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Myths about Saving for College

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There are several myths about saving for college. The most common myths are that there is a penalty for savings, that college savings plans are available only for wealthy families or that a family will qualify for more need-based aid if they don't save for college. These myths are harmful because they discourage families from saving for college.

Myth #1: Penalty for Savings

Many families mistakenly believe that they are penalized for saving, and that they would be better off if they didn't save. The Federal Need Analysis Methodology does count a portion of the family's assets in determinations of financial need, so a family with more assets will get less need-based aid. However, the federal government does not count all of the assets, just a fraction, so a family that saves for college will have more money left over than a family that does not save for college.

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The federal need analysis formula shelters several types of assets. Money in retirement plan accounts is ignored, as is the net worth of the family's home and any small businesses owned and controlled by the family. A portion of parent assets is also sheltered by an asset protection allowance based on the age of the older parent. This shelters about $50,000 for the typical family with college-age children (median age 48). As a result, less that 4% of dependent children have any contribution from parent assets.

Money in a dependent child's 529 college savings plan (or other qualified tuition plan) is treated as though it were a parent asset on the Free Application for Federal Student Aid (FAFSA). This is a more favorable treatment than for child assets. Child assets are assessed at a 20% rate while parent assets are assessed according to a bracketed scale with a top bracket of 5.64%. While every $10,000 in a 529 college savings plan may reduce need-based aid eligibility by up to $564, that still leaves you with at least $9,436 more available to pay for college than if you hadn't saved.

It's Cheaper to Save than to Borrow

The more money you save, the more options you'll have and the less you'll need to borrow. It is always cheaper to save now than to borrow later. If you save $200 a month for 10 years at 6.8% interest, you'll accumulate about $34,400. If you were to borrow this money instead of saving, you'd pay $396 a month for 10 years at 6.8% interest, almost twice as much. When you save, the interest is paid to you, while when you borrow, you pay the interest.

529 college savings plans are a tax-advantaged way of saving for college. Earnings in the plan are tax-deferred and, if used to pay for qualified higher education expenses, entirely tax-free. These tax benefits were made permanent by the Pension Protection Act of 2006 and will not expire.

Myth #2: Student Aid will Pick Up the Tab

Many parents mistakenly believe that if they don't save for college, they'll be able to shift the costs to their children through loans, or that the federal government and the schools will pick up the tab. Student loans only go so far in covering college costs, and the government and schools consider parents to have the primary responsibility in paying for their children's education. Even if your child gets a lot of need-based aid, it doesn't cover the full costs. The Pell Grant, for example, covers only 10% of current private four-year college costs. Work study covers only 10-20% of college costs. Failing to start saving now will only hurt you later. The only viable hedge against increases in college costs is to save as much as possible as early as possible.

Myth #3: Scholarships will Cover All the Costs

Families also think that they can rely on scholarships to pay for college. For example, four-fifths of parents expect that their children will receive scholarships, but only about 7% of students actually receive private sector scholarships. The average amount of the scholarship received by undergraduate students is $2,000. Moreover, due to outside scholarship policies, receiving a private scholarship will often reduce need-based aid packages. It is still worthwhile to search for scholarships, because scholarships often replace loans, but one must be realistic about the chances of winning a scholarship (1 in 15) and the impact of scholarships on paying for college (less than 10%).

Myth #4: 529 Plans are Only for the Wealthy

While it may be more difficult for low and moderate income families to save, everybody can benefit from a 529 college savings plan. College savings not only increases access to a college education by spreading the cost over time but it also maximizes choice. It helps families choose the college that is most appropriate for their children, as opposed to just the least expensive college.

All state 529 college savings plans have low minimum contribution requirements of just $15 to $25 a month. Some states will even match the contributions by low income families to encourage them to save.

Myth #5: It's Too Late to Start Saving

It is never too late to start saving for college.

It is best to start saving when the child is young, since a your greatest asset is time. If you start saving at birth, about a third of the savings goal will come from earnings on the investment. If you start saving when the child enters high school, less than a tenth of the savings goal will come from earnings on the investment. Some personal finance experts even advise starting to save before birth.

However, there are financial benefits to saving even if your child will enroll in college next year (or even if the child is already in college). 32 states and the District of Columbia offer a state income tax deduction or tax credit for contributions to the state's 529 college savings plan, with four states providing a tax deduction for contributions to any state's 529 college savings plan. This is like getting a small discount on tuition, with the discount equal to your marginal tax rate. That's a 3% to 10% discount, depending on your state. You might have to keep the money in the plan for a year, since some states base the deduction on contributions net of distributions.

Myth #6: The Stock Market is Too Risky

The stock market is risky, but one can manage the risk through a careful investment strategy.

The S&P 500 dropped 39% in value in 2008, causing some state 529 college savings plans to lose money and many prepaid tuition plans to have actuarial funding shortfalls. This caused about half of families to change how they save for college, according to a 2010 college savings survey.

However, stock market volatility is to be expected. During any 17 year period, the stock market will drop significantly at least two or three times. The severity of the 2008 stock market plunge was unusual, but not the drop itself. When you are saving for a long-term life cycle event like college, you should plan for the volatility by using an age-based asset allocation and by using dollar-cost averaging.

  • Age-based Asset Allocation. Age-based asset allocation starts off with an aggressive mix of investments when the child is young and gradually shifts toward a more conservative mix of investments when college approaches. It bottoms out with less than one fifth of the portfolio in risky investments a year before high school graduation. (Risky investments include stocks and other investments where there is a potential risk to principal. Low risk investments include bank certificates of deposit and money market accounts.) When the child is young the amount of any losses will be small and there is a lot of time to recover from the losses. When college is close there is more money at stake.

  • Dollar-Cost Averaging. Dollar-cost averaging invests a fixed amount of money at a regular interval. When the stock prices go down, the number of shares purchased increases. When stock prices go up, the number of shares purchased decreases. This implements the sage advice to buy low and sell high. Dollar-cost averaging is one of the most effective blind strategies for investing. It works best when the stock market is volatile.

Myth #7: 529 Plans are Limited to Certain Colleges

Some prepaid tuition plans may be restricted to the tuition and fees at in-state public colleges. But 529 college savings plans are not. They can be used at any accredited public or private college in the United States. This includes vocational and technical schools, 2-year colleges, 4-year colleges, graduate schools and professional schools (medical, business and law schools). 529 college savings plans can be used for Certificates, Associate's degrees, Bachelor's degrees and Master's degrees, as well as more advanced degrees. They are not restricted to public colleges and can be used at private colleges (non-profit and for-profit), so long as the college's programs are eligible for federal student aid.

 

 
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