Parents need to save for their child’s college education and to start that process early.
However, no one college saving strategy will work well for every family because the right approach is dependent on several variables:
- Tax bracket
- Student age
- Anticipated financial aid (both need and merit)
- How much control parents wish to retain over their investments
The goal of young parents?
Young parents should invest in their child, both educationally and financially, so when the reality of college stares them in the face, they have the latitude to make decisions. To have options financially is what we want to achieve.
But that’s easier said than done.
If you want to make even the most stalwart investor weak in the knees, calculate how much four years of education will cost ten years from now and what that means in terms of a monthly savings goal.
That’s what traditional college savings calculators do. It’s fairly simple. First, the future cost of college when your child reaches age 18 is determined. Second, based on the current rate of return, the future value of your investments and savings is calculated. Then future investment value is subtracted from future college costs. That gives you the amount you’ll need to save in the given time period.
Based on what you need to save, how long you have to save it, and what your investments are returning, a monthly figure is calculated.
That’s when the well-intentioned parent faints.
That’s when they realize that they’ll have to save some huge monthly sum — totally beyond the family’s budget to absorb. So they do nothing.
Let’s put this in perspective. Again, parents need to create options by investing both educationally and financially.
Educationally, parents need to invest their time to ensure their child is:
- Given every opportunity to excel in school.
- Provided the opportunity to explore the world and broaden their horizons.
- Encouraged to participate in activities that develop teamwork and leadership.
Maximize their strengths and help them compensate for their weaknesses.
Yes, parents may feel like taxi drivers and might even have to read that textbook along with their child. But that investment in time will be returned tenfold when admissions officers start separating the sheep from the goats. If they’ve done a good job preparing their student educationally, he or she has many more options in shopping for the right college or university. The student might even qualify for merit scholarships and grants.
Financially, traditional college savings calculators are too simplistic.
Calculators often result in an unreasonably high investment figure. But consider whether most folks paid cash for their home. Probably not. So they shouldn’t expect to pay cash for college. If they have four years of college expenses saved by the first day of college, they are, in effect, paying cash for college. That’s unnecessary and unrealistic. Most families simply cannot save that amount of money, nor do they need to.
Furthermore, the government doesn’t expect the family to pay the entire cost of a college education — only their fair share based on their financial circumstances. Thus enter the financial aid formula for calculating Expected Family Contribution (EFC). This formula is the method the Department of Education uses (or The College Board via the CSS Profile) to determine the student’s fair share of one year’s cost of education and then their financial aid eligibility.
There are two basic types of financial aid:
- Self-Help Aid: This consists of interest subsidized loans and work-study
- Gift Aid: This consists of grants and scholarships.
The amount and types of financial aid are based on two factors:
- The merit of the student (scholarship, athletic achievement, musical or artistic ability, etc.).
- The financial need of the student.
Need is by far the most important factor in determining financial aid, but that is slowly changing. Most of the financial aid given by the federal and state governments is based on the financial need of the student, while most of the financial aid given by colleges is merit-based.
How is the financial need of a student calculated?
“Needs Analysis” (determining the financial need of the student) is calculated with this formula:
1 Cost of Attendance (COA)
– Expected Family Contribution (EFC)
= Financial Need
2 Financial Need
– Resources of the Student
= Adjusted Financial Need
Example: If the cost of attendance at a particular college is $24,000 and the expected family contribution is calculated to be $12,000, the financial need of the student is $12,000. In this case, the student is eligible to receive $12,000 in financial aid. Whether he receives a financial aid award for the entire $12,000 is up to the discretion of the individual college. Nonetheless, the financial aid eligibility of the student is directly related to the financial need.
If the student had other resources to help pay for the college cost, the financial need would be reduced on a dollar-for-dollar basis for these resources. In this example, assume the student had received a $1,000 private scholarship from the local Chamber of Commerce. Since private scholarships (scholarships which are not given by the college) are considered a resource, the $1,000 scholarship would reduce the financial need down to $11,000. This means the student would now be eligible for only $11,000 in financial aid from the college. Merit-based scholarships may be added to the mix as well.
The bottom line?
Parents don’t have to save the whole enchilada. But they do need to invest something.
If they can have a year or maybe two of college expenses ready when the student begins college, they’re in good shape. They have options: choose to pay for college from loans, from the investment account, from your income, or from a combination of all three. They can also take advantage of the monthly installment plans.
How can parents use this information?
They should combine the traditional savings calculator with the needs analysis process.
- Use the traditional calculator to determine what college is going to cost X number of years from now.
Figures will be different depending on whether one uses a current public or private college dollar figure. It would serve to use both for planning purposes.
- Determine, based on a given annual cost of living adjustment and appreciation rate, what the parent’s income and assets will be at that same time in the future.
If they are going to use the institutional method (used by the College Board), they’ll need to figure out what their home equity will be worth as well. Also, establish an estimate of the student’s future income and assets. $1,500 to $2,000 is a good estimate of a high school senior’s current part-time income.
- Use an Expected Financial Contribution (EFC) estimator (finaid.org and collegeboard.com have these available) to determine what the student’s EFC will be.
This is assuming that today’s rules will still apply in the future.
- Compare the future cost of education to the EFC.
If the EFC is less, subtract it from the cost. The difference is need-based financial aid eligibility. If the EFC is greater than the cost, need-based aid isn’t in the student’s future.
This information allows us to make some judgment calls.
First, the remainder would be their savings goal — the family’s cost after aid. Based on this, they can go back to the traditional calculator to determine their monthly savings goal. And it is just that, a goal; they should not put retirement savings at risk.
What parents want is to have financial options when it comes time to pay for college.
Even a small educational nest egg is better than none.
Second, and most importantly, it gives parents the guidelines they need to determine where best to invest their college savings. It’s important for parents to remember that whatever investment strategy they choose will ultimately have consequences when it comes to taxes, rate-of-return vs. risk, and financial aid eligibility.
Whether need-based financial aid eligibility is established dictates whether the parents should concern themselves with looking for options to shelter assets from the needs analysis formula.
If there’s no need-based aid, parents should concern themselves with the tax and rate of return questions of investing.
However, if it appears that need will be established, parents should make every effort to shelter assets from the formula, divert income, and so on to lower the EFC as much as possible, thus increasing the amount of need-based aid they are eligible to receive.