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By Christine Benz | 09-28-2016 05:00 PM

Timing and Emotions Can Cloud Plans to Save for College

Vanguard's Maria Bruno offers a framework to help tackle college saving strategically during an emotional period.

Note: This video is part of Morningstar's October 2016 College Savings Report.

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. With the cost of tuition high and moving higher, paying for college is a heavy lift for many families. I recently sat down with Vanguard's senior investment analyst, Maria Bruno, to discuss some strategies.

Maria, thank you so much for being here.

Maria Bruno: Thank you, Christine.

Benz: You recently co-authored a paper where you looked at college funding. I know that this is a big issue for a lot of our Morningstar.com readers and viewers where this is a big challenge for them in addition to retirement planning. But let's talk about why the challenges are different for college savers, why the spending horizon for college is different from spending during retirement.

Bruno: I think that's a good starting point. When you think about retirement, which is the number-one goal for most individuals, it's a very long time horizon, so long savings horizon and then a long spending horizon for most.

Benz: Might be 30 years for a lot of people.

Bruno: It can be, yes. So, you have a lot of time to be flexible with your financial planning and make adjustments along the way. With college, it's different. The saving period and the spending is much more finite. What's also different is that when you get to the college point, to the point where you actually need to start thinking through in terms of how to pay the college bills, really it's only at that point that the cost really crystallizes.

Benz: And those costs higher and higher.

Bruno: They are going higher and that is a legitimate continued concern, but it's not until your child really determines what school they want to go to and what sources of assets or income you might have that it really comes together in terms of putting the pieces of the puzzle together. And then it's also for many a very emotional time because this is the first time that your child is leaving the nest. So there's a lot of emotions that go along with this. And what we did in the paper was provided a framework to help start tackling those steps strategically so that you can plan accordingly and not during an emotional period.

Benz: Right. So, your child is hitting that first year of college and you're trying to figure out where to go for that money that you need for a tuition. So you break it down and you say that one of the first steps for families who are at this life stage is to take an inventory of all of the sources of tuition funding that they might have. So what sorts of things would fall under that umbrella? Obviously, 529 assets if I've been saving in that dedicated 529 plan. What other things should I have on my radar?

Bruno: Yeah, it's the first thing--in any financial plan--the first step is to take an inventory. So what assets you have earmarked for college? It could be 529 assets; it could be Coverdell accounts; it could be UGMA accounts; it could be parental-own accounts. Also think about income sources. So, as parents think through this, they should think about, OK, well, what income can I use to pay the college sources directly. Also think about any expected contributions from grandparents or other family members. So, both from an asset standpoint but also from an income standpoint and cash flows directed toward those bills. Then think about, well, is there an opportunity for potentially loans and how does that fit in? What is the comfort level with taking loans? So, the first part is really just to take stock of what you have.

Benz: And then another key step is to investigate the financial aid piece. There is need-based aid as well more merit-based aid. How should families approach that question?

Bruno: We do think that the first step is to think about financial aid and whether, as parents, whether they qualify for this. And really do no harm when it comes to financial aid.

Benz: What do you mean by that?

Bruno: Well, I think, it's general knowledge that income and assets impact financial aid eligibility, but different types of assets and different types of income impact it differently. So, for instance, student income impacts--well, first, income is more impactful than assets and then student income is more impactful than parental income. So really think about what the sources of the assets are, and we've framed this in the paper. And some of it's pretty intuitive in terms of what falls where. But those two factors really come into play in terms of financial aid eligibility.

We do think it's important for parents to go through this process and fill out the financial aid forms, particularly if they are also thinking about federally subsidized loans because you do need to fill those out every year. I think many parents may just rule out financial aid altogether but you really need to think about aid broadly in terms of federal aid but also grants and scholarships from schools as well. Many schools offer grants, and they can be pretty generous.

Benz: So, some of the merit-based aid that higher income families might be eligible for?

Bruno: Yes, it's a combination of both.

Benz: So, assuming a family has multiple sources that they might be able to lean on for tuition coverage--let's talk about that. You say that it's important to think about some of the tax ramifications of those decisions.

Bruno: Right. So, have really a two-pronged approach: first to think about aid and then to think about, OK, well, then how do I close that gap? So we talked about this college expenses are really, and it's not realistic that parents, many parents are going to be actually able to meet that bill as a whole. So the deficit actually can work out for some families, particularly low-income families or middle-income families because there are tax opportunities that they may be able to take advantage of.

Benz: Let's talk about some of those.

Bruno: Yes. There's a few different types of tax credits or deductions. The most lucrative one is the American Opportunity Tax Credit, and with that credit you can take up to $2,500 per year per student for four years. There are income limits, of course, in terms of who can take advantage of that. But that is one, probably one of the most beneficial. There's other credits and deductions as well. I think the thing to think through is, is there is only one either credit or deduction that you can take per year per student. So you need to be wise in terms of strategically which one you take. So, for middle- and low-income households, there are credits that can be pretty rich. For many, for the higher-income households then their income maybe too high to qualify for those tax benefits, they need to really focus on spending strategically from their portfolio of assets.

Benz: What are some examples of that? When would it make sense for me to prioritize my child's 529 plan, the one that I've been using, versus, say, what the grandparents have been using if they've been to trying to kick in toward college?

Bruno: Yeah, and we did this framework in the paper and I'll just cover it at a very high level. Most parents will have a household of assets, primarily 529 assets, and intuitively it makes sense to spend those assets first. They are earmarked for college; you want to spend those down first. But that may not necessarily be the best thing everyone. Parents might also have taxable assets that they may want to consider using as well which are taxed but taxed differently. The reason is, when you think about the combination of 529s, they should be considered a piece of the overall portfolio and maybe spend from those strategically, meaning not to front-load and spend those all in the beginning of the college years, but maybe spread that out and look at strategic spending from the 529s in addition to loans, for instance. That allows the accounts to continue to grow tax-free. So there's a few extra years of earnings potentially there.

Also, if you think about how some of the distributions from 529s are treated, if you think about grandparent-owned 529s, for instance, they are actually distributions from grandparent-owned 529s, are considered student income. Student income impacts aid more greatly. So that maybe an opportunity to not spend from grandparent-owned 529s until the junior or senior year for instance. So there's some thoughtful approaches that can be done in terms of how you spend from these assets.

Benz: And I would assume this is a place where using an advisor could be really appropriate. If you're sort of listening to all this and feeling a little bit overwhelmed, education-savvy financial advisor could be a great help on this front I would think?

Bruno: Yes, and when we built this framework, it's really for individual investors to have a conversation with their advisor as well too, because we really see the framework as a starting point. Everyone's situation is individualized. The other thing that I will add too is once you start with the child in college and you have 529 accounts, you still can continue to contribute to the 529 accounts and still potentially take advantage of state tax benefits as well through the contributions. So there are strategic tax-savvy moves that can be made, and they will differ by individual and household based upon what their income situation looks like.

Benz: One other thing I liked about this paper was that it also considered the role of household cash flows, like using my current income in that current year to help defray part of the college expenses. Anecdotally, a lot of families that I have known have had to rely on their household cash flows. They have had to tighten their belts in those years when their kids are in school.

Bruno: Absolutely. I have a sister who is going through that. She has one--her son is graduating this year, she has another one going in and it's a …

Benz: Lean years.

Bruno: … continuous cash flow. So, it's very real for most households. And it's a series of trade-offs as anything is within financial planning. But retirement needs to come first and yes, parents can use retirement assets as well. They really generally should be the last source of tapping when it comes to college planning because of all these other opportunities.

Benz: Well, that's a really good point. I have sometimes heard from our Morningstar.com users that they like to use Roth IRAs potentially as something that they would tap for college expenses. But you say that that should be maybe a last resort or you need to be sure that your retirement plan is in ultra-good shape before you consider doing that.

Bruno: Yes. When you think about Roths and 529s, there are similarities from a tax standpoint, but Roths really are earmarked for retirement; 529s could be likened to for Roths for education. Can you use them? Yes. Does it make sense for everyone? No. But really think through that and just make sure that you're not jeopardizing the retirement goals by using those assets to fund for college because it is a trade-off. But yes, there are some tax considerations that can come into play. Again, I would really look at this and I would encourage advisors and individual investors to really think through holistically to make sure that--because it might make sense for you, but it may not make sense for me, for instance.

Benz: Maria, important topic. Thank you so much for being here to discuss it with us.

Bruno: Thank you, Christine.

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