There are many different options to help you pay for college. Scholarships offer another avenue, as do student loans. Each option has its unique benefits and risks and you may want to consider more than one vehicle depending on your timeline and overall savings goals.
Comparing Your Options
Michigan Education Savings Program (MESP)
With MESP funds can be used at accredited colleges and universities in the United States — even certain colleges abroad.
MESP enables your savings to grow free of state and federal income tax and your contributions to receive a state income tax deduction up to a certain amount.
There is no federal or state income tax on withdrawals if the money is used for qualified educational expenses, such as tuition, fees, books, and certain room and board. If your child does not go to college, you can transfer the funds to another eligible family member and preserve the tax benefits. Should you need to withdraw the money yourself, you may so long as you pay the regular income tax plus a 10% Federal penalty on any earnings. Unlike many other education savings programs, 529 College Savings Plans allow for participation regardless of income with a higher ceiling on contributions than other options.
529 State and Private Prepaid Plans
A 529 State Prepaid Plan allows you to pre-pay all or part of the costs of an in-state public college education at today’s rates. They may be converted for use at private and out-of-state colleges, and there’s also a separate Private College 529 Plan specifically for private colleges. As is the case with all 529 college savings plans, funds are exempt from federal income tax when used for qualified education expenses, but there are some caveats you need to be aware of. Funds invested in state-run prepaid plans can be used at full value to pay for tuition and fees at in-state colleges, but a refund value can usually be used to pay tuition and fees at out-of-state colleges. Funds invested in the Private College 529 plan can only be used for member colleges. In either case, room and board won’t be covered. Should your child choose not to attend college in that state or one of the participating private colleges, you may rollover funds to an immediate family member or request a refund. In some cases you might not earn interest on your principal.
Coverdell Education Savings Account (CESA or ESA)
This is a tax advantaged education savings account similar to a 529 Savings Plan except qualifying expenditures cover primary and secondary schools in addition to college, universities and post-secondary institutions. While it can be used to cover tuition, fees and a wide variety of education related expenses, room and board costs can only be paid if a requirement of attending that school. With an ESA, you only receive federal tax advantages — there are no state tax deductions. If your child doesn’t use the funds, you can designate another beneficiary within the family. Coverdell ESA contributions are limited to $2000 per year, per beneficiary. The account is not available to high income families. And you’re limited to select mutual funds and securities.
Custodial Accounts (UGMA/UTMA)
The Uniform Gifts to Minors Act and Uniform Transfer to Minors Act are ways some states allow assets such as securities to be held in a custodian’s name for the benefit of a minor without an attorney needing to set up a special trust fund. The income from a custodial account must be reported on the child’s tax return and is taxed at the child’s rate, subject to the Kiddie Tax rules. The parent is responsible for filing an income tax return on behalf of the child. There is no special tax treatment for UGMA accounts. Children aged 14 and older must sign their own tax returns.
This option includes all normally taxed accounts. Examples range from a typical bank savings account to a brokerage account. State income tax treatment varies depending on state laws. Because you’re already paying the standard tax rate, there are no penalties for non-qualified withdrawals. There are no education-specific advantages.
A Roth IRA is to retirement savings what a 529 plan is to college savings. They both allow for after-tax contributions while your earnings grow free from income tax. Withdrawals are tax-free when used for their qualified purpose. While some people choose to save for college with a Roth, there are certain restrictions: the ability to contribute to a Roth phases out at higher income levels, and there is a limit to how much you can contribute each year. It’s also worth noting that using funds from a Roth one year can hurt the student’s financial aid eligibility the next.
This is a popular retirement savings option many people use for long term investing. Because contributions are tax deferred until the owner is 59.5 years of age, the multiplier effect from compounding is greater. While there are penalty free withdrawals for qualified higher education expenses, the entire withdrawal is taxed at the owner’s tax rate. State income tax treatment varies.
Educational Savings Bonds
The savings bond education tax exclusion permits the redemption of savings bonds when the bond owner pays for qualified higher education expenses at eligible institutions. Tax free status is subject to some income limits. State income tax treatment varies.
This is an award for a student to further his or her education based on various criteria set by the scholarship creator. While scholarships do not require repayment, unless they’re full scholarships, they can affect the status of other forms of education savings.
Financial aid includes government educational aid in the form of federal and state grants and federal student loans.
There are three types of federal student aid:
- Grants or “Pell Grants,” which do not need to be paid back.
- Student loans, which do need to be paid back.
- Work Study
Grant awards vary according to the type of grant and the organization issuing the grant. Like scholarships, they do not need to be repaid, but typically only cover a portion of a student’s educational costs.
Pell Grants are usually awarded to undergraduates who have a high degree of unmet financial need. This need is mainly defined by income but includes family size, number of kids in college at same time, family assets and cost of school. In 2012-13, 61% of Pell Grants were awarded to dependent students who came from families with an adjusted gross income of $30K or less.1 Pell Grant eligibility for students from families having income higher than $50,000 is less common. (1 Trends in Student Aid 2014-College Board).
Generally speaking, income or lack thereof, not savings, is the major driver for Pell Grant awards.
Federal Student Loans
Because it is not always possible to pay for college expenses out of savings, many families may find that they will need to borrow at least some money to help pay for college.
Federal Student Aid (FSA) is a program authorized under Title IV of the Higher Education Act of 1965. It provides grants, loans, and work-study funds to students attending college or career school. The most commonly used way to apply for student aid is through the Free Application for Federal Student Aid, also known as “FAFSA.”
The following eligibility requirements apply for students considering federal financial aid:
- Social Security Number.
- High school diploma or GED.
- Males between the ages of 18-25 must be registered with the Selective Service.
- U.S. Citizen (several exceptions apply)
- Not in default of an existing student loan.
- Enrolled or will enroll in a qualified institution of higher learning.
Student loans may be federally subsidized or unsubsidized and there are also private loans.
|FEDERAL SUBSIDIZED LOANS||PRIVATE LOANS||UNSUBSIDIZED LOANS|
|Payment deferred until graduation.||May require payment while in college.||Six month grace period for repayment; but the interest must still be paid or accrued during that time.|
|You won’t need a credit check.||Require an established credit record.||You won’t need a credit check.|
|Borrower needs to demonstrate financial need. Doesn’t require a cosigner.||May require a cosigner.||Borrower does not need to demonstrate financial need. Doesn’t require a cosigner.|
|Interest is tax deductible.||Interest is not tax deductible.||Interest is tax deductible.|
|Interest rate is fixed.||Interest rate will depend on your credit score and other factors.||Interest rate is fixed.|
|Can be consolidated into a Direct Consolidation Loan.||Loan consolidation may not be allowed.||May consolidate federal unsubsidized loans.|
The amount of federal financial aid provided to a student is partly determined by the “Expected Family Contribution” (EFC).
- The EFC is a complex formula that determines the minimum amount the student’s family is expected to contribute to their child’s higher education costs.
- The EFC takes into account many elements, such as income (both parents & students); savings, including 529 accounts; how many kids in the household and how many kids are in college. It doesn’t consider family debt. 529 plans do not disqualify students from receiving federal financial aid.
- Retirement account assets (401k, 403b, IRA, etc.) and home equity are considered protected assets and are not included in the EFC formula.
After completing the FAFSA, many families find that their savings, in 529 plans or otherwise, do not have a significant effect on the ability to receive financial aid.
For more information about federal financial aid, please visit https://studentaid.ed.gov/sa/
Additional Student Loans
There are federal loans and a wide variety of private loans that fall outside the scope of primary government financial aid.
Parent PLUS Loans are federal loans available to parents with relatively good credit, and are made to cover the difference between the cost of attendance and any other aid your child has been awarded. While the interest rate is lower than most private student loans, it’s much higher than Stafford loans.
Private Student Loans are created by private institutions ostensibly for the purpose of helping students fund education. While Private Student Loans have better terms than many other private loans, interest rates can be much higher than government student loans, in some cases as much as 18% and many require payments while you’re still in school. These types of loans can adversely affect the borrower’s available income after graduation.