It’s back to school season—a perfect time to think about your children’s future. Parents and grandparents should start planning for college costs as early as possible.
Most Americans would do almost anything for their children and grandchildren, and sending them to college is a top priority for many. According to studies, more than 50% of parents are willing to go into debt to fund their child’s college education, and at least 95% of parent expect to cover at least half the costs.
The trouble is, college debt is extremely high—currently $1.77 trillion in the U.S. The average student loan debt amount is now $37,338 according to recent data.
Why is college debt so high? Well, for one thing, the average in-state tuition cost at public four-year institutions is $11,260 for the 2023-24 school year—and that’s per semester. That is about three times as high as it was in 1989-90, according to the College Board.
And on top of that, interest rates have risen. For the 2024-25 school year, federal parent PLUS loans will be at their highest point in more three decades, at a whopping fixed interest rate of 9.08% plus fees.
So, what is a loving parent or relative to do? Here are some of your options.
1) 529 Plans
A 529 plan, technically known as a “qualified tuition program” under Section 529 of the Internal Revenue Code, is an education savings plan offered by all 50 states and the District of Columbia. There are generally two types—prepaid tuition which allows you to lock in today’s tuition rates for the future college attendee, and the more popular 529 savings plan.
Keep in mind that you aren’t restricted to your own state’s plan. You can invest funds in any state’s plan, and your student can attend college in any state. Each state’s 529 plan is unique, with a different combination of sales channels, investment offerings and fees. It can pay to shop around when choosing a plan because even if your state offers a tax deduction or credit for contributing to your state’s plan, that benefit might not stack up against the performance or lower cost of another state’s plan.
| PROS As of 2023, if a 529 plan is owned by a grandparent, aunt, uncle or other person, it is virtually invisible on the FAFSA’s calculations for both assets and won’t count as student income later if used for qualified expenses. Although contributions to a 529 plan aren’t tax deductible on your federal tax return, the earnings grow tax-free when withdrawn and used for qualified education expenses. Many states offer state income tax deductions for contributions if you choose to invest in your state’s plan. (Your child can still attend college anywhere.) There are no income limits on 529 plan contributions, so they’re available to everyone. Plans vary, but most have high total contribution limits—usually in the $235,000 to $529,000 range. | CONS If owned by a parent or student, a 529 plan is counted as an asset on the student’s FAFSA (free application for federal student aid), although only a percentage of the total account is calculated. There are limited investment options available with 529 plans, and only one investment change per year is permitted. Some plans have high costs and fees. If your child, you or any family member does not want to attend college, and if 529 plan money is withdrawn and not used for education expenses, the account’s earnings are subject to both income tax as well as a 10 percent penalty tax, and you may have to pay back any state income tax deduction amounts as well. (There are exceptions to 529 plan penalties if your student receives scholarships.) |
2) Roth IRAs
If a 529 plan doesn’t work for your family for some reason, a Roth IRA (individual retirement account) may be an option to consider. You can withdraw money from Roth IRA accounts to be used for college expenses for you, your spouse, children or grandchildren as long as the account has been in place for five years. If the account owner is under age 59-1/2, the only tax liability for college expenses will be on any withdrawn earnings—if over 59-1/2, the entire withdrawal amount is tax- and penalty-free for any purpose as long as you’ve owned the account for five years.
| PROS There is a lot of flexibility with a Roth—you can invest in nearly any type of account you want to within a Roth IRA wrapper. If your child doesn’t choose to go to college, the money can be used for any purpose, including retirement, with no mandated withdrawals or RMDs (required minimum distributions) or taxes due. Inherited Roth IRA accounts are also tax-free. | CONS One of the difficulties with Roth IRAs is that high earners can’t open them, and the yearly limit in 2024 for contributions is only $7,000 ($8,000 per year for those 50 or older). In some cases, what’s called a “backdoor Roth” might be indicated for high earners, where they can legally convert taxable IRA funds into Roth IRA accounts and pay taxes on the money converted, but these are complex and strict IRS rules apply. While a Roth IRA does not show up as an asset for financial aid calculations, amounts withdrawn and used for college expenses are considered income for the next school year, and therefore may reduce the amount of student financial aid that’s available. |
3) Life Insurance
Permanent life insurance policies, such as whole or universal life, include both a death benefit and a savings/cash account component which you can borrow against to pay for college.
| PROS Many permanent cash value policies regularly credit the policy with interest in a guaranteed* amount specified in the policy terms (*guaranteed by the claims-paying strength of the issuing insurance company.) Money borrowed from the cash value in a life insurance policy is not taxable in most cases. Interest credited to a life policy grows tax-deferred, but the credited interest portion is taxable if that part of the money is borrowed for any purpose, including college. If the insured dies, the death benefit plus remaining cash value is almost always tax-free when left to individually-named beneficiaries. Buying a flexible, permanent policy for a child at a young age when they are healthy can ensure that they are insurable even if there’s an unexpected future adverse event; for instance, if they develop a severe illness later. | CONS While a life insurance policy does not show up in financial aid calculations as an asset, amounts borrowed to pay for college are considered as income on the next year’s FAFSA, potentially reducing the amount of student financial aid available. Life insurance policies can be costly for those who are older or in poor health. If you are using life insurance to pay for college, consider buying the policy when the child is a healthy toddler—with them as the insured to keep the cost of insurance low. If you borrow money from the cash portion of a permanent life insurance policy, interest is charged by the insurance company on the amount borrowed until you pay the money back—in essence, you are paying “yourself” back—and regular premium payments must be made to keep the policy in force. It is advisable to work with a qualified professional to examine the structure of any policy so that you understand its terms. |
4) Annuities
Annuities are another option to consider.
| PROS Annuities can offer a tax-advantaged option for college costs in some cases because annuity policy growth is not taxed until funds are withdrawn. You could purchase a fixed annuity with a short payout schedule to make payments to cover tuition, but you may have to contribute a significant amount to achieve the payout needed. Another way to potentially make an annuity work is to start early when your child is young and purchase a deferred annuity policy which guarantees* a high credited interest rate (*guaranteed by the claims-paying strength of the issuing insurance company). | CONS While an annuity does not show up on the FAFSA as an asset, annuity amounts paid out are considered income the next year, which can reduce your student’s chances of receiving financial aid. So rather than taking annuity payments while attending college, optionally you could take out student loans, allowing your annuity to continue to grow, then use the annuity to pay off the loans after graduation depending on interest rates, crediting rates, and whether or not it saves you money in the long run. |
How College Savings Can Impact Financial Aid Eligibility
Working with a qualified financial and tax professional is advised when planning for college costs. Legislation is always changing for parents and grandparents looking to get a jump-start in funding their child or grandchild’s education. For example, due to the FAFSA Simplification Act of 2020, in July of 2023 the EFC (expected family contribution) was replaced by the SAI (student aid index).
Where the EFC bottomed out at $0, the SAI goes as low as -$1,500, meaning students can qualify for more need-based financial aid. SAI also simplifies the FAFSA form itself, drastically reducing the number of questions. Where possible, the new law mandates data received directly from the IRS be used to calculate the SAI and federal Pell Grant eligibility.
Where the new SAI may truly be a boon to students who need more aid is through 529 plans owned by extended family members. As of July 2023, 529 accounts owned by grandparents, aunts, uncles or others are not counted as assets, nor are qualified distributions taken from them counted as income. Therefore, they no longer have significant impact on eligibility for financial aid.
FAFSA (free application for federal student aid) and the CSS (college scholarship service)
While it is true that life insurance, annuities and 529 plans owned by anyone other than parents or students are not counted as assets on the FAFSA, they may be counted on the CSS (College Scholarship Service) profile, another aid form used for aid by about 240 colleges in addition to the FAFSA. The CSS profile is extremely complex and steps are being taken to simplify it, but changes to the form have not been finalized.
More Resources
Federal Student Aid Estimator https://studentaid.gov/aid-estimator/
FAFSA https://studentaid.gov
If you have any questions or would like to discuss your family’s financial goals, please call us! You can reach Pathlight Advisors at (770) 450-4993
This article is for general information purposes only and should not be relied upon for financial or tax advice. In every case, it is recommended that you work with financial, tax and legal professionals to determine what might be best for you and your family based on your unique situation and circumstances.
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