It's that time of year again! To celebrate the back-to-school season, this week's episode of Industry Focus: Financials is all about how to most effectively pay for college tuition. Host Gaby Lapera and finance expert Dan Caplinger walk you your options from cradle to graduation day and how to get the most from your college savings investments.
First, a look at the different education savings plans and then what you need to know about applying for federal student aid and/or scholarships. And finally, tax credits, loan forgiveness programs, consolidation firms, and more advice about what to do when you're finally paying those loans off.
A full transcript follows the video.
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This podcast was recorded on Aug. 29, 2016.
Gaby Lapera: Hello, everyone! Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the Financials edition, filmed today, on Monday, August 29, 2016. My name is Gaby Lapera, and joining me on Skype is Dan Caplinger, one of The Motley Fool's top personal finance experts. How's it going, Dan?
Dan Caplinger: I'm doing good, Gaby. How are you doing today?
Lapera: I'm doing excellent, thank you. Our episode today is really exciting. We figured that since kids are heading back to school, or maybe already in school, depending on what state you're in, we would talk about financing their college education.
Caplinger: Makes sense. It's never too early to start with that. Pretty much from birth, you have the colleges and the educational institutions telling you, there's going to be a big bill at the end of the day, and the sooner you get started, the more you're going to have that compound interest working in your favor.
Lapera: Absolutely. The reason we're starting with the section that we're starting with is that, hopefully you're saving. Saving is going to be the best way to reduce the student loan debt that the kid is going to have at the end of college, if they already have money going into it. That being said, let's start with one of the most popular plans that there is out there, which is the 529 plan. These are called qualified tuition plans legally by the government. The reason they're called 529 plans by everyone else is because they are governed by section 529 in the tax code. Do you want to tell us a little bit about how those are structured, Dan?
Caplinger: Basically, 529 plans are generally offered by institutions authorized by each state. There's more than 50 different plans out there. What many people don't realize is, just because your state offers a plan, that doesn't mean you have to stick with that plan. A lot of people go outside of their state to get a plan.
Basically, what the 529 plan lets you do is, it lets you contribute to this educational account. As a result of that, the investment income inside of the 529 doesn't get taxed along the way. It's tax-deferred, a lot like a 401(k) plan for retirement, except this is going for education. And then, at the end of the day, if you use that 529 plan for qualified educational expenses, you don't have to pay any taxes on any of the earnings. So, it's a really good deal for tax savings in order to help you save and invest long-term for that 18, 19 years that you're accumulating money to put your kids through college.
Lapera: Just to be clear, contributions are not deductible, but earnings are exempt from federal taxes and a lot of state taxes, that's going to vary from state to state.
Caplinger: That's exactly right. It's not like a 401(k) in the sense that contributions don't get you an up-front tax break. But what they do get you is, when you make those withdrawals later on, you're going to be eligible for tax-free treatment for those earnings. And you're absolutely right. Some states, if you're a resident of that state, you can get some state income tax benefits as well. Some states actually do let you deduct your contribution or a certain amount of contribution against your state income tax, not against your federal tax, though.
Lapera: Yeah. And just to be clear, this is something that someone was asking me the other day. If you are, say, a resident of Montana, but the Maryland 529 plan looks good to you, you can open one up in Maryland, and your kid can go to school in North Carolina and use it. It doesn't really matter where you are, you can still use these plans.
Caplinger: Absolutely correct. The way that the 529 plan is, it's sort of misleading and some ways, because those state names make it sound like you're going to have to decide when your kid is two years old, "Oh, they'll probably go to school in North Carolina, so I'll get the North Carolina plan." No. They don't want you having to pre-commit. So, the bulk of 529 plans now are totally portable. They let you use the money for any educational institution, as long as it qualifies as a legitimate college or university, they let you use that in pretty much any way that you see fit, anywhere you want.
Lapera: Question for you: is there a contribution limit on the 529 plans?
Caplinger: There are contribution limits, but they're usually very high. They vary from state to state. In general, you can contribute as much as, generally between $200,000 and $300,000 over the course of all of your savings for one particular child in a given 529 plan. For practical purposes, it's virtually unlimited for most people, in terms of how much you contribute to a 529. Now, the timing of those contributions does make a difference. There are gift tax implications. So, it's something you should pay attention to in terms of putting maximum amounts in on a yearly basis. That can get complicated in a hurry. But the general rule of thumb is, if you're putting $14,000 or less in a 529 plan in any given year toward any one child, then you're perfectly fine.
Lapera: That is a significant chunk of change. The other thing that's really important to note about 529 plans is that you can only use these for qualified education expenses. That means, if you were a really good saver, or maybe your kid gets a scholarship and you don't have to pay for school at all, you can take the money out of the plan, but you're going to be hit with an earnings tax and a 10% withdrawal penalty. What you could do instead is you could change the plan into someone else's name, who might be going to college, or you could just leave it in there if you think your kid is going to go to grad school and not get a scholarship.
Caplinger: There is an exemption, Gaby, for the scholarship situation. In general, you're absolutely right -- if you don't use that money for educational purposes, and you withdraw it, then all the earnings become taxable, you get hit with that extra penalty on top. But at some point, Congress figured out that it wasn't entirely fair to penalize people who were fortunate enough to get scholarships. So, what they did in that case was they wave that 10% penalty. You'll still pay income tax on the earnings that the money that went toward the scholarship came out of, but you don't have to hit that 10% penalty as well. So, that's one benefit. It's still a good idea, anytime, any chance you can get that scholarship, that's always the best move. And you're absolutely right -- if you have more than one child, you can change the beneficiary of the 529 plan to the other child and not have to pay any penalties on that, as well.
Lapera: This is totally a matter of opinion, but are there any 529 plans that you think are good to look into?
Caplinger: In general, the best 529 plans are the ones that have the lowest costs. You've heard us talk in previous shows about 401(k) plans, that some employers have have low cost 401(k)s, some employers have high-cost 401(k)s. The exact same thing is true in the 529 plan world. It's something that, you have to look at each individual state and figure out, "Are they charging me a lot? Are they charging me a little bit?" All the 529 plans will charge you an annual fee that's based on a percentage of the amount of money that you have under management.
The best situation is one where you can keep those expenses down to about 0.25% or less. I've seen some plans that start to approach 1% or even more, and that's something that you really need to be careful about. It can make it smart to look at a state even outside of your own state, if you can end up saving money in the long run. As small as those percentages sound, over 15-20 years, they really do add up.
Lapera: Absolutely. Let's talk about a couple other savings accounts that are available for parents. Custodial accounts, I think, are the other most popular option besides 529 plans.
Caplinger: That's right. Basically, what a custodial account is is, you opening up an investment account on behalf of your child. Most of these are set up under what's called the Uniform Transfer to Minors Act, or the Uniform Gift to Minors Act. It's basically something where you, the parent, have investing control over the account. There's no tax benefits really in terms of tax-free treatment of earnings. The earnings on the investment account, up to a certain amount, is taxable to the child at the child's tax rate, which is almost always lower than the parent's tax rate. Above a certain amount, the income gets treated as the parent's income for tax purposes, which means that you end up paying the tax at the higher amount.
The reason why people like custodial accounts is, there's no limitation on what you can invest in. The 529 plan itself dictates what your investment options are. If you want to invest in something else, you're out of luck. With a custodial account, you can invest in whatever you want to. You can get an account with a fund company, ETF company, with a regular broker. You can buy individual stocks and bonds and other investments. You can do pretty much whatever you want.
The downside of the custodial account, there's a couple. One is, for financial aid purposes, the custodial account is treated as the child's assets. So, when it comes time to qualify for financial aid, the school will expect the child to pay more of that money out of their account than they expect parents to contribute on the child's behalf. The other downside of the custodial account is, when the child reaches the age of majority, usually 18 years old in most states, the parent has to turn it over to the child. The parent no longer has the legal right to exercise control over the money in the custodial account. There's no guarantee that the child needs to use it for college. From a legal standpoint, they can spend it on whatever they want.
Lapera: Oh, wow, OK. And for some kids, that'll work out great. For other kids, that would work out terribly. I'm just thinking about some people that I've known in my past. (laughs)
Caplinger: Exactly. That's one reason why the 529 plan is as popular as it is. You get to keep control, as the parent, beyond 18, beyond 21. It's still pretty much in your control, and it goes directly to educational expenses.
Lapera: The third plan we're going to talk about is the Coverdell account. This is probably the least popular of them all, but people still use them, so I thought we would mention it. The reason that it's not very popular is that the total contribution limit for the Coverdell plan is $2,000, and that's total. You can have more than one Coverdell account for a kid, but it doesn't matter, because you can't contribute more than $2,000 to that child, to that beneficiary, over the course of a year. So, say grandma has a Coverdell account and the parents have a Coverdell account. They have to figure it out so that they don't exceed that amount.
Caplinger: It's a per-year thing, and it's something that, once upon a time, $2,000 was equal to what the maximums allowed for IRA contributions, other sorts of contribution. For whatever reason, Congress didn't raise that limit to keep up with inflation the same way that IRA contributions do. So, while now you can contribute $5,500, $6,500 for IRAs, that $2,000 limit is still there. And most people find, again, the 529 plan with the much higher contribution limits lets you make a real dent in how much the total cost of college is going to be. We're up to several hundred thousand dollars over the course of a four-year program. $2,000 a year is nice, but it's not enough to get the job done for most people.
Lapera: Yeah, and it's not just that. There's also income limitations. In theory, if you're an individual that makes more than $110,000 a year, or a couple that makes more than $220,000 a year, you can't contribute to these at all. People have circumvented that by letting the kids open it up in their own name, and then contributing to it. But it's just kind of a headache that a lot of people don't really need. But what's interesting to me is that certain elementary and secondary schools also qualify for Coverdell accounts. So, you can use the money in them to pay for a private school, if you want to.
Caplinger: Right, private school, high school tuition, or something like that. But the lack of popularity, you can see how unpopular these are by the fact that even some major financial institutions don't even offer them anymore. It can be hard to find a place that will let you open a new Coverdell account. Really, in general, you're stuck with either the 529 or opening up a custodial account.
Lapera: So, let's say that you saved and they're still not quite enough, and your kid is about to go to college. There are a few things you should do. The first thing is to fill out the FAFSA, which stands for the Free Application for Federal Student Aid. This is something that you need to fill out every year. I knew a kid in college who thought that you only filled it out one time, and sophomore year, there was a rude awakening. You want to fill that out as soon as possible after January 1st. If possible, you want to file your taxes first.
Caplinger: Yeah. A lot of the information you're going to use on that financial aid form looks a lot like a tax return, in many ways. It's asking you for income information, for asset information, and yeah, the sooner you get it completed, the sooner you can check the box off as far as that aspect of running through your college or university's financial aid program, so they can calculate how much money they're going to be willing to give you in your financial aid package.
Lapera: Yeah. And the other thing to keep in mind is, you need to fill out the FAFSA, I believe, if you're going to take out federal loans.
Caplinger: That's true. It's something that almost all financial aid programs ... I can't think of a situation where there's a college or university that doesn't use that form. Sometimes, they'll ask for supplemental information that specific to whatever that college or university wants. But it's pretty much uniform at this point where everybody expects that FAFSA. That's one of the reasons that the gateway to opening up some of the federal funding for funding sources for education hinges on the student and the student's family having filled out that information correctly.
Lapera: Yeah. The reason that we're harping on this so much is that federal loans, in general, are a much better idea than private student loans. That's because interest rates on federal loans tend to be much lower.
Caplinger: That's right. There's also the benefit, some federal loans have deferment provisions where they'll actually give you an interest-free period while you're in school, even sometimes for a limited period of time after you come out of school. Most private loans don't have that sort of thing. They might not make you make payments, but the interest is accumulating in the background, so when you do start making those payments, it's on a higher amount, because that interest has been accumulating. So, yeah, the federal programs, in general, lower rates, better repayment terms, some qualifications for better treatment, and also some eligibility for various types of loan forgiveness programs, depending on what career path you decide to follow after you come out of school, then loan forgiveness can be an option as well.
Lapera: Yeah, and let's chat about that really quick -- the three main programs that the federal government offers for loan forgiveness -- and this only applies to federal loans. So, if you have private loans on top of your federal loans, you still have to pay those off.
There's the Public Service Loan Forgiveness Program. Loans are forgiven after making 120 qualifying monthly payments. That's 10 years worth of payments, while working full-time for a qualifying employer. Those tend to be non-profits, the government, they have a whole list of places that you can work where you would qualify for this.
There's Teacher Loan Forgiveness. You need to make five consecutive years of payments. You need to work for at least five years in low-income public schools, which is an option you can do. They offer up to $17,500 in direct loans or Stafford Loan Forgiveness. While you qualify for the Teacher Loan Forgiveness, you also qualify at the same time for Public Service Loan Forgiveness if you work for another five years.
And there's also the Perkins Loan Cancellation if you have a Perkins loan. Perkins loans are given to students who have extraordinary financial need. You can have up to 100% of your loan forgiven if you work in public service for up to five years. If you're wondering about what kind of jobs qualify for this, you just need to go online, the government has plenty of resources available for you to figure this out.
Caplinger: There's also been a lot of talk during the recent presidential election campaign about just how overwhelming student loan debt is in general. There's going to be a big political push, especially as the current generation of students who are coming through school, who are five or ten years out of school. As they start to get politically mobilized, I think you can expect to see a lot of pressure to try to expand some of these forgiveness programs.
The impact that the large amounts of debt that people are coming out of school with is having an impact on the economy. People are delaying buying homes longer than they did, they're living with their parents more. We're even saying some studies that say people are delaying having families longer because they're buried under this debt, and they don't want to start a family until they have more financial stability in their lives, to be able to cover the expenses of having a child, and hopefully put their student loan stuff behind them at that point.
Lapera: Right, and correct me if I'm wrong -- if you file for bankruptcy, that doesn't apply to your student loans, right?
Caplinger: It's a much higher barrier to have student loan debt discharged in bankruptcy. It's not 100% never, but it's a lot harder to convince a bankruptcy court that you can get them extinguished. So, for the most part, yes, even if you're successful and having credit card debt, car loan debt, that kind of thing extinguished in a bankruptcy preceding, the student loan lender is still going to be able to come back and say, "Yes, you filed for bankruptcy, but because of this federal provision, we're still going to be able to collect going forward on that."
Lapera: Yeah. This is why, at the beginning of the show, we were emphasizing saving so much. If you can have smaller loans, that's definitely the better option. Of course, talking about financial aid, I think we covered FAFSA, federal loans over private loans. The other thing to consider is scholarships. It's never been easier to find scholarships, which means it's also probably harder to get them, because so many people are applying for them. But if you go online and search for scholarships, I'm sure you can find something. I think they even give out a scholarship for being left handed. You have to apply, and I'm sure a lot of left handed people apply. But it's there. There's so, so many.
Caplinger: Yeah, in all seriousness, it's a confusing thing that a lot of people get into trouble with. They see a size of a financial aid package, and they just compare it based on the size, and they don't look into how much of it is a grant or a scholarship that they just don't have to pay, versus how much of it is loans? And I've seen people make mistakes, and say, "This school gave me $40,000 and this other school gave me $30,000." But when you ask them how much of it was loans and how much of it was grants, it turns out that they would have been better off taking the smaller package because more of it was an outright gift that they would never have to pay back.
Lapera: Yeah. And I just want to take a moment to talk to college students out there. At the end of every semester, I would receive emails from students saying, "You can't give me a D, I'll lose my financial aid." And that always killed me because, I know there are professors out there who aren't great about helping, but I would literally meet you in a coffee shop, I would meet you after hours, I would give so much help. So, make sure that you do the work to get the good grades. Don't blow off the opportunity that you've been given, because you're making it very expensive for yourself.
After that heartfelt message, let's talk about taxes. (laughs)
Caplinger: The silver lining in all this is, the federal government understands how expensive it is to go to college. There are a number of tax breaks that a lot of people can take advantage of in order to reduce the cost, offset the cost, a little bit. Some of them hit while you're in school, others apply after you're through school trying to pay those student loans off.
Lapera: And the ones you get while you're in school are some of the biggest ones, correct?
Caplinger: That's right. Things like the American Opportunity Tax Credit, for up to four years of undergraduate education. That can often be the largest, because it'll pay 100% of up to $2,000 a year, then 25% of the next $2,000 a year. So, up to a maximum of $2,500 for a maximum of four years. Do the math, that's $10,000 toward your college education. Subject to income limits and that kind of thing, but it's readily available for a lot of people.
Beyond undergraduate, there's another credit called the Lifetime Learning Credit. It's not quite as generous, because it only applies to a smaller percentage of the amount that you pay. It's up to 20% of the first $10,000 that you pay for education over the course of the year. The benefit here is, it's not just limited to undergrad. It could be graduate school, it can be work training related, things that later in your career. The whole name of Lifetime Learning is design to emphasize just how much more flexible that is. Looking at those two credits, it can make a big dent in how much you're having to pay out of pocket, because the government is coming back and putting some back in your pocket.
Lapera: Yeah. I know that sometimes when people do their taxes, especially younger people, they look at them and they're so overwhelmed, they're just like, "I'm just going to take the standard deduction. I'm not even going to try to do any of these other things." But it can really help you out. Keep an eye out for that when you're filing your taxes this year.
The other thing we wanted to touch on briefly is, you have your student loans, you've graduated from college. Whatever is not eligible for forgiveness or whatever, you have to pay off. And sometimes people get overwhelmed with that. There are a few options you have if you are overwhelmed. First and foremost, I really encourage you to reach out to your creditors, because ultimately, it's in their best interest to get paid. They will work with you to help you make a payment schedule that works for the both of you, so you don't default and they don't get any money at all.
Caplinger: Yeah. It's in everybody's interest, it's in the creditor's interest to get some money back. Any arrangements that they can make that result in you making some payments is better than the reality of getting $0 back from you because you're just totally overwhelmed and can't afford to deal with it.
Lapera: Yeah. And then, the other thing I really encourage you to think about is debt consolidation, which is basically, they take all of your loans and bundle them. In theory, you can end up paying a lower interest on it afterwards.
Caplinger: Yeah. You have to be really careful with that, because there are reputable consolidation outfits, and there are unreputable consolidation providers. The real question that you have to look at very closely is what the makeup of your loans is currently. If you're heavily with private student loans, the consolidation is a lot more likely to make sense, because the private loans aren't all that good to begin with, so you don't really have a whole lot to lose with consolidation. When you have a lot of federal loans, however, you really need to look closely before you consolidate.
The questions you need to be asking the institution you're working with is, are you going to lose the benefits of these federal loans? Are you going to lose interest deferment? Are you going to lose the opportunity to have loan forgiveness? If the answer is yes, and you're in the category of people who would have taken advantage of those provisions, you're going to want to really think twice before you consolidate and give those up all in exchange for what can be a smaller monthly payment.
The other thing to look closely at is, most consolidation firms will offer you the smaller monthly payment. But what they don't really highlight is, the way they get you the smaller payment is often by extending the period of the loan a lot longer. So, I've seen situations where what would have been a five-year or a 10-year loan repayment period turns into a 20-year loan repayment period. And yes, you have smaller payments, but when you look at the total amount of interest you pay over the lifetime of your loans, it skyrockets after these consolidations, because you expended that period so much longer.
Lapera: Yeah, and part of the reason you could potentially lose benefits if you have federal loans is, because of the way consolidation works, it's basically a company buying your debt, and you promising to repay them rather than the original creditors. That's how you end up in these messes. You mentioned earlier that there's good consolidation companies and bad consolidation companies. Can you highlight what you should look for when you're looking for a consolidator?
Caplinger: One of the things that's ideal is, if you have a federal loan provider that you're already working with, the odds are much better that, if that federal loan provider reaches out to you to make consolidation recommendations, they're going to have the big picture there. Because they've already been vetted by the federal government to become eligible to give these federal loans. So, in general, they're a little bit more reputable.
On the other hand, if you're working with a private loan provider, they're always going to be looking for ways to get more of a loan balance under their umbrella, even if it's not necessarily the best decision for you. You can't have a blanket rule of, "All federal loan providers are good, all private loan providers are bad." Often, it's the same institution. But just being aware of the situation ... if you can sense that they understand the issues involved, that they understand that consolidation is not always the right answer, that's the best sign that you have that they're a provided that can give you the consultation that you really need to make the right decision for you.
Lapera: Yeah. This has been a journey that we've taken you through, from the birth of your child, when we hope that you start saving, to them applying for college and financial aid, to what you should do to manage your student loan debt afterwards. If you guys have any questions, definitely let us know.
If I could ask our listeners to provide some feedback on the length of our episodes -- I know that they all vary widely across Industry Focus. If you have any opinions, longer or shorter, just right like Goldilocks, that would be great. Just email us at [email protected] or by tweeting us @MFIndustryFocus. As usual, people on the program may have interests in the stocks they talk about, and The Motley Fool may have recommendations for or against, so don't buy or sell stocks based solely on what you hear. Thanks so much for joining us, Dan. I really appreciate it. It's always a pleasure to talk to you.
Caplinger: Thanks for having me, Gaby! It's really fun to be with you.
Lapera: Thanks. And thank you, Austin Morgan. I hope you are not battling heavy student loan debt. He's shaking his head no. I'm relieved for him. Thank you, everyone, for joining us, and I hope everyone has a great week!