Ways to Pay for College If Your 529 Isn't Enough
The best sequence to tap your other assets will depend on your family's individual circumstances.
Question: The amount we've saved in our child's 529 account will likely not cover the full cost of college. What are our options? Is there an order to tap other assets that makes the most sense?
Answer: There are many considerations, and the best strategy will, of course, depend on your individual situation. In addition to taking stock of the assets your family already has available to pay the bill in various college-savings accounts (529s, Coverdells, UGMA/UTMA accounts, and so on), you'll also want to assess whether your child might qualify for scholarships, grants, and credits.
Definitely do not skip the step of filling out and submitting a Free Application for Federal Student Aid, or FAFSA; schools use the information reported on the FAFSA to determine how much aid you qualify for. Also, remember to fill it out every year you plan to attend college. Bear in mind that colleges define "aid" more broadly than you or I might. Some of this aid will need to be paid back (such as loans), and some of it will not (such as grants and scholarships).
The amount of financial aid you are eligible to receive is based on your "financial need," which is the difference between the cost of attendance (determined by each school) and the expected family contribution (a measure of the family's financial strength, calculated according to a formula established by law). So, the lower your expected family contribution and/or the higher the cost of attendance at the school, the greater your financial need.
1) Grants and Scholarships
Grants and scholarships are among the most desirable forms of financial aid and should be considered first. Grants and scholarships, also sometimes referred to as "gift aid," are essentially free money--they are financial aid that doesn't have to be repaid. Grants are often need based, while scholarships are usually merit based. Do your research to find out which grants or scholarships you might be eligible for and what their application deadlines are. (One caveat, however: Per the Department of Education's website, you might have to pay back part or all of a grant in the event you withdraw from school before finishing an enrollment period such as a semester.)
2) The AOTC
If you are eligible for the American Opportunity Tax Credit (AOTC), carve out $4,000 in college expenses to be paid with cash or loans ahead of all other sources of money, advises Mark Kantrowitz, a financial-aid expert. You can then use the AOTC to offset those expenses. The AOTC isn't available to everyone: Qualified taxpayers with modified adjusted gross incomes of $80,000 or less (or $160,000 or less for joint filers) qualify for the full credit. Taxpayers earning more than this may qualify for a partial credit, but a taxpayer whose MAGI is greater than $90,000 ($180,000 for joint filers) cannot claim the credit. For more on this, click here.
The reason that AOTC-eligible families should carve out $4,000 of tuition and textbook expenses each year that will be paid for with cash or loans is because the AOTC is worth more than the tax-free 529-plan distribution. The AOTC yields a dollar-for-dollar tax credit based on the first $2,000 of tuition and textbook expenses, then $0.25 on the dollar for the next $2,000). It's also important to remember that you can't use the same qualified higher-education expenses to justify two education tax benefits. For example, you can't use a tax-free distribution from a 529 plan to pay for tuition and textbook expenses that you also want to use to justify the AOTC.
3) Federal Student Loans
As a next step, Kantrowitz recommends figuring out how much of a gap you'll have beyond need-based aid and the 529-plan money, and whether some of it can be covered with Direct Subsidized Loans or Direct Unsubsidized Loans, which have low fixed interest rates and do not require a credit check.
One of the benefits of subsidized loans is that the U.S. Department of Education pays the interest for you if you're in school at least half-time and for a limited grace period after you leave school. This makes subsidized loans a better deal for the borrower than other types of loans, where interest begins to accrue immediately. In addition, subsidized loans have low fixed interest rates--the current rates are 3.76% on a Stafford loan for an undergrad and 5% on a Perkins loan.
Another option is unsubsidized Stafford loans, which are available to all students regardless of financial need. The unsubsidized federal Stafford loan has a fixed interest rate that is among the lowest available interest rates for unsecured debt (currently 3.76% for an undergrad) that is not based on the borrower's credit, Kantrowitz points out. Though the limits are higher than with subsidized Stafford loans, there are also limits to how much you can borrow with unsubsidized Stafford loans.
4) Spend Down Certain Types of Student-Owned Assets Before 529 Assets
In terms of drawing down different types of college-savings accounts, some important considerations have to do with how different assets are "counted" when calculating the expected family contribution. If possible, you should first spend down any assets that have a bigger impact on reducing the aid a student is eligible to receive.
For instance, if you have one, UGMA and UTMA accounts should be spent down before taking a qualified distribution from a 529 plan. The reason is that UGMA/UTMA assets are student owned and reduce financial-aid eligibility by a harsher 20% of the asset value. For this reason, Kantrowitz recommends spending the assets in UGMA/UTMA accounts down to zero before taking a qualified distribution from the 529 plan. Likewise, savings accounts, real estate, mutual funds, or stocks and bonds held in the student's name can also have a bigger impact in terms of reducing the aid a student is eligible to receive.
5) Spend 529-Plan Money to Fill In Any Remaining Gaps
Assets in a 529-plan account can also reduce aid eligibility, but not to the same extent that UGMA/UTMA and other types of student-owned assets can. If the 529-plan account is owned by a dependent student or the dependent student's custodial parent, it is reported as a parent asset on the FAFSA. In a worst-case scenario, this will reduce aid eligibility by up to 5.64% of the asset value, Kantrowitz said.
6) Federal Parent PLUS Loan
Another option is to use a federal Parent PLUS loan to address any remaining gaps that can't be covered by grants and scholarships, student loans, and 529 assets, Kantrowitz says. The PLUS loan has a fixed interest rate for the life of the loan (currently 6.31%), plus a loan fee.
Unlike with student loans, the Parent PLUS loan does depend on the borrower's credit history, but the credit check may not be as stringent as with some private loans. That said, Kantrowitz points out that borrowers with excellent credit may be able to qualify for a lower interest rate on a private loan than on the federal Parent PLUS loan. (Just be aware that if you sign up for a variable-rate loan, rates are likely to rise.)
Kantrowitz also points out that needing to borrow a Federal PLUS loan or a private student or parent loan may be a sign of overborrowing. Although taking on debt to finance college is unavoidable in many cases, there are some important considerations. In terms of students taking on debt, an oft-cited rule of thumb is that their total education debt should be less than their expected starting annual salary--otherwise, they will have trouble paying back that loan debt. Likewise, it's a good idea for parents to be conservative about how much debt they can comfortably take on, particularly as they near retirement and may have reduced incomes and fewer resources available to pay off the loans.