The Funding Dilemma: Retirement or College?

Editor: Michael David Schulman, CPA/PFS

At a recent meeting, a client wanted to talk about paying for his child’s college costs for the upcoming spring semester. When asked if he had any retirement savings, he answered that he had a small amount in a whole-life insurance policy. He also noted that he had very little in personal savings. Did he have any other investments? No.

This client is not unique. The dilemma between funding college and retirement can be a difficult one. A parent’s first reaction is to provide for his or her child, so the child does not start out life burdened with debt, a very noble cause. In a perfect world, it would be wonderful to have sufficient savings to fund retirement fully and put money away for college. Often, however, a parent cannot afford to do both.

If parents can save for only one of these goals, they should fund their retirement before paying for college, because there are very few ways to fund retirement, but many ways to pay for college. Put simply, money can be borrowed for college, but not for retirement.

Retirement Funding

Experts estimate that an individual will need to replace approximately 65% to 75% of pre-retirement income to maintain his or her current standard of living. Lower-income earners may need up to 90%. One-third of current retirees receive more than 90% of their income from Social Security; see Munnell and Soto, “How Much Pre-Retirement Income Does Social Security Replace?” Center for Retirement Research at Boston College Issue in Brief (No. 36, November 2005), available at www.bc.edu/centers/crr/issues/ib_3d.pdf.

Thus, the first question is, how much confidence does the client have that Social Security will be there on retirement? And, will it provide sufficient funds to maintain his or her current standard of living? With more and more companies no longer providing pension plans, the burden of funding retirement is squarely on the retiree’s shoulders.

The main source of retirement funding will come from the retiree, either through a company-based Sec. 401(k) or 403(b) plan, the retiree’s own business (in the form of a savings incentive match plan for employees, a simplified employee pension or other qualified retirement plan) or through funding a regular or Roth IRA. Other funding sources are investments, including real estate, stocks, bonds, life insurance, deferred annuities and mutual funds.

Sources: In addition, an individual’s residence may be used to fund retirement. For example, New York real estate has increased tremendously in value over the last few years. A homeowner could sell his or her house and bank the proceeds for retirement. The problem with this strategy is timing; it will not work if retirement coincides with a down market in real estate. Also, the retiree needs to move somewhere else affordable. A New York retiree generally would have to move far away (or into a place smaller than the one previously owned) to gain any real benefit from selling.

For the owner of a successful business, the needed retirement funds may be obtained by selling the business. Others may be counting on an inheritance or hoping to win the lottery.

All in all, there are only a limited number of ways to fund retirement. Of course, the longer a person lives, the more he or she will need. The best asset in all of these opportunities is time. With the right planning and funding, the proper amount of retirement savings can be achieved.

However, all of these options require retirement to be funded in some manner; there are no borrowing options. In funding college costs, many options are available to ensure that children are provided for.

Determining College Costs

The first step is to determine how much will be needed for college—the cost of attendance (COA). A parent should pick three colleges, with low, medium and high tuitions. Using the child’s age and a 7.8% college inflation rate (the amount of the average annual increase for public colleges and universities for the 2004–2005 school year), tuition costs can be reasonably determined; see “College Investing: Planning for your Child’s Future” (American Century Investments, 2005). The COA includes not only tuition, but also fees, room and board, books and supplies, personal computers, child care, transportation and personal expenses.

Next to be determined is the expected family contribution (EFC). The EFC is the amount a family is expected to contribute to the child’s college education for one year. Typically, the lower the EFC, the more financial aid the child will receive. Factors such as family size, number of family members in college, family savings and current earnings (information found on the Free Application for Federal Student Aid (FAFSA), available at www.fafsa.com) are used to calculate this figure. Once a FAFSA is processed, a family will receive a
Student Aid Report with its official EFC “score.” College Answer (www.collegeanswer.com) has a quick fill-in schedule that can be used to estimate this amount.

COA, less the expected family contribution, equals financial need. In determining financial need, if a family’s income exceeds:

• $75,000, a child is unlikely to qualify for financial aid at most public universities.
• $125,000, a child is unlikely to qualify for financial aid at most private universities.

A key EFC strategy for maximizing financial aid involves limiting the assets in a child’s name, to avoid the child having more than $3,000 in income. This is because the child’s assets and income count much more heavily than the parents’, thereby increasing the EFC score and resulting in a lower financial-need amount, making it harder for the student to be eligible for most types of Federal, state and college financial aid.

One of the most difficult discussions for parents is telling a child that they cannot afford a college that the child has chosen. However, parents must be realistic about how much they can spend for college without putting themselves deeply in debt. Parents who send a child to a college that is out of their price range risk being in debt for a long time; the money spent on college loans will not be available to invest for retirement. With people living longer and healthier lives, this may result in having to work much longer than anticipated.

FAFSA

Whether or not a child qualifies for financial aid, it is highly recommended that the FAFSA form be completed. Most other types of aid and loans also use this form. Although personal identification numbers (PINs) are optional, they may be used to save time and enable the FAFSA application to be processed and sent to the school’s financial-aid administrators much faster. PIN numbers may also be used to make corrections to the form online and to view Federal student-aid history online at the National Student Loan Data System (at www.nslds.ed.gov). The form can be submitted online or over the phone.

Gift Aid

The first option for college funding is gift aid—i.e., grants and scholarships that do not have to be paid back.

Federal Pell Grants: These are need-based grants; amounts are determined by the college based on EFC. To be considered, a FAFSA form must be filed. Information on Pell Grants, as well as other types of funding options, can be found at www.studentaid.ed.gov. The grant will be in the student’s name, but go directly to the school. The college determines the amount; for the 2006–2007 school year, the minimum grant is $400, with a maximum of $4,050. An applicant’s EFC must be under $3,850 to qualify. Undergraduate students in four-year programs may receive Pell Grants for up to six years, if they are part-time students.

FSEOGs: Federal Supplemental Educational Opportunity Grants (FSEOGs) are also need-based and are capped at $4,000 per year ($100 minimum). The college determines the amount of the grant based on the EFC.

Endowment funds: The child’s college of choice may offer grant/scholarship amounts derived from endowment funds or a tuition discount. These awards are given to merit, as well as need-based, students; the college determines the amount.

Other grants: Other grants and scholarships include the Academic Competitiveness Grant and the National Science and Mathematics Access to Retain Talent Grant (National Smart Grant). The former is available for the first time for the 2006–2007 school year and is given in addition to a Pell Grant. The amounts range from $750 for the first year to $1,300 for the second year (undergraduate). The National Smart Grant is also in addition to a Pell Grant, and totals $4,000 for each of the third and fourth undergraduate years; for details, see www.ed.gov/about/offices/list/ope/ac-smart.html.

State grants: State grants vary. For example, the Tuition Assistance Program (TAP) is New York’s largest grant program. It helps eligible in-state residents attending in-state postsecondary institutions pay for tuition. TAP grants are up to $5,000, based on the applicant’s and family’s New York State net taxable income. Approximately three weeks after submitting a FAFSA, the New York State Higher Education Services Corporation will notify a candidate by postcard or e-mail that he or she can go to www.hesc.org, establish a PIN and complete the TAP application online.

Work-study programs: A school’s work-study program should be one of the first stops for a student. The funds awarded are administered by the college. Usually, the program consists of 8–15-hour workweeks at minimum wage. Individual states may also have work-study programs (implemented through colleges). Work-study programs are not included in the EFC formula.

Need-Based College Loans

There are two types of college loans: need-based and non-need-based. All Federal loans require a FAFSA form; all qualify for the Federal Loan Consolidation Program or hardship deferrals.

FSSL: The Federal Subsidized Stafford Loan (FSSL) is in the student’s name; he or she will be entitled to the student-loan interest deduction. A FAFSA form needs to be filed; the loan will be part of the award letter from the college. FSSLs carry both a life and disability benefit on the student. Effective July 1, 2007, the loan amount is based on the year the student is entering college: $3,500 for freshmen; $4,500 for sophomores; $5,500 for juniors and seniors. A fifth year, if necessary, is capped at $4,000. Interest is paid (subsidized) by the Federal government until six months after the student leaves college. For loans disbursed before July 1, 2006, the interest rate is variable and adjusted once a year (on July 1). The interest rate on the repayment is capped at 8.25%. A 3% origination fee and a 1% insurance premium are subtracted from the loan proceeds. After July 1, 2006, the interest rate is fixed at 6.8% and the origination fee reduced to 2% for the 2006–2007 academic year; see Carpenter, “College Debt” (2006), at www.tuitionsolutionsnow.com/College%20Debt%20.pdf.

The origination fees on the FSSL (as well as the Federal Unsubsidized Stafford Loan (FUSL), discussed below) phase out at half a point per year, until they are completely phased out in 2010.

FPL: The Federal Perkins Loan (FPL) is also in the student’s name; he or she will be entitled to the student-loan interest deduction. A FAFSA form needs to be filed; the loan will be part of the award letter from the college. FPLs are low-interest, need-based loans with a 5% fixed rate. Students are eligible for up to $4,000 per year if undergraduate and $6,000 if graduate. The interest is subsidized by the Federal government until nine months after the student leaves college. The college determines which students will receive this loan and the amount.

Non-Need-Based College Loans

FUSL: A FAFSA form must be filed and the student must file a financial aid application. The loan amount, interest rate and repayment terms are the same as for an FSSL, except that the interest is not subsidized by the Federal government while the student is in college. Repayment does not start until six months after the student leaves college.

Federal PLUS loans: Parents’ Loans for Undergraduate Students (PLUS) are available only to parents or step-parents; a legal guardian will need permission from the school. These loans are not available to grandparents. A FAFSA form needs to be filed before applying. The amount available to a borrower is limited to the cost of attendance, less any financial aid awarded to the student. For loans disbursed before July 1, 2006, the interest rate is variable and adjusted once a year, on July 1; the interest rate on the repayment is capped at 9%. A 3% origination fee and a 1% insurance premium are taken from the loan proceeds. For loans disbursed after July 1, 2006, the interest rate is fixed at 8.5%; discounts on the rate may be available if the payments are made automatically from a checking account; see, e.g., Franklin and Marshall College, Financial Aid Office, PLUS Loan Application, at www.parentplusloan.com.

PLUS loans are 10-year loans, but may be consolidated into one loan and repaid over a 30-year period after the child leaves school. The loan balance is forgiven on the death or disability of the signatory parent.

If a parent is not creditworthy and cannot obtain a PLUS loan, the student can borrow an additional $4,000 per year in FUSLs for the first year of college, and $5,000 for the second, third, fourth and fifth years of college (the limit for an independent student).

Private education loans: Taxpayers should check with colleges for the terms and rates of these loans, which are set up with commercial lenders.
A listing of preferred lenders for
the school can be obtained by either calling the school or going to its website.

State loans: Some states offer their own loan programs (see, e.g., New Jersey’s program, at www.hesaa.org/).

Other loans: Other alternative loans include those against real estate, margin accounts, life insurance and from employers and commercial lenders. The strategy of last resort is to borrow against retirement accounts. The ability to borrow against retirement plans is limited; borrowed funds must be repaid, with interest. While an individual cannot borrow from an IRA, Sec. 72(t)(2)(E) exempts distributions for college expenses from the 10% penalty.

Loan consolidation: A consolidation loan is designed to help student and parent borrowers simplify loan repayment, by allowing the borrower to consolidate several types of Federal student loans with various repayment schedules into one loan. Even one loan can be converted into a consolidation loan, in order to get benefits (such as flexible repayment options). The interest rate on the consolidation loan may be lower than the rate currently being paid on one or more loans.

Saving for College

Sec. 529 plans: A Sec. 529 plan is a specific type of college savings plan. It is a tax-deferred way to save for college, by putting money into an account that, when used for qualified college costs, would be exempt from tax on its earnings. There are some restrictions on the amount that can be invested; a financial adviser or a certified college planning specialist should be consulted for information on the best options for investing in these plans.

Are Sec. 529 plans the best option for college savings? The advantages include tax-deferred savings and tax-free distributions for college; in addition, contributions are completed gifts. There are tax benefits to investing in some state plans and, for high-income individuals, there are no income limits banning their investment in such plans. As for disadvantages, the account can lose money, investment selections are limited, state Medicaid agencies may require that plan assets be used to pay for medical and long-term care expenses before Medicaid payments start and, if plan amounts are not used for a qualified distribution, there is a 10% penalty on the earnings, and the earnings become taxable; see Hurley, The Best Way to Save for College: A Complete Guide to 529 Plans (Savingforcollege.com Publications, 2007).

Other Options

Are there other cost-efficient ways to fund college and retirement at the same time? There are several opportunities available to an investor that allow funds to be used for either college or retirement, depending on need.

Regular or Roth IRA: The advantage of using an IRA is that the funds are tax-deferred and can be distributed and used for college costs penalty-free (the holder is still taxed on the ordinary income, however). The disadvantage is that the amount contributed is limited to $4,000 per year (for 2007), provided the contributor has earned at least that much for the year. Also, if IRA funds are used for college, they are no longer available for retirement. If a student has earned income, a possible strategy is for the student to open an IRA and take an IRA deduction against that income. This strategy is not recommended if the student is eligible for financial aid.

Bonds: Investing in tax-exempt municipal bonds (triple-tax-free if invested in the investor’s state of domicile) and tax-deferred U.S. savings bonds (Series EE) gives the investor the flexibility of using the funds for either college or retirement. Using the interest from a municipal bond takes advantage of its tax-free status; if U.S. savings bonds are used for qualified higher education expenses (QHEEs), the income may be tax free under Sec. 135 (depending on the owner’s adjusted gross income (AGI)).

Tax-efficient funds: Tax-efficient funds (such as index funds) are excellent long-term savings vehicles due to their low turnover, which reduces capital gains distributed over the investment’s life. This strategy is not recommended for a child eligible for financial aid.

Coverdell ESAs: Under Sec. 530, Coverdell education savings accounts (ESAs) are exempt from taxes if the amounts are used for QHEEs. The disadvantages are that a limited amount can be contributed each year ($2,000), contributions cannot be made after the beneficiary reaches age 18, the funds must be used before the beneficiary reaches age 30, contributions are phased out based on the contributor’s AGI (starting at $95,000 for an individual, $190,000 if filing jointly), and a 10% penalty is imposed on excess distributions over qualified expense amounts.

Mutual funds: The major advantage of using a mutual fund instead of a Sec. 529 plan is the flexibility of the fund’s use. It can be used for either college or retirement, with no penalty for distributing the funds. If a child receives a scholarship, grant or financial aid, the balance can be kept in the mutual fund and used for the child’s post-college needs. Other advantages include higher potential for investment performance, greater investment choices and lower fees. The major disadvantages are that distributions potentially result in capital gains, and dividends and capital gains earned each year are currently taxable.

Life insurance/annuities: Investing in a permanent life insurance policy, a group universal life insurance policy or an annuity is another way to fund retirement and (in the case of  insurance policies) ensure that insurance needs are covered with the same investment dollars. College planning comes into play with these types of investments, as these policies allow for loans or withdrawals. In many cases, however, withdrawals are subject to surrender charges that further erode the original investment’s value. For example, if $10,000 is needed for a child’s tuition and the contract has a 4% surrender charge, a total of $10,417 will need to be withdrawn. Borrowing from a life insurance contract entails loss of policy equity, and interest must be paid on the borrowed funds.

UGMA/UTMA: The major advantage of Uniform Gift to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts is that income is realized by the minor beneficiary and will generally result in a lower tax expense for the family. However, the “kiddie tax” rules may apply in certain situations if the child is under age 18. This strategy would be used by families not eligible for financial aid. The major disadvantage of these types of accounts is that the minor will take control of the account at majority and can use the funds for anything. The child must be trustworthy enough to use the funds for college, if that was the intent when the account was established.

Sec. 2503(c) trust: A “minor’s trust” gives the trustee total discretion for the benefit of a minor before he or she turns 21. A financial adviser should be consulted before setting up one of these trusts.

Secs. 401(k) and 403(b): The strategy of last resort is to borrow from retirement accounts to fund college costs. Secs. 401(k) and 403(b) plans allow loans from the contributor’s account that usually need to be repaid over five years. The major disadvantage to such loans is that pretax dollars are being borrowed; these funds are not able to grow in their intended fashion, as the funds used for college are no longer being invested.

Conclusion

The funding dilemma between college and retirement is one of the most difficult for a parent. Proper planning and long-term thinking should be involved when parents sit down to discuss the options, given their financial and personal circumstances and needs. The general consensus is that parents should not sacrifice retirement savings for college. Once funds are used to pay for college, they no longer can work and grow. Not fully funding retirement is a risky strategy that should be done only after consideration of the severe long-term consequences.

For further information about this column, contact Mr. Schulman at michael@schulmancpa.com or Mr. DeCandido at fjdcpa@si.rr.com.