Family Help: Intro
The Temptation & The Fall
Perhaps no single set of financial issues vexes parents of teens more those regarding the funding of college. Decisions to help someone in big ways never come easy, and in this arena parents face immense pressures, internal and external, in addition to their innate desires to get their newly adult kids to a good place.
As a result too many parents fuel their kids’ college careers without much regard to their own needs. In doing so they often ensure their kids don’t have to move back in with them later only to find that later they have to move in with their kids. When parents want to help, how do we know how much is too much?
Before exploring the options for college funding, families need to predetermine the affordability of the expense much like I encouraged students to do in earlier chapters. Only in this case we don’t need to develop a Return filter because we need to think of college support as a gift as opposed to an investment, since family members can only expect non-financial rewards in return for their sacrifices.
Parents: You need to ensure college payments don’t detract from higher-ranking family needs and goals. As a first step I encourage the family decision-makers to sit down and run through an exercise like the one I recommended for students in Chapter Five. Only in this case, list out all of the bigger ticket items you need or want to set aside money for. This might include emergency funds, retirement, college, housing, housing improvements, upcoming tax bills, vehicles, medical procedures and small business ideas to name a few.
Once everything has been listed, write down each item on a sticky note. Then ask yourselves, “If we could fund one of these items, and only one, which one would it be?” Place the sticky note with that item on it to the far left of a wall or table. Then ask yourself, “Which of these other items would we fund if we could have money for only one more?” Place the sticky note with that item right next to the first item and so forth right on down the line until you have all the items in the proper order, left to right, according to priority. You now have a Rank filter to keep you in the right frame of mind.
Picking up where you left off with the Rank exercise, now assign dollar amounts to each item. This will take some effort in order to get accurate and agreeable numbers, but you will find it well worthwhile to do so. Talk to an advisor, read, or run some online calculators in order to determine good and prudent amounts for each goal. How much should the family emergency account contain? How much should the parents have set aside at this point in life for retirement? How much does the family want to contribute to college?
Until parents and other family members know the answers to such questions and have a good idea of how much of their resources should already be slated for needs, they cannot know the affordability of their college help. Only when the answers are known and all items of higher priority are fully funded through savings and investments, does it would make sense to go ahead and help out with family assets. The next question entails where the money should come from.
Look in the resources section for a tool I have developed for families to track their priorities and how far their savings currently go toward goal funding. Simply replace the sample items with the items from, and in order according to, the Rank exercise. Then replace the sample numbers with your own. Once done, simply keep track of your progress toward your goals by putting your savings total into the highlighted field.
Many families have several types of accounts available for college savings and payments. Great care should be taken when spending money from these accounts, as the tax incentives will often conflict with each other as well as with financial aid benefits. Each contribution to college necessitates great care so as to get the maximum benefit.
Families will probably want to tap two or three types of sources in concert together to achieve maximum tax/aid efficiency. I highly encourage parents of students nearing college age to meet with a qualified financial advisor for a better and more personal understanding of their situation and their options. You’ll also want to check out some of the recommended resources to familiarize yourself with the concepts. In the meantime, let’s explore four of the more common funding sources and briefly discuss their relative merits.
Money From Loans
Parents can borrow money from any number of sources for a student’s education, including home equity lines of credit, their insurance policies, the government, the bank and their 401(k)s. However, I don’t recommend any of these. To a parent, all college debt is “bad debt.” If a parent has the ability to help offset college costs, they by definition have the ability to not borrow. If they do borrow they more likely than not face unaffordable outcomes, especially when we factor in collateral risks and financing costs.
Money From Savings and Checking Accounts
If a guardian of a dependent student or a student utilizes cash to pay for college several things happen from a tax standpoint. Firstly that money, whether it’s the result of earnings or interest, has been subject to income taxation. Then, when the money is spent on college it may qualify for various tax credits or deductions. The wisdom of accumulating and spending cash assets will vary widely according to income tax brackets and distribution amounts. For many families who owe taxes each year, the first $2,000 spent on college from savings for dependent students will get returned via the American Opportunity Tax Credit, and the next $2000 receives a 25% credit on federal taxes. Thus, it likely makes sense to fund the first several thousand dollars of college from cash flow or cash savings before all other options.
Gift tax exemptions may also play a part in the account type decision if a student is in line to receive more from a donor concerned with estate taxes. If a donor wants to contribute more than the annual gifting exclusion amount ($14,000 in 2013) they may want to do so by writing a check directly to the school to cover tuition as this form of payment doesn’t count toward any gift tax reporting requirements.
As for financial aid concerns, great care must be taken when saving and dispensing cash. It is worthy of note that a student’s income and savings negatively affect financial aid packages more than a parent’s resources do, and that the income and assets of other family members don’t count at all. Thus it becomes critical to educate family members that the improper timing and structuring of help could have an offsetting negative impact.
Money From Tax-Advantaged Education-Specific Accounts
The federal government has created allowance for different college-specific savings and investment accounts, each of which has its own set of benefits and drawbacks. Primarily you will encounter two types when looking to establish college-specific accounts: The Educational IRA (also known as a Coverdell ESA) and the 529. Of the two, the 529 has become the most popular thanks largely to its more generous funding limits, state income tax incentives, financial aid treatment and beneficiary designation flexibility.
Both the 529 and the Coverdell ESA allow the establishment of an account into which family members or students can place funds. Contributions into either of these accounts do not generate any federal tax benefit, but certain states do provide income tax incentives in the year of funding for certain plans. Money in these can then be invested and all growth, income and distributions will be completely tax-free from that point forward, so long as the funds go toward qualified education expenses. However, unlike cash drawn from checking or savings accounts, distributions from 529s and Coverdells do not generate any credits or deductions.
Money From Tax-Qualified Retirement Accounts
As we’ve already discussed, retirement accounts don’t count as assets for federal financial aid calculations. Withdrawals from traditional IRAs, Roth IRAs, 401(k)s and the like for college expenses also escape the 10% early withdrawal penalty normally reserved for premature distributions (money taken before the owner reaches age 59½). Thus, a strong temptation exists to use these accounts as a college funding vehicle. This may make sense in limited instances, but of course one must know the dangers. Be careful if making distributions from a retirement account as typically these are set aside for retirement, a higher savings priority for parents. So too, must one be careful when making distributions from retirement accounts because the amount withdrawn will count as income in the following year for financial aid purposes. Lastly, as with college-specific accounts, contributions drawn directly from retirement accounts won’t qualify for income tax credits and deductions.
Obviously, I’m not knocking a family helping a student out with whatever resources they have available. However, I am a little bit gun-shy given what I’ve seen transpire time and time again. Thus, I encourage families to explore more creative ends first, as those tend to engage the wheels of the student in the bargain and tend to provide the income needed with little negative consequence to the family’s overall position. Keep exploring this site for more family help ideas.