Advisor Today > > September 2000 Cover Story: 2000 College Funding 101

Cover Story: 2000 College Funding 101

By Edward Staples, Senior Editor, Advisor Today

Riff Notes for Advisor Today's College Funding curriculum:
"Examines such fundamental propositions and questions as: How do the state 529 plans measure up versus VUL for college saving? Will the 529 plans steal away some of your clients' assets under management? What do you do when clients won't save for their kid's college... or don't save nearly enough and their kid suddenly gets in Whiz Kid U. at $35,000 a year?"

Finally, you've convinced your client to take out enough life insurance to take care of his twins' education if he dies. Both you and he breathe a sigh of relief. But how is their education going to be paid for if your client lives? Twin tuition bills, not even to mention the other college expenses for four years.

"The client shoulda got variable universe life in the first place," some advisors might immediately retort. But it's not always that simple. VUL, structured correctly, could provide a valid solution. But sooner or later, any halfway savvy parent is likely to ask about the relatively new and increasingly publicized 529 plans. Further, advisors should know that Harvard can cost the family, relatively speaking, the same as State U.

Whether Ivy League, Big 10 or State U., the downright scariest part about college for today's parents is how the cost of tuition and incidentals continue to climb like a rocket leaving Cape Canaveral. Whether the family income level is average or affluent, it doesn't matter. College still presents a formidable financial challenge. The inflation rate for college tuition has been double the overall inflation rate throughout most of the 1990s, and near the end of the decade it was sometimes triple. Funding college tuition needs now takes more assets than the value of the family home. Most young people today, when they graduate, are often saddled with debt greater than their yearly income in their first job. And often, so are the parents, when they should be saving for retirement.

Clearly, the degree of complexity in college funding programs and the learning curve for them have risen sharply, opening the door for experts. "You can benefit if you have a college funding program as a helping tool in your practice," says college funding expert Kenneth A. Richard, ChFC, RFC.

But what's the best way to acquire such knowledge? For two college funding mavens, their expertise was gained the hard way: both with high-achieving twins. Richard, one of the mavens, and his wife, Colleen, have to date forked out $300,000 to educate his three daughters and they're not done yet. Their twins both graduated Phi Beta Kappa, one from Rice University and the other from Washington & Lee University. The Washington & Lee alumna is now in medical school, and his youngest is scheduled to graduate from Duke University in 2003.

Today Richard, chief executive of Kenneth A. Richard & Associates in St. Paul, Minn., helps other financial planners learn what they need to know to help their clients with college planning.

Maven Number Two, college planning specialist Ray Loewe, CLU, ChFC, was Richard's mentor. His introduction to this area came in 1974, at college acceptance time. A wealthy client, a physician, walked into Loewe's office and said: "I've got good news and bad news. The bad news is I can't go ahead with my investment plan. The good news is my twin sons were just accepted to medical school." On top of that, the doctor had another son and a daughter already in medical school.

Loewe, surprised that even well-off clients run into difficulties sending their kids to college and grad school, got busy finding ways to help this client put four children through medical school simultaneously.

Today, Loewe is chief executive of College Money, his advisory firm in Marlton, N.J. He has written a book on the subject, and figures he has probably helped about 50,000 families put their children through school. Both Loewe and Richard also conduct college planning seminars for advisors, to help them guide parents through the labyrinth of potential college funding plans.

Preparing:
The Big Picture
Planning for college funding breaks down into two categories. The ideal, long-range planning, starts at least 10 years before a child is due to matriculate. The other, regrettably more common, is crisis planning. "Unfortunately, too many financial planners do not bring this to a head early enough," says Loewe.

And what's needed-or what's predicted to be needed-can vary quite a bit. Recently, financial advisor and author Ric Edelman did a survey for his newsletter of college cost calculators run by five web sites-one at Money.com and four at mutual fund company sites. The amounts the calculators said would be needed to cover the expected costs varied widely, even though the same variables were entered into each calculator. For example, to have enough for a child to attend a state university, if parents start when the child is 3, they need to save $121,000, according to Money.com's calculator, and $297,000 according to Strong Funds' calculator.

That's a lot of dollars. And according to Loewe, as a general rule, parents usually don't wake up until the first child's junior year. By that time, the parents are in crisis mode. Often, Loewe finds, parents rob retirement to pay education. Or they don't set a college budget, a crucial initial step, especially for crisis planning. "The kids get excited after acceptance, and then Mom and Dad have to say they can't afford it," he says. "What parents have is not a college problem, but a retirement and a cash-flow problem," he adds.

The idea is to help clients pay for their kids' college without sabotaging their retirement. Loewe cited a case from one of his clients, a three-child family with annual income of $150,000. To educate each child would run about $160,000, or nearly $500,000 for all three kids.

The eldest, a son, was accepted at Carnegie Mellon, which costs $30,000 a year. His parents knew they couldn't afford the whole tuition, but because they knew they had to be in crisis mode, they had set a budget and knew they could afford $10,000 a year, enough to cover a state college. However, says Loewe, "just because you set a budget does not mean the kids cannot go to a good school." The family did find loans and a tuition discount, and the son got a $10,000 Navy ROTC scholarship. "The son never would have gotten creative and found additional funding if he had not been given a budget figure," Loewe says.

By analyzing Peterson's College Money Handbook, families can find which schools are most likely to provide the most help to families needing to bridge the financial aid gap. Further, a college where the average Scholastic Aptitude Test score is 1100 might give a "selective discount" to a high-school student who scored 1150 or higher, or to a student with a particular talent, like arts or sports, that the college is seeking.

The EFC Factor
The most important figure for families, and for you as their advisor, to know as the college funding planning process progresses is the "expected family contribution." This EFC number, which is the definitive number families need to know for planning and budgeting, is what colleges use to determine how much the family is expected to pay before it will kick in any financial aid. It is determined by a secret federal formula, which produces a "magic" number based on the family's assets and sources of income for the parents and the child.

Some factors of this classified formula are known. According to Loewe, they are income-driven, not asset-driven. Income weighting for children is 50% and for parents, 47%. Asset weighting is 35% for students and 6% for parents. Retirement plans such as IRAs and 401(k)'s as well as permanent life insurance are not counted. However, small employer plans and 403(b) plans are.

For example, if a student's EFC were $10,000 and the tuition at a state university totaled $10,000, that student would not qualify for financial aid. But, Richard points out, at a private college with tuition of $22,000, the student could qualify for $12,000 in financial aid.

An irony in these formulas is that a kid can work all summer and then have it held against him as the amount of his financial aid is reduced by half his earnings. It's virtually the same if the parent receives a raise or bonus. Another irony is that if assets such as mutual funds are sold to pay for college, the capital gains are typically counted for taxes and they are counted as parental income for the EFC.

While most people are floored by their EFC, thinking it's way too high, there is a silver lining. Whether a college costs $10,000 or $35,000 a year, it can cost the family with a $10,000 EFC the same, as long an extra $25,000 in other aid can be found. But colleges don't usually come up with enough money to bridge that $25,000 gap, and the student and his or her family usually have to find other ways.

Loewe recommends getting a rough estimate of a child's EFC early, even as young as age three, to target "the order of magnitude," even though the figure may not be precise. Both his web site, Collegemoney.com and Smartmoney.com. have EFC calculators.

Long-Term Planning
Advisors should stress that the sooner a parent begins planning, the easier paying for college will be for them.

If an advisor convinces a family to start planning and investing a few years before their child starts college, plenty of investment vehicles, both public and private, are available for funding needs.

Many advisors recommend deploying a combination of tactics and vehicles. In Honolulu, Kirk S. Barth, CLU, ChFC, says, "When a college funding plan is implemented, I try to get the children involved, by educating them as to how investing works, and when we review, showing how the investments have grown." Barth uses charts that show how compounding works, and discusses various investment vehicles if the child is old enough to understand. He also involves the parents by educating them and showing them how to track their investments.

One investment vehicle Barth, a New England Life agent with the Pacific Rim Group, sometimes recommends for long-term college planning is the popular zero-coupon bond. The advantage of zero coupons is that they carry a deep discount to their face value, and must be timed to mature when tuition funds are needed. But they also have interest rate risk. If inflation and interest rates are low when the bond is bought and then rates rise, not only will that bond be worth less if your client needs to sell it before maturity, but it will also earn less than many other investments, and the face value at maturity will buy less. Of course, if interest and inflation rates fall after you buy a z-bond, count yourself lucky.

Also, when a z-bond matures or is cashed in, a taxable event-either a gain or a loss-occurs for the z-bond holder. Barth says, "To avoid the annual taxation of the interest factor, you can opt for a tax-free municipal issue."

State Funding Plans
Several college funding mavens agree that state-sponsored college funding programs are good programs for this purpose, especially for affluent families, who do not fare too well in today's college planning system.

States sponsor two kinds of college funding plans, both of which are known as 529 plans (after the section of the federal tax code that details the rules). The first, which have fallen into disfavor, are prepaid tuition plans, which allow parents to pay in current tuition cost for a contract that covers future tuition cost at a state-supported university. The contract guarantees that what they put in will cover tuition when the time comes, no matter how much higher than expected tuition rises over the years.

The drawback of this type of plan is its lack of flexibility. Your clients will not receive a competitive rate of return if they have to pull out because their kid either does not go to college, or wants to go to an out-of-state school or a high-priced private institution.

The second state program, qualified college savings plans, are what most people think of when they speak of 529 plans. These plans, which are very popular with some financial planners, have grown substantially: nearly every state now has one. In 1995, only one state had a 529 plan.

These plans, which have similarities to mutual funds, typically take the form of a managed account. Most state accounts are professionally managed by institutions such as Merrill Lynch and Fidelity. Essentially, money is contributed to these accounts, and it grows tax-deferred. Income and contribution limits for parents, grandparents or others are high to nonexistent, and vary from state to state. Be aware that monies that go into a 529 will qualify for the $10,000 gift tax exclusion. Also, when the cash comes out, it is taxed at the child's rate, usually 15%. And the monies must be used to defray educational expenses.

Some 529 plans allow residents of other states to participate in their plans, though these investors do not get whatever state tax breaks are offered to residents of the state where the fund is domiciled. Typically, 529 minimum contributions are quite low, and maximums are high or nonexistent. The assets in the fund remain under parental control even after the student reaches the age of majority (18 or 21, depending on the state). While contributions are made on an after-tax basis, gains on the investment accrue tax-deferred.

One of the advantages of using a 529 plan is that those assets are not counted as an asset on the EFC formula. The money can be used to pay tuition at any public or private institution, no matter where that institution may be located. If the child does not go to school and the money is withdrawn for other purposes, then there's a 10% penalty assessed on earnings plus taxes.

Loewe says qualified college savings plans work best at the 31% tax-bracket and above. At first, when children are young, these plans usually invest in growth vehicles. As the child approaches college, the funds are switched to safer fixed-rate instruments. This switch can help avoid the risk that the stock market might nosedive at the very time the parent must cash out to meet college payments.

However, the 529 is not perfect. It lacks the liquidity and the flexibility of mutual funds, and unlike many other vehicles cannot be cashed out without penalty in order to meet changing markets or changes in family circumstances, according to Nels A. Nelson, Ph.D., CFP, LUTC, chief executive of New Life Financial & Insurance, a financial advisory firm in Sheridan, Wyo. And as Ric Edelman, CFS, RFC, CMFC, CRC, RIA cautions, "You need to verify that these 529s are the most profitable strategy in saving for college. They might not produce as much money as investing on your own."

IRA, 401(k) Strategies
Retirement vehicles, as a rule, allow tax-deferred growth, can be tapped for education, and as a rule, do not count in the EFC formula. But advisors don't always recommend this strategy for several reasons. Under the Taxpayer Relief Act of 1997, the 10% penalty for early withdrawal from a retirement IRA is waived for education. However, withdrawals will be included in your income for tax purposes, and the withdrawal can count as income against financial aid eligibility at a high level (47%). And, of course, the client is robbing retirement to pay education.

The federal Education IRA, another alternative, limits contributions to $500 a year and to a $22,500 lifetime cap. Plus, the funds go into the child's name at 18 or 21, depending on the state. The two drawbacks here are that the money counts at a steepest percentage against eligibility for aide, and the 18-year-old might go off to Paris instead of going to Penn. Parental income limits are $95,000 for an individual and $150,000 for a married couple filing jointly. Parents cannot put money in an education IRA the same year they put money in a 529 plan. On the plus side, money going into an IRA is not taxed. A negative, however, is that this vehicle lacks the flexibility to be used as needed like a mutual fund or VUL, since a 10% penalty is assessed for many types of early withdrawals. Be aware, too, that assets put into the Education IRA, ironically, do count toward the EFC.

The Roth IRA, which has income limits, can also be used, as it also allows penalty-free withdrawals for education. The money going into it, however, is taxed. And it offers most of the same drawbacks as the retirement IRA.

Finally, 401(k) plans allow borrowing for college education, but that loan must be repaid in five years. That's tough when the child is still in college, Loewe notes. A default triggers taxes. On the plus side, the employer may offer a match.

The VUL Solution
A VUL contract can present a panoply of advantages to parents when youngsters are about 10 years from matriculation. The VUL has several advantages: first, it is not counted in the EFC formula. Second, it offers tax-deferred growth, and cash can be withdrawn from it without tax consequences. Third, the investor retains considerably more control of how the funds are invested than in a 529 plan. Some VULs even have automated investment strategies that establish asset allocation formulas and will rebalance the contract investments on a regular basis. And, of course, if the insured dies prematurely, life insurance is there to help defray college costs.

The VUL can be also used if an emergency arises before college, and is not adversely affected if the child elects not go to college. Further, funds can be allocated among a number of professionally managed subaccounts. The investment strategy can be structured to parallel that of some 529 plans, while at the same time offering more fine-tuning to family circumstances and market conditions. For example, when the child is young, a more aggressive posture is generally warranted, commonly leaning toward a major percentage of growth stocks. But as college draws near, the percentage of indexed funds and bonds might be raised, with a high percentage of bond funds near the end to avoid market risk.

A feature of VUL not available with non-insurance products is a specified-premium waiver, according to Michael Irvine, CLU, a vice president at MetLife. If the insured is disabled, he says, the waiver will pay the premium on the client's behalf. This means the policy will continue, and can be drawn from for college expenses. "You can't get that with mutual funds," Irvine adds.

Nelson says that for psychological reasons, he likes to use VUL for clients who have a tendency to rob Peter to pay Paul. "Impress upon the client that insurance can do more than one job," he says, adding that often, "clients will go anywhere else before they rob that."

Loewe says VUL works best at a 31% tax bracket or above, where tax benefits are leveraged. The policy, however, should be structured to minimize death benefit and maximize cash value, he says, noting that this structure also minimizes commission and entails special considerations.

Keep in mind that policyholders cannot withdraw more than what they put into the policy without tax penalties, unless they take a loan. If a policyholder pays in $2,000 a year for 18 years, for example, it would total $36,000, and the individual could not withdraw more than $36,000 tax-free. Of course, if the subaccounts grew, then more than $36,000 could be taken out, but only as a policy loan if tax consequences are to be avoided. This loan, done right, is tax-free.

Variable annuities can offer many of the same benefits as VUL, but only if one of the annuity owners reaches age 59 1/2 while a child is in college, so that the 10% withdrawal penalty can be avoided. But even penalty-free withdrawals have a drawback. "Withdrawals from annuities are taxed as income, whereas they are not taxed from VUL if done right," notes K.C. Dempster, ChFC, a director at Loewe's firm.

UGMAs
According to Jerry S. Rosenbloom, Ph.D., CLU, CPCU, a professor at Wharton's Department of Insurance and Risk Management, if a family's income means the student is not eligible for any form of aid, the Uniform Gifts to Minors Act for children under age 14 can offer a way to shelter some money in a custodial account. The first $700 a year in earnings on whatever amount is in the account is tax-free, and the next $700 is taxed at the child's rate. The rest is taxed at the parents' rate until the student turns 14, when it is all taxed at the student's rate, usually 15%.

G. Victor Hallman, LL.D., Ph.D., also at the Wharton School, recommends using growth stocks that produce no dividends or income in UGMAs. The potential shortcoming here is that the child gains control at the age of majority and could blow it.

If the student qualifies for financial aid, however, the money in the UGMA reduces his or her eligibility for financial aid and "does so to an extent greater than if the parent owned those same assets," Loewe says.

Other Alternatives
Despite the absence of tax breaks, parents frequently use mutual funds to save for college. Nelson likes their simplicity and liquidity. He remembers a family where the father lost his job, and the mutual funds invested for college kept a roof over the family's head and put food in their mouths. "Sometimes," he says, "simplest is best."

Series EE United States savings bonds also offer some tax advantages for lower-income families, but Edelman recommends against them because their rate of return is too low.

Parents can also take out a home-equity loan on their home. The interest will be tax-deductible so long as the total debt on the home does not exceed its value.

Whatever methods are chosen, most advisors will likely end up agreeing with Jeffrey P. Diehl, CFP, a general agent at the Advisory Group in Appleton, Wis.: "It's rewarding to me as an advisor to watch these accounts grow as the kids grow up, and to think these kids are receiving advantages that many in earlier generations did not."

As Richard quips: "There is little difference between a college education and buying a car, but with a car, there is less smoke and mirrors and there's a warranty." U

Top | Back | E-mail to a Friend | Print

If you are not receiving your magazine or need to change your address,
please contact membersupport@naifa.org.

For comments on articles on this website contact mleyes@naifa.org.