avoid the 10% penalty if they use the funds for non-qualifying expenses).

Finally, funding a child’s college education is important BUT it should never be at the expense of an adult’s own retirement or personal needs. Paying for college has to be in balance with your own financial plan. In addition, a 529 plan requires careful monitoring and reporting. It is a great financial learning opportunity for a student to annually track the 529 budget and file taxes.

Edi Alvarez, CFP®
BS, BEd, MS

www.aikapa.com