For most families paying for college, a 529 plan on its own is not enough to cover all of the costs. The number of years to save for college is short. Every dollar is stretched thin for young families, and many parents still have student loans of their own that they are paying on.
Yet, families across the country are figuring out how to pay for college without going broke or taking on insane amounts of debt. A well thought-out college funding plan will always include a smart college choice, cash flow and tax planning, and smart lending strategies.
Understanding the implications
When faced with the high cost of college, parents may be forced to consider using their retirement savings or home equity to help pay for it. Choosing these options should be done as a last resort.
Preserving retirement assets and retiring mortgage free are high priorities. College should not be looked at in a vacuum. As you know, good financial planning is about choices and understanding the trade-offs if a family raids their retirement or home equity. They will either need to work longer, or retire on less. Just be sure they understand the long-term impact on the overall financial plan.
Paying for college: Let’s look at home equity first
A home equity line of credit (HELOC) is money that can be borrowed against the value of a home minus any other outstanding mortgage amount. To qualify, consumers must have enough equity in the home, a high credit score, and a good debt-to-income ratio. For HELOCs, typically lenders want the loan to value (LTV) to be 80% or less.
A HELOC is a mortgage with a revolving balance, like a credit card, with an interest rate that varies with the prime rate. An owner can only access the funds that they need when they need them. For consumers with good credit, the interest rate available via a home equity line of credit may be more favorable than the rate from a Federal Parent PLUS loan or a private student loan.
But here’s the deal, does a family really want to put their home at risk to pay for college?
The Parent PLUS loan may have a higher interest rate, but it comes with some perks like loan deferment and flexible repayment options that a home equity line of credit does not. A home equity line of credit should only be used for small funding gaps. This is the same guidance we give for the Parent PLUS loan – to cover a small gap.
Also, be aware that if a family takes out a home equity loan or line of credit and the money is in their bank account when they complete the FAFSA, it will be counted against them as an assessable asset in the financial aid calculation. Those who may be eligible for need-based financial aid do not want the money from their home to be sitting in their bank account when they fill out the FAFSA.
Important to note with the changes to the tax code starting in 2018, loan interest on a home equity line of credit will no longer be deductible on your federal taxes. However, some tax filers (depending on your Adjusted Gross Income) may claim up to $2,500 in interest paid on federal student loans. This deduction can be claimed without itemizing.
What about those retirement funds?
Even if a parent is not yet 59 and a half, they can take distributions from their IRAs for qualified higher education expenses without having to pay the 10% additional penalty tax. The funds must be used for the parent, their spouse, their child, or their grandchild. The funds must be used for qualified expenses like tuition, room, board, and necessary fees. The student must be enrolled more than half-time to qualify.
If they use a Roth IRA, they can avoid the 10% penalty on the growth if the account has been open for at least five years.
Traditional IRA withdrawals will be subject to federal and state taxes. Withdrawals from a Roth IRA used for higher education can be free from tax liability if they limit the withdrawal to an amount up to the amount they contributed.
Money in an IRA is not counted in your assets on the FAFSA. In other words, retirement money does not count against a family’s need-based aid calculation. However, withdrawals from an IRA will be counted as earned income the following year. This income can be assessed as high as 47%! So, taking a $10,000 distribution from a traditional IRA could increase the EFC (expected family contribution) for by as much as $4,700 the following year. If tapping retirement funds is a necessity and a family is a need-based candidate, choosing to do so in the final/senior year typically will not affect financial aid.
A Roth IRA and a 529 plan could both be considered tax-deferred savings options for college. However, because contributions to an IRA are limited every year ($5,500 per year/$6,500 age 50 years or older), a 529 plan is still a great savings vehicle if using those funds to pay for college is your intent.
A blended saving strategy that balances tax advantages and flexibility upon distribution is important to consider. Frequently this is a combination of Roth IRA, 529, and tax efficient mutual funds.
But here is a key question a family must consider; do they want to risk their retirement?
Yes, paying for college is a huge bill, but they have many options available to help them. Can they get a loan to pay for college? Yes. Can they get a loan to pay for retirement? Not really. So, making the decision to use retirement funds to pay for college should be done with careful consideration.
In general, we always stress a blended approach to paying for college: incorporating smart college choices, cash flow options, tax planning, student loans, work-study, and only tap retirement and home equity to fund a small gap. Understanding the impact on retirement and taking a holistic approach is always the wisest course.
The original version of this post was published by Capstone College Partners.