When it comes to a topic that is as important as saving for the big financial milestones like college and retirement there can be quite a bit of social pressure to act like you know more than you do, especially when talking to a professional. But don’t do it. I’m not judging your financial acumen. You’re an expert in your field, I’m an expert in mine. I understand that you don’t know the best way to save for all of your financial goals. That’s what I do.
Over the last few weeks, however, I’ve encountered too many confidently communicated financial decisions that were unfortunately a mistake. Let me go into a few pertaining to college saving so you’ll know what not to do.
Saving in a prepaid 529 plan when there is a good chance your child will go to an out-of-state or private school. I think using a 529 plan to save for college is a great idea. You benefit from a variety of factors but there are many types of 529 plans. One type is the pre-paid 529 plan. In this plan, you pay for the price of a semester defined by the state and when your child goes to college each “semester” you’ve purchased can offset the future price of the semester of college. Therefore, the return on investment is equal to the price a semester will increase by the time the student enrolls. The problem is when the student wants to go to a private or out-of-state public college. The state will give you your investment back with a “reasonable rate of return” which is not reasonable at all. It is below inflation. Saving in a prepaid 529 plan when you are not confident your child will go to college in state is not as good as saving in the Invest 529 plan in Virginia which does not restrict where the saved funds are spent except to “any qualified higher education institution.”
Moving your taxable assets into an illiquid insurance contract, such as a variable annuity, so your child can qualify for financial aid. The Free Application for Federal Student Aid (FAFSA) will become a household acronym for a family looking to receive scholarships of just about any kind. It’s a daunting form that takes into account the assets a family has in determining how much of a scholarship an institution will offer to entice a qualified student to attend. There are a variety of ways to shelter assets from being included on the FAFSA application. A method I do not recommend is putting taxable assets into a variable annuity. The saving on the FAFSA is at most 12% in the “Expected Family Contribution” or EFC calculation. Paying the 2%+ extra fee per year for the rest of your life to be in an illiquid annuity with all the negatives regarding paying taxes on getting your money back to save 12% in just one element of a calculation that will be used to determine financial aid for the years your children are in college does not make sense. This strategy will cost significantly more in the long term despite the short term benefit of getting some extra financial aid dollars.
Saving for your child’s college by giving the money to your child or putting it in an account under his or her name. This often happens because the parents can quickly calculate the tax savings by the child paying tax at their lower effective rates. It also incentivizes the child to choose a cheaper option between two equally good colleges when he or she knows that whatever isn’t spent on college can be spent on a car, used toward a down payment, or jumpstart their savings. The problem arises again in the EFC calculation in the FAFSA. Whereas a parent’s EFC is 5.64% in a 529 plan where the student is a beneficiary, an asset owned by the child is assessed at 20%. Any savings in a child’s name is going to quickly eliminate any opportunity to qualify for student aid through the FAFSA.
These are relatively easy mistakes to avoid but they all involve talking to someone knowledgeable about college savings before embarking on the path to save. Here’s one more to consider: if grandma or grandpa has saved for their grandchildren’s college, consider having them pay for the student’s final year. The FAFSA will include any contribution to college by grandparents as income to the student so either gift the money to the parent’s 529 for their children or have them contribute in their final year of study. Since the FAFSA looks at income from the previous year, when the child is a senior that income will not be included at the 12.5% EFC hit it would otherwise be.