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The Funding Dilemma: Retirement or College?

If your client can save for only one of these goals, they should fund their retirement. Simply put, money can be borrowed for college, but not for retirement.

April 2007
from The Tax Adviser

If your client can save for only one of these goals, they should fund their retirement. Simply put, money can be borrowed for college, but not for retirement.

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 percent to 75 percent of pre-retirement income to maintain his or her current standard of living. Lower-income earners may need up to 90 percent.

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.

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 percent 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. 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) 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 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. The form can be submitted online or over the phone.

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 percent. A three percent origination fee and a 1 percent insurance premium are subtracted from the loan proceeds. After July 1, 2006, the interest rate is fixed at 6.8 percent and the origination fee reduced to two percent for the 2006–2007 academic year.

The origination fees on the FSSL (as well as the Federal Unsubsidized Stafford Loan (FUSL)) 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 five percent 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 nine percent. A three percent origination fee and a one percent insurance premium are taken from the loan proceeds. For loans disbursed after July 1, 2006, the interest rate is fixed at 8.5 percent; discounts on the rate may be available if the payments are made automatically from a checking account.

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).

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 percent penalty on the earnings, and the earnings become taxable.

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.

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 percent 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 four percent 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.

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.

 

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Michael David Schulman, CPA/PFS and Frank J. DeCandido, CPA/PFS are contributors of The Tax Adviser. Their views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.

 


Copyright © 2007 The Tax Adviser