529s aren’t always the best way to save for college
Dear Liz: I am returning to college in my later years for a second degree. Can I save in a 529 plan for my own college use in two years?
Answer: You can, but why would you want to?
The big benefit to a 529 plan is that your returns can grow tax-free. That’s a boon for parents in higher tax brackets contributing for young children, since their money has years to grow and they can put at least some of their cash into riskier assets, such as stocks.
If you need the money within two years, though, it should be in a cash account that won’t earn much. (The average money market fund pays around 0.02% right now.) You wouldn’t be getting any real growth, so the tax benefit of a 529 plan is minuscule. What you would get are restrictions on how you use the money and possible complications for your tax returns. If you want to use education tax credits, for example, you won’t be able to apply those on expenses you’ve paid with a 529 withdrawal.
A simple FDIC-insured savings account — perhaps at an online bank that pays around 1% — is probably the better way to go.
Don’t borrow for an education you can’t afford
Dear Liz: My son will be going to a for-profit technical school about 120 miles away from home. Unfortunately, we have not saved any money for his college education. What are our best options for borrowing to pay for his college education, which will cost about $92,000 for four years? He is not eligible for any financial aid other than federal student loans. Our daughter will graduate debt free with her bachelor’s degree in December. Since we concentrated on her education first, our son kind of got left behind.
Answer: Please rethink this plan, because your family probably cannot afford this education.
Federal student loans would allow your son to borrow, at most, about a third of this school’s cost. If he were to borrow the rest of the money, he would have to turn to private student loans, which have variable rates and none of the consumer protections embedded in federal student loans. Private student loans are like using credit cards to pay for college — except unlike credit card debt, student loan debt can’t be discharged in bankruptcy.
The other alternative would be for you to borrow the difference between his federal student loans and the cost of his education using PLUS loans. These are federal education loans for parents and graduate students. As with federal student loans, the rates for PLUS loans are fixed, although they’re somewhat higher — 7.9%, compared with 6.8% for unsubsidized Stafford student loans.
But using PLUS loans means taking on a lot of debt at a time in your life when you should be concentrating on saving for your own retirement. If making the payments would interfere with your ability to contribute sufficiently to your retirement funds, you shouldn’t even consider borrowing the money.
Even if you already have a well-funded retirement plan, you should think twice. Your son may be able to get a better, more affordable education from a public college — particularly if he starts at a two-year community college nearby, allowing him to live at home more cheaply, and then transfers to a four-year school.
For-profit colleges can be expensive, and loans made to students who attend four-year for-profit colleges have twice the default rates of loans made to other college students. Figures provided by the U.S. Department of Education show that of loans that entered repayment in 1995, 30% of those made to students attending four-year for-profit colleges were in default 15 years later, compared with 15.1% for four-year public colleges and 13.6% for four-year private nonprofit schools.
That high default rate should give you pause, even if you were paying cash for this education, because it indicates that many graduates either aren’t finishing their educations or aren’t finding jobs that pay well enough to repay their loans.
Critics complain that for-profit schools often over-promise and under-deliver when it comes to training students for existing jobs. The for-profit schools attribute high default rates to the demographics of their students, who are more likely to be lower income and from minority groups than other college attendees.
You may feel guilty for shorting your son when it came to saving for college. But please don’t compound the problem by blessing an education that could leave him, and you, with unaffordable debt.
Withdrawals from 529s can be tricky
Dear Liz: As a parent of a college freshman, I rushed out and closed out one of my son’s 529 college savings plans, thinking I would use the money to pay his expenses for the whole year. It turns out I will have pulled out $6,000 too much in 2010, because I was charged only for one term of room and board. Can I prepay the extra in 2010 for 2011 room and board and tuition as a valid college expense to avoid any 2010 taxes on the extra funds? If not, do you have any suggestions to avoid 2010 taxes?
Answer: Withdrawals from a 529 plan are trickier than many people think. They’re tax free only to the extent that you pay qualified higher education expenses in the same calendar year that you take the distribution — and that other tax breaks aren’t used.
Qualified expenses include tuition, fees, books, supplies, equipment and additional expenses for “special needs” beneficiaries. Qualified expenses do not include insurance, sports or other activity fees, transportation costs or the purchase of a computer, unless it’s required by the school.
If you pull out too much, you have to pay income tax and a 10% federal penalty on the earnings portion of the excess withdrawal. (For example, if your account totaled $10,000, and $6,000 was earnings while $4,000 represented your original contributions, you would pay the penalty on 60% of any excess withdrawals.)
There’s another way you might get hit. If you were planning to use an education tax credit, such as the Hope or Lifetime Learning credit, you would have to deduct from your qualified expenses the amount used to generate the credit. Let’s say you used $5,000 in tuition expenses to generate a $1,000 Lifetime Learning credit. That $5,000 would have to be deducted from your qualified expenses total, which would further reduce the amount of your 529 withdrawal that’s tax free. You wouldn’t have to pay the penalty on the excess withdrawal created by the tax credit adjustment, but you would have to pay income tax on any earnings.
Now the good news: You are allowed to prepay next year’s costs to help boost your qualified expenses total. If it’s been less than 60 days since the withdrawal, you also would be allowed to roll the excess distribution over into a new 529 account.
Fortunately, you discovered the problem before the end of the year. If you’d learned about the problem only when you started preparing your tax return next spring, as many people do, it would be too late and you would be stuck with the extra tax and penalty.
It’s too late to borrow for child’s college education
Dear Liz: I’m facing the end of child support and need to finance my son’s college education, plus I have some home maintenance costs looming. Should I get a home equity loan or line of credit (assuming I can qualify) to pay off these pressures, or should I raid my retirement fund? I am 60, make about $80,000 a year and have no debt besides the mortgage and a car loan, but I have only about $100,000 in retirement accounts. (I had to wipe out my savings once before in a two-year spell of unemployment.)
Answer: There’s no polite way to put this: You’re too old and too inadequately prepared for retirement to be paying for your child’s college education.
It isn’t a good idea to raid retirement funds prematurely in any case, but certainly not when you have so little saved. Borrowing to pay for school would make sense only if you were adequately prepared for retirement and had plenty of time before then to pay off the loan.
Even if you plan to work into your 70s, life may interfere. Nearly 40% of retirees interviewed by the Employee Benefit Research Institute say they had to quit work before they wanted to, typically because of layoffs, poor health or the need to take care of a family member.
You must focus on building up your retirement fund as much as possible while you still can. That means your child will need to figure out how to pay for college on his own. Many students save money by attending a community college for two years while living at home, then switch to a four-year public institution to finish their degrees. Your son may qualify for scholarships or grants; if not, federal student loans can help him pay the bills without sinking too far into debt.
You really shouldn’t be borrowing for home maintenance costs either. Ideally, you would have set aside money from your current income that’s earmarked for these costs. If the repairs are pressing, however, you can pay for them with a low-cost home equity line of credit and then repay the loan as quickly as possible.
Is graduate school worth borrowing for?
Dear Liz: As a student I was not aware of finances as much as I should have been and borrowed too much. I have about $60,000 in student loan debt plus an $11,000 car loan. I am contemplating going back to school because the job I really want — to be a counselor — requires that I have a master’s degree. My friends say I’d be crazy to go into that field because the pay isn’t that high and I would most likely incur more debt. I am hoping to get scholarships and grants or pay out of pocket as I go. I currently pay all my bills and am really tight with spending. I want to take this leap without destroying my financial future. Any advice?
Answer: In general, you shouldn’t borrow more for an occupation than you expect to make the first year out of school. If you check the U.S. Department of Labor Statistics, which tracks pay for various occupations, you’ll see that the median wage for counselors depends on their specialty (vocational counselors get paid more than rehab counselors, for example), but the median wage tends to be in the $30,000-to-$50,000 range. Expect your starting salary to be somewhat lower.
That doesn’t mean you can’t go back to school, but you probably shouldn’t take on more debt to do so. You can apply for financial aid but expect stiff competition for grants and scholarships — most aid comes in the form of loans. Your best bet may be to attend a public college, perhaps at night so you can keep your day job. For more on attending college without loans, read Zac Bissonnette’s “Debt-Free U: How I Paid for an Outstanding College Education Without Loans, Scholarships or Mooching Off My Parents.”
