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Helping Your Clients Face Their College-Financing Fears—Part 2

In part one of this two-blog series, we established that higher education is frighteningly expensive. But with a proper plan in hand, you and your clients will be better prepared to tackle college tuition bills in an organized and financially sound way.

Recently, I explored the factors that affect financial aid eligibility. In this post, I’ll provide some tax smart tips to help your clients maximize their tax benefits. (Our new research, Tackling the tuition bill, has all the details on both topics.)

While it may seem intuitive to first tap into the qualified education savings accounts when the bills come, there are a few things your clients need to consider before doing so.

Educate your Clients on Potential Tax Breaks Before They Tap 529 Accounts
Consider the AOTC for the parent, or the child. Don’t rush to deplete the 529 account in the first year, as there may be some beneficial tax credits available each year. For example, the American Opportunity Tax Credit (AOTC) is available to taxpayers who meet income eligibility requirements.

The credit amounts to the first $2,000 spent on qualified education expenses and 25 percent of the next $2,000, for a total of $2,500. Funds counted toward this credit must come from current parental income or parental-owned assets held in taxable accounts. In other words, they cannot be funds from qualified savings plans, such as 529 plans. This tax credit can be taken each year in which qualified education expenses are incurred for a maximum of four years per student. With a total benefit of $10,000 over the student’s educational career, it may be smart for eligible parents to first take advantage of this credit before spending from 529 accounts.

Note that if the parents’ income exceeds the AOTC limits, but the child is reporting income for that tax year, the child may have the option to claim the AOTC. This would require the child to file as an independent, rather than as a dependent the parent’s tax return. Although this is possible, there may be other financial implications in doing so. The AOTC is refundable up to $1,000.

See if your clients qualify for the LLC or other deductions. Some taxpayers, such as those who have exhausted the AOTC, may qualify for the Lifetime Learning Credit (LLC). This credit is worth up to $2,000 for expenses related to tuition and other qualified expenses for students enrolled at an eligible financial institution (note that for the 2016 tax year, the Lifetime Learning Credit is worth 20 percent of the first $10,000 of qualified college expenses. The LLC is not refundable). The credit can be used each tax year and applies to undergraduate and graduate school, as well as programs geared toward professional degrees or expanding job skills.

If they do not qualify for the AOTC or the LLC, the Tuition and Fees Deduction may be another option. For the 2016 tax year, this deduction can total up to a $4,000 reduction in income. Note that only one tax credit or deduction (AOTC, LLC, or Tuition and Fees Deduction) may be claimed per tax year. Keep in mind that IRS Publication 970 is a good source for more information on education tax credits and deductions. The figure below provides a brief summary of the most basic information.

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Tax benefits may ease both tuition and tax bills.

Be Mindful of Tax-Sensitive Withdrawals
Aside from the potential tax benefits that can be received from paying for college expenses out of pocket, there are tax implications to be aware of when your clients are withdrawing from retirement accounts and taxable savings accounts to pay for college. Withdrawals from parent-owned and student-owned tax-deferred retirement accounts (such as traditional IRA and 401(k) accounts) are taxed as ordinary income. Note that withdrawals that meet the criteria of qualified education expenses are not subject to the 10 percent penalty tax. Withdrawals from parent-owned and student-owned Roth IRAs, on the other hand, can be taken tax free as long as the distribution is composed of the contributions made into the account on an after-tax basis. Withdrawals that represent earnings will be taxed as ordinary income. Note that Roth withdrawals in excess of contributions are not subject to the 10 percent penalty tax if used for qualified education expenses.

As you’re aware, care should be taken when selling assets from taxable accounts, whether parent-owned or student-owned. Realized gains will be subject to capital gains tax, but they may be offset with realized losses elsewhere.

Although the challenges of paying for college expenses may seem overwhelming to your clients, proper planning is critical to a successful outcome. Remember that bottle of smelling salts I suggested keeping at your desk in part 1 of this series? Put it away! Remember that balancing financial aid and grant considerations with tax-efficient spending strategies is a good way to help your clients start facing their college financing fears.

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Maria Bruno, CFP®
Senior Investment Analyst
Vanguard Investment Strategy Group
Philadelphia, Pa.

 

Editor’s note: This post originally appeared on the Vanguard Advisor Blog. See also Part I of the series. The author gives a special thanks to her colleagues Jonathan Kahler and Jenna McNamee for their research contributions.


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Helping Your Clients Face Their College-Financing Fears—Part 1

Higher education is expensive—frighteningly expensive. For most parents, providing for their children’s college education is second only to retirement as their largest investment goal. But even with diligent saving, the first tuition bill may be a shock to your clients, so you may want to keep a jar of smelling salts on your desk just in case.

How can you help your clients face this fear head-on? It’s all about creating a solid plan. With a proper plan in hand, you and your clients will be better prepared to tackle college tuition bills in an organized and financially sound way. Sallie Mae recently published research titled “How America Pays for College 2016,” that reported families are paying less out of pocket for college as they take advantage of scholarships and grants. The report noted that scholarships and grants funded 34 percent of college costs in the 2015-2016 school year, up from 30 percent the prior school year.

Vanguard’s new research, Tackling the tuition bill, provides a practical framework to help you develop a plan with your clients. In this post, I’ll explore the factors that affect financial aid eligibility. (In Part 2 of this series, I’ll provide tips on how to help your clients maximize federal tax perks while also considering how to spend tax-efficiently from assets earmarked for college.)

As you know, household assets and income affect financial aid eligibility, but these sources are not treated equally, based on whether they come from the student or the parents. The graphic below summarizes the key points—income matters more than assets, and student income matters more than parental income.

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The potential impact of student and parental income and assets on financial aid.

So what does this mean? Obviously, individual circumstances will vary, but here’s a savvy strategy to pitch to your clients:

  • Spend the student’s assets first.Because student assets affect aid eligibility more than parental assets (oddly enough, 529s owned by dependent children are considered parental assets), it can make sense to spend student assets before spending from a 529 plan. Such an approach gives 529 savings more time to compound tax-free. And by spending the more heavily penalized assets early, students increase their aid eligibility in later years, when inflation may boost tuition costs.
  • Tell the grandparents to hold off.Gifts from grandparents and others are considered student income, which has the greatest impact on your student’s financial aid eligibility. As a result, consider tapping those grandparent-owned 529s in the later years of college, when they will no longer be reported or considered in financial aid evaluations.
  • Don’t drain the 529 right away.Parent-owned assets, including 529 plan accounts, have more limited impact on aid eligibility. Unless a client plans to pay for the entire degree with 529 savings, it can make sense to spend from this account strategically over the course of a student’s college career. The account can benefit from continued tax-free growth. A client may also be able to time 529 withdrawals to create opportunities for additional aid or benefits.

I realize there’s a lot for you and your clients to think about; but with a bit of knowledge of the rules and some planning, the tuition bills can be tamed. Look for part 2 of this series, in which I’ll share some tax-savvy tips for tackling tuition.

maria-bruno

Maria Bruno, CFP®
Senior Investment Analyst
Vanguard Investment Strategy Group
Philadelphia, Pa.

Editor’s note: This post originally appeared on the Vanguard Advisor Blog. The author also gives a special thanks to her colleagues Jonathan Kahler and Jenna McNamee for their research contributions.


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Financial Planning Priorities for New Parents

Everyone in my life is having kids. And, as the fee-only financial planner in my community, I’ve frequently been asked: “How do I set up a 529 college savings account?”

It’s a good question. But, as another adviser used to say, “it’s the wrong question.” While opening a 529 college savings account is usually a good idea, it’s very low on the list of financial planning priorities. Why ins’t a 529 college savings account a big deal?

Without a 529, attending college is still possible via either student loans and/or work-study programs. Moreover, there is even the chance that higher education might be free in the future, or that your client’s child determines that college isn’t right for them. Either way, not having a 529 doesn’t mean a catastrophic life event for you client.

I’m not saying don’t create a 529 account. I’m just saying that a client’s attention, energy and time are extremely limited—especially if they’re a new parent. So, if a client only has so much time in his/her hectic schedule, focus on the financial planning moves that will make the biggest impact.

What Planners Need to Emphasize for New Parents
A Will. While having a conversation with a client about their own mortality may not be easy, our profession knows that this subject is very important. Parents of minor children definitely need a will. In the will, it is critical to designate the names of the godparents in the instance that both clients pass simultaneously in an untimely manner.

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To illustrate the importance of a will, consider a worst-case scenario: Without a 529 account, a client’s child may have to resort to student loans to finance his/her education. Without a will, a client’s child may end up in a state-run orphanage. Of those two scenarios, which single issue is most dramatic—and which issue should receive the highest priority in terms of prevention as you advise new-parent clients?

Life insurance. You likely don’t need me to convince you that life insurance is important for new parents. The point here is that term-life insurance is infinitely more important than funding a 529 college savings plan. Household breadwinners need to designate their spouse as primary beneficiary with godparents (outlined in the will) designated as the contingent beneficiary.

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Illustrating a worse-case scenario to your client is the best way to effectively communicate the value of prioritizing life insurance over college funding: it’s more important that a client’s child has food on the table, clothes on his/her back and shelter over his/her head for ages up to approximately 18, rather than money for college.

Disability Insurance. In the context of financial planning moves for new parents, a disability insurance policy plays a pretty similar role as life insurance: providing money to fund a child’s lifestyle when your client (the parent) is no longer able to do so. For this reason, it’s much more important than a 529 plan, with a disability insurance policy providing money for food, clothes and shelter.

Prioritize Financial Planning Needs for New Clients

So, while having a college savings account is certainly a “nice-to-have,” it’s not a make-or-break financial planning move. A 529 college savings account is simply not that important. What is very important for parents (or prospective parents) are a will, life insurance and disability insurance. Address those three items FIRST, and then work with clients to open up a 529 college savings account.

jon-luskin

 

Jon Luskin
Fee-only Financial Planner and Fiduciary
Define Financial
San Diego, Calif.

Editor’s note: Find more of Luskin’s blogs about personal financial planning for employees of Deloitte at UncleDmoney.com.