Ask Liz Weston

Student loan lender Sallie Mae will provide experts to answer your questions about filing out the Free Application for Federal Student Aid (FAFSA) during a live chat Thursday night, from 9 p.m. to 10 p.m. Eastern. To submit a question in advance or join the chat, visit www.SallieMae.com/FAFSA.

You’ll also find brief how-to videos to learn what documents you need to complete the aid form, get answers to commonly-asked questions and explore the next steps in the financial aid process.

Another great resource is FinAid.org. The site has a FAFSA calculator that can estimate your expected family contribution as well as tons of information about the financial aid process.

Dear Liz: I have twin boys and have been looking for a college fund to set up for them. Most bank saving accounts don’t pay much interest. The only thing I have found that is halfway decent is a certificate of deposit. My grandmother set up a trust for me, but I don’t know whether that’s a good idea these days. Do you have any ideas that would help?

Answer: You’re actually asking two questions. The first is what vehicle to use for college savings, and the second is how to get a decent return on your money.

Let’s take the latter question first. Bank savings accounts or certificates of deposit are fine if your kids are headed off to college in a year or two, but these low-risk investments won’t give you much growth on your money. In fact, you’ll almost certainly lose buying power over time when you consider inflation. If your money is in a taxable account, you’ll lose that much more.

Many parents opt to take more risk in order to accumulate more funds. If college is 10 years or more in the future, investing at least some of the money in stocks or stock funds makes sense.

The vehicle you use is also important. If you expect to get financial aid, you’d be better off avoiding custodial accounts such as Uniform Transfers to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA) accounts. These were popular accounts years ago when tax rates were higher, but they count heavily against you in financial aid formulas.

Many families find 529 college savings plans to be the best choice. These state-run accounts allow your contributions to grow tax-free for college and are treated favorably in financial aid calculations. These plans typically offer a choice of investment options, including age-weighted options that start out more heavily invested in stocks but that ratchet back exposure to risk as college draws closer. For more information, visit SavingForCollege.com.

The average family starts saving for college as their child begins preschool, but only 29 percent say they are on track to reach their savings goal, according to a recent survey by student lender Sallie Mae.

Families saved an average $2,676 annually for their children’s education, for a total of $13,827, the survey found. That represents 3.6 percent of their annual household income. However, households earning under $50,000 annually set aside far more than that, saving 7.5 percent of their income, annually, for college.

The survey was conducted from March 20-April 17, 2009, by the Gallup Organization, which conducted more than 1,200 interviews by phone with parents of children under age 18. Some of the survey’s other findings:

• “529” college savings plans are gaining in popularity.  Parents with children under age 7 were twice as likely to use 529 plans (43 percent) compared to parents of teens (20 percent.) Overall, 33 percent of parents used these plans.
• 66 percent of parents said if employers matched contributions that would encourage them to save for college. Another motivator? Parents said a tax benefit (44 percent) would help them save more. (And I can’t leave this one out: 25 percent of parents said a shopping rewards program would also motivate them to save more for college.)
• Families in the Northeast saved the most with an average of $15,846. The West was a close second at $15,589. The South had an average savings of $13,722, and the Midwest had the lowest with an average of $9,693.

College costs are still increasing faster than inflation, so families who want their kids to get a head start in life should be contributing to college savings plans if at all possible. Anything you save could help reduce your child’s future debt load. For more, read:

• If you can save for college, you should
• College plans for the rich, poor and in-between
• Cram for college costs in 5 years or less
• Can colleges keep promises of aid?

Dear Liz: Our question is about student loans.

We have a total of $69,000 in education debt. We also have a home worth $400,000 and our mortgage balance is $266,000, plus a home equity loan with a balance of $14,500.

We make a good salary, have excellent credit, pay all our bills on time, and, if gas weren’t so darn high, we would have a decent amount of discretionary income.

 

Does a home equity loan make sense in this case?

Answer: Generally speaking, trading student loan debt for home debt isn’t a great idea.

Student lenders typically are much more flexible than mortgage lenders, with a wider variety of repayment options. You also can get a deferment or forbearance if you lose your job or otherwise encounter a financial hardship. This respite from payments can last as long as three years on many student loans.

Compare that with what would happen if you couldn’t make your mortgage payments. Within a year, and usually much less, your home lender would start foreclosure proceedings.

In addition, most student loan debt can be consolidated. This would allow you to lock in your current interest rate and perhaps lengthen the repayment term to lower your monthly payments.

A longer loan means you would pay more interest over time, but it could help ease the monthly crunch you’re feeling.

All that said, not being able to deduct the interest on your student loans is a significant disadvantage.

If you’re confident you’ll be able to make the payments, then you might consider paying off at least some of your student loan debt with home equity borrowing.

You should, however, limit your total borrowing — all your home equity loans plus your primary mortgage — to no more than 80% of the value of your house.

You want to keep at least a 20% equity cushion in your home whenever possible, as a last-resort emergency fund and also to protect yourself in case of declining home values. (You don’t want to be faced with having to sell your home and owing more than it’s worth.)

Given the loans you already have, you should be able to pay off $39,500 of your student loans with home equity debt. Then you could consolidate the remaining $29,500.

Dear Liz: My teenage daughter has a modest amount in a Roth IRA that has only a very small gain. I am thinking about using the principal on her private high school tuition so that the account is not considered when she applies for college tuition aid. Is this shortsighted?

Another factor is that I have inherited part of the estate of a relative. Although the transfer isn’t finalized, I probably will get the money during the same year that will be used to determine the financial aid for her first year in college.

Would she be better off if I left the Roth alone and used the inheritance? Or should I reduce the funds in her account?

Answer: Leave that Roth alone!

Retirement funds aren’t included in federal financial aid calculations. And it’s an awful idea to use retirement funds for educational expenses in any case.

Left alone, even a modest sum in a Roth can grow substantially, particularly because it will be 50 years or so before she reaches retirement. In that time, a $5,000 balance could grow to nearly $235,000, assuming she averages 8% annual returns.

Your inheritance will affect your daughter’s financial aid package, but perhaps not by as much as you think. The federal aid formula generally requires you to contribute less than 6% of your “discretionary” assets toward your children’s education.

Q: I was confused about a statement you made regarding penalties on withdrawals from 529 college savings plans. You mentioned a 10% penalty on withdrawals that aren’t used for qualified education expenses but didn’t say whether the penalty applies to the entire withdrawal or just the earnings.

If it’s just the earnings, why should I care about the penalty? Even if I don’t use the money for education, I’d still be ahead because the money had a chance to grow tax-deferred.

A: That would be a heck of a loophole, wouldn’t it? But, alas, it doesn’t exist.

It’s true that only the earnings in your 529 are subject to the penalty, not your original contributions. But you’ll also have to pay regular income taxes on any gains that you withdraw.

The combination of taxes and penalties effectively eliminates the 529 as a tax shelter for most folks unless the money is used for education — or unless they’re in a much lower tax bracket when they withdraw the money than they were during the years in which the gains were accrued.