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You are here: Home / Archives for Financial Literacy

Save For College With Tax Advantages

April 18, 2018 By SeaCure Advisors Leave a Comment

tax advantaged college savingsThe best college savings vehicles offer special tax advantages if the funds are used to pay for college. Tax-advantaged strategies are important because over time, you can potentially accumulate more money with a tax-advantaged investment compared to a taxable investment. Ideally, though, you’ll want to choose a savings vehicle that offers you the best combination of tax advantages, financial aid benefits, and flexibility, while meeting your overall investment needs.

529 plans

Since their creation in 1996, 529 plans have become to college savings what 401(k) plans are to retirement savings — an indispensable tool for saving money for a child’s or grandchild’s college education. That’s because 529 plans offer a unique combination of benefits.

There are two types of 529 plans — savings plans and prepaid tuition plans. Though each is governed under Section 529 of the Internal Revenue Code (hence the name “529” plans), savings plans and prepaid tuition plans are very different savings vehicles.

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer’s official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.

529 savings plans

The more popular type of 529 plan is the savings plan. A 529 savings plan is a tax-advantaged savings vehicle that lets you save money for college and K-12 tuition in an individual investment-type account, similar to a 401(k) plan. Some plans let you enroll directly, while others require you to go through a financial professional.

The details of 529 savings plans vary by state, but the basics are the same. You’ll need to fill out an application, name a beneficiary, and select one or more of the plan’s investment portfolios to which your contributions will be allocated. Also, you’ll typically be required to make an initial minimum contribution, which must be made in cash.

529 savings plans offer a unique combination of features that no other education savings vehicle can match:

Federal tax advantages: Contributions to a 529 account accumulate tax deferred and earnings are tax free if the money is used to pay the beneficiary’s qualified education expenses. (The earnings portion of any withdrawal not used for qualified education expenses is taxed at the recipient’s rate and subject to a 10% penalty.)

State tax advantages: Many states offer income tax incentives for state residents, such as a tax deduction for contributions or a tax exemption for qualified withdrawals. However, be aware that some states limit their tax deduction to contributions made to the in-state 529 plan only.

High contribution limits: Most plans have lifetime contribution limits of $350,000 and up (limits vary by state).

Unlimited participation: Anyone can open a 529 savings plan account, regardless of income level.

Wide use of funds: Money in a 529 savings plan can be used to pay the full cost (tuition, fees, room and board, books) at any college or graduate school in the United States or abroad that is accredited by the Department of Education, and for K-12 tuition expenses up to $10,000 per year.

Professional money management: 529 savings plans are offered by states, but they are managed by designated financial companies who are responsible for managing the plan’s underlying investment portfolios.

Flexibility: Under federal rules, you are entitled to change the beneficiary of your account to a qualified family member at any time as well as roll over (transfer) the money in your account to a different 529 plan once per calendar year without income tax or penalty implications.

Accelerated gifting: 529 savings plans offer an estate planning advantage in the form of accelerated gifting. This can be a favorable way for grandparents to contribute to their grandchildren’s education while paring down their own estate, or a way for parents to contribute a large lump sum. Under special rules unique to 529 plans, a lump-sum gift of up to five times the annual gift tax exclusion amount ($15,000 in 2018) is allowed in a single year, which means that individuals can make a lump-sum gift of up to $75,000 and married couples can gift up to $150,000. No gift tax will be owed, provided the gift is treated as having been made in equal installments over a five-year period and no other gifts are made to that beneficiary during the five years.

Transfer to ABLE account: 529 account owners can roll over (transfer) funds from a 529 account to an ABLE account without federal tax consequences. An ABLE account is a tax-advantaged account that can be used to save for disability-related expenses for individuals who become blind or disabled before age 26.

Variety: Currently, there are over 50 different savings plans to choose from because many states offer more than one plan. You can join any state’s savings plan.

But 529 savings plans have a couple of drawbacks:

No guaranteed rate of return: Investment returns aren’t guaranteed. You roll the dice with the investment portfolios you’ve chosen, and your account may gain or lose value depending on how the underlying investments perform. There is no guarantee that your investments will perform well enough to cover college costs as anticipated.

Investment flexibility: 529 savings plans have limited investment flexibility. Not only are you limited to the investment portfolios offered by the particular 529 plan, but once you choose your investments, you can only change the investment options on your existing contributions twice per calendar year. (However, you can generally direct how your future contributions will be invested at any time.)

529 prepaid tuition plans

Prepaid tuition plans are cousins to savings plans – their federal tax treatment is the same, but their operation is very different. A 529 prepaid tuition plan lets you prepay tuition at participating colleges, typically in-state public colleges, at today’s prices for use by the beneficiary in the future. Prepaid tuition plans are generally limited to state residents, whereas 529 savings plans are open to residents of any state. Prepaid tuition plans can be run either by states or colleges, though state-run plans are more common.

As with 529 savings plans, you’ll need to fill out an application and name a beneficiary. But instead of choosing an investment portfolio, you purchase an amount of tuition credits or units, subject to plan rules and limits. Typically, the tuition credits or units are guaranteed to be worth a certain amount of college tuition in the future, no matter how much college costs may increase between now and then.

However, if your child ends up attending a college that doesn’t participate in the plan, prepaid plans differ on how much money you’ll get back. Also, some prepaid plans have been forced to reduce benefits after enrollment due to investment returns that have not kept pace with the plan’s offered benefits.

Even with these limitations, some college investors appreciate not having to worry about college inflation each year and want to lock in college tuition prices today. The following table summarizes the main differences between 529 savings plans and 529 prepaid tuition plans:

529 savings plans 529 prepaid tuition plans
Offered by states Offered by states and private colleges
You can join any state’s plan (though some plans may require you to enroll with a financial professional) State-run plans require you to be a state resident
Contributions are invested in your individual account in the investment portfolios you have selected Contributions are pooled with the contributions of others and invested by the plan
Returns are not guaranteed; your account may gain or lose value depending on how the underlying investments perform. Generally a certain rate of return is guaranteed in the form of a percentage of tuition being covered in the future, no matter how much costs may increase by then
Funds can generally be used for the full cost of tuition, fees, room and board, equipment and books at any accredited college or graduate school in the U.S. or abroad, or K-12 tuition expenses up to $10,000 per year Funds can be used only for tuition at participating colleges (typically state colleges); room and board and graduate school generally are not eligible expenses

Coverdell education savings accounts

A Coverdell education savings account (Coverdell ESA) is a tax-advantaged education savings vehicle that lets you save money for college, as well as for elementary and secondary school (K-12) at public, private, or religious schools. Here’s how it works:

  • Application process: You fill out an application at a participating financial institution and name a beneficiary. Depending on the institution, there may be fees associated with opening and maintaining the account. The beneficiary must be under age 18 when the account is established (unless he or she is a child with special needs).
  • Contribution rules: You (or someone else) make contributions to the account, subject to the maximum annual limit of $2,000. This means that the total amount contributed for a particular beneficiary in a given year can’t exceed $2,000, even if the money comes from different people. Contributions can be made up until April 15 of the year following the tax year for which the contribution is being made.
  • Investing contributions: You invest your contributions as you wish (e.g., stocks, bonds, mutual funds, certificates of deposit)–you have sole control over your investments.
  • Tax treatment: Contributions to your account grow tax deferred, which means you don’t pay income taxes on the account’s earnings (if any) each year. Money withdrawn to pay college or K-12 expenses (called a qualified withdrawal) is completely tax free at the federal level(and typically at the state level too). If the money isn’t used for college or K-12 expenses (called a nonqualified withdrawal), the earnings portion of the withdrawal will be taxed at the beneficiary’s tax rate and subject to a 10% federal penalty.
  • Rollovers and termination of account: Funds in a Coverdell ESA can be rolled over without penalty into another Coverdell ESA for a qualifying family member. Also, any funds remaining in a Coverdell ESA must be distributed to the beneficiary when he or she reaches age 30 (unless the beneficiary is a person with special needs).

Unfortunately, not everyone can open a Coverdell ESA–your ability to contribute depends on your income. To make a full contribution, single filers must have a modified adjusted gross income (MAGI) of less than $95,000, and joint filers must have a MAGI of less than $190,000. And with an annual maximum contribution limit of $2,000, a Coverdell ESA can’t go it alone in meeting today’s college costs.

Custodial accounts

Before 529 plans and Coverdell ESAs, there were custodial accounts. A custodial account allows your child to hold assets–under the watchful eye of a designated custodian–that he or she ordinarily wouldn’t be allowed to hold in his or her own name. The assets can then be used to pay for college or anything else that benefits your child (e.g., summer camp, braces, hockey lessons, a computer). Here’s how a custodial account works:

  • Application process: You fill out an application at a participating financial institution and name a beneficiary. Depending on the institution, there may be fees associated with opening and maintaining the account.
  • Custodian: You also designate a custodian to manage and invest the account’s assets. The custodian can be you, a friend, a relative, or a financial institution. The assets in the account are controlled by the custodian.
  • Assets: You (or someone else) contribute assets to the account. The type of assets you can contribute depends on whether your state has enacted the Uniform Transfers to Minors Act (UTMA) or the Uniform Gifts to Minors Act (UGMA). Examples of assets typically contributed are stocks, bonds, mutual funds, and real property.
  • Tax treatment: Earnings, interest, and capital gains generated from assets in the account are taxed every year to the child under special “kiddie tax” rules that apply when a child has unearned income. The kiddie tax rules generally apply to children under age 18 and full-time college students under age 24 whose earned income doesn’t exceed one-half of their support. Under the kiddie tax rules, a child’s unearned income is taxed using the trust and estate tax rates.

A custodial account provides the opportunity for some tax savings, but the kiddie tax reduces the overall effectiveness of custodial accounts as a tax-advantaged college savings strategy. And there are other drawbacks. All gifts to a custodial account are irrevocable. Also, when your child reaches the age of majority (as defined by state law, typically 18 or 21), the account terminates and your child gains full control of all the assets in the account. Some children may not be able to handle this responsibility, or might decide not to spend the money for college.

U.S. savings bonds

Series EE and Series I bonds are types of savings bonds issued by the federal government that offer a special tax benefit for college savers. The bonds can be easily purchased from most neighborhood banks and savings institutions, or directly from the federal government. They are available in face values ranging from $50 to $10,000. You may purchase the bond in electronic form at face value or in paper form at half its face value.

If the bond is used to pay qualified education expenses and you meet income limits (as well as a few other minor requirements), the bond’s earnings are exempt from federal income tax. The bond’s earnings are always exempt from state and local tax.

In 2018, to be able to exclude all of the bond interest from federal income tax, married couples must have a modified adjusted gross income of $119,300 or less at the time the bonds are redeemed (cashed in), and individuals must have an income of $79,550 or less. A partial exemption of interest is allowed for people with incomes slightly above these levels.

The bonds are backed by the full faith and credit of the federal government, so they are a relatively safe investment. They offer a modest yield, and Series I bonds offer an added measure of protection against inflation by paying you both a fixed interest rate for the life of the bond (like a Series EE bond) and a variable interest rate that’s adjusted twice a year for inflation. However, there is a limit on the amount of bonds you can buy in one year, as well as a minimum waiting period before you can redeem the bonds, with a penalty for early redemption.

Roth IRAs

Though technically not a college savings account, some parents use Roth IRAs to save and pay for college. In 2018, you can contribute up to $5,500 per year. Earnings in a Roth IRA accumulate tax deferred. Contributions to a Roth IRA can be withdrawn at any time and are always tax free. For parents age 59½ and older, a withdrawal of earnings is also tax free if the account has been open for at least five years. For parents younger than 59½, a withdrawal of earnings–typically subject to income tax and a 10% premature distribution penalty–is spared the 10% penalty if the withdrawal is used to pay for a child’s college expenses.

But not everyone is eligible to contribute to a Roth IRA–it depends on your income. In 2018, if your filing status is single or head of household, you can contribute the full $5,500 to a Roth IRA if your MAGI is $120,000 or less. And if you’re married and filing a joint return, you can contribute the full $5,500 if your MAGI is $189,000 or less.

Financial aid impact

Your college saving decisions can impact the financial aid process. Come financial aid time, your family’s income and assets are run through a formula at both the federal level and the college (institutional) level to determine how much money your family should be expected to contribute to college costs before you receive any financial aid. This number is referred to as your expected family contribution, or EFC. Your income is by far the most important factor, but your assets count too.

In the federal calculation, your child’s assets are treated differently than your assets. Your child must contribute 20% of his or her assets each year, while you must contribute 5.6% of your assets. For example, $10,000 in your child’s bank account would equal an expected contribution of $2,000 from your child ($10,000 x 0.20), but the same $10,000 in your bank account would equal an expected $560 contribution from you ($10,000 x 0.056).

Under the federal rules, an UTMA/UGMA custodial account is classified as a student asset. By contrast, 529 plans and Coverdell ESAs are counted as parent assets if the parent is the account owner. In addition, student-owned or UTMA/UGMA-owned 529 accounts are also counted as parent assets. For 529 plans and Coverdell accounts that are counted as parent assets, distributions (withdrawals) from the account that are used to pay the beneficiary’s qualified education expenses are not counted as parent or student income on the federal government’s aid form, which means that the money is not counted again when it’s withdrawn.

However, the situation is different for grandparent-owned 529 plans and Coverdell accounts. If a 529 plan or Coverdell account is owned by a grandparent instead of a parent, the account isn’t counted as a parent asset–it doesn’t count as an asset at all. However, money withdrawn from a grandparent-owned account is counted as student income, and student income is assessed at 50% in the federal aid formula.

Other investments parents may own in their name, such as mutual funds, stocks, U.S. savings bonds, certificates of deposit, and real estate, are also classified as parent assets. However, the federal government doesn’t count retirement assets at all in its financial aid formula, so Roth IRAs aren’t factored in to aid eligibility.

Regarding institutional aid, colleges generally dig a bit deeper than the federal government in assessing a family’s assets and their ability to pay college costs. Most colleges use a standard financial aid application that considers assets the federal government might not, for example, home equity. Typically, though, colleges treat 529 plans, Coverdell accounts, UTMA/UGMA custodial accounts, U.S. savings bonds, and Roth IRAs the same as the federal government.

Filed Under: College, Financial Literacy

Saving For College And Retirement

March 13, 2018 By SeaCure Advisors Leave a Comment

savings for college and retirement
You want to save so that you can retire comfortably when the time comes. You also want to have a saving strategy to help your child go to college. So how do you juggle the two? The truth is, saving for your retirement and your child’s education at the same time can be a challenge. But take heart–you may be able to reach both goals if you make some smart choices now.

Know what your financial needs are

The first step is to determine what your financial needs are for each goal. Answering the following questions can help you get started:

For retirement:

  • How many years until you retire?
  • Does your company offer an employer-sponsored retirement plan or a pension plan? Do you participate? If so, what’s your balance? Can you estimate what your balance will be when you retire?
  • How much do you expect to receive in Social Security benefits? (One way to get an estimate of your future Social Security benefits is to use the benefit calculators available on the Social Security Administration’s website, www.ssa.gov. You can also sign up for a my Social Security account so that you can view your online Social Security Statement. Your statement contains a detailed record of your earnings, as well as estimates of retirement, survivor’s, and disability benefits.)
  • What standard of living do you hope to have in retirement? For example, do you want to travel extensively, or will you be happy to stay in one place and live more simply?
  • Do you or your spouse expect to work part-time in retirement?

For college:

  • How many years until your child starts college?
  • Will your child attend a public or private college? What’s the expected cost?
  • Do you have more than one child whom you’ll be saving for?
  • Does your child have any special academic, athletic, or artistic skills that could lead to a scholarship?
  • Do you expect your child to qualify for financial aid?

Many on-line calculators are available to help you predict your retirement income needs and your child’s college funding needs.

Figure out what you can afford to put aside each month

After you know what your financial needs are, the next step is to determine what you can afford to put aside each month. To do so, you’ll need to prepare a detailed family budget that lists all of your income and expenses. Keep in mind, though, that the amount you can afford may change from time to time as your circumstances change. Once you’ve come up with a dollar amount, you’ll need to decide how to divvy up your funds.

Retirement takes priority

Though college is certainly an important goal, you should probably focus on your retirement if you have limited funds. With generous corporate pensions mostly a thing of the past, the burden is primarily on you to fund your retirement. But if you wait until your child is in college to start saving, you’ll miss out on years of tax-deferred growth and compounding of your money. Remember, your child can always attend college by taking out loans (or maybe even with scholarships), but there’s no such thing as a retirement loan!

If possible, save for your retirement and your child’s college at the same time

Ideally, you’ll want to try to pursue both goals at the same time. The more money you can squirrel away for college bills now, the less money you or your child will need to borrow later. Even if you can allocate only a small amount to your child’s college fund, say $50 or $100 a month, you might be surprised at how much you can accumulate over many years. For example, if you saved $100 every month and earned 8 percent, you’d have $18,415 in your child’s college fund after 10 years. (This example is for illustrative purposes only and does not represent a specific investment.)

If you’re unsure how to allocate your funds between retirement and college, a professional financial planner may be able to help you. This person can also help you select the best investments for each goal. Remember, just because you’re pursuing both goals at the same time doesn’t necessarily mean that the same investments will be appropriate. Each goal should be treated independently.

Help! I can’t meet both goals

If the numbers say that you can’t afford to educate your child or retire with the lifestyle you expected, you’ll have to make some sacrifices. Here are some things you can do:

  • Defer retirement: The longer you work, the more money you’ll earn and the later you’ll need to dip into your retirement savings.
  • Work part-time during retirement.
  • Reduce your standard of living now or in retirement: You might be able to adjust your spending habits now in order to have money later. Or, you may want to consider cutting back in retirement.
  • Increase your earnings now: You might consider increasing your hours at your current job, finding another job with better pay, taking a second job, or having a previously stay-at-home spouse return to the workforce.
  • Invest more aggressively: If you have several years until retirement or college, you might be able to earn more money by investing more aggressively (but remember that aggressive investments mean a greater risk of loss).
  • Expect your child to contribute more money to college: Despite your best efforts, your child may need to take out student loans or work part-time to earn money for college.
  • Send your child to a less expensive school: You may have dreamed your child would follow in your footsteps and attend an Ivy League school. However, unless your child is awarded a scholarship, you may need to lower your expectations. Don’t feel guilty–a lesser-known liberal arts college or a state university may provide your child with a similar quality education at a far lower cost.
  • Think of other creative ways to reduce education costs: Your child could attend a local college and live at home to save on room and board, enroll in an accelerated program to graduate in three years instead for four, take advantage of a cooperative education where paid internships alternate with course work, or defer college for a year or two and work to earn money for college.

Can retirement accounts be used to save for college?

Yes. Should they be? Probably not.

Most financial planners discourage paying for college with funds from a retirement account; they also discourage using retirement funds for a child’s college education if doing so will leave you with no funds in your retirement years.

However, you can certainly tap your retirement accounts to help pay the college bills if you need to. With IRAs, you can withdraw money penalty free for college expenses, even if you’re under age 59½ (though there may be income tax consequences for the money you withdraw). But with an employer-sponsored retirement plan like a 401(k) or 403(b), you’ll generally pay a 10 percent penalty on any withdrawals made before you reach age 59½ (age 55 or 50 in some cases), even if the money is used for college expenses. You may also be subject to a six month suspension if you make a hardship withdrawal. There may be income tax consequences, as well.

Check with your plan administrator to see what withdrawal options are available to you in your employer-sponsored retirement plan.

Filed Under: College, Financial Literacy, Retirement

Correction Time: The Market Takes A Hit

March 6, 2018 By SeaCure Advisors Leave a Comment

market correctionAfter reaching all-time highs on January 26, 2018, the Dow Jones Industrial Average and the S&P 500 went into a two-week slide that saw both stock indexes drop by more than 10%, a decline that is typically considered a market correction.1

Analysts have been saying for several years that the long, booming bull market was overvalued and due for a correction, so the drop was not a surprise in the big picture.2 And even after the 10% plunge, the Dow was up 19% over the previous 12 months, and the S&P 500 was up 12.5%.3

It’s natural to be concerned about this kind of shift, but more important to maintain perspective and focus on your long-term goals. It may be helpful to consider some of the reasons behind the surge of market volatility.

Too Much of a Good Thing?

The initial trigger for the downturn was a better-than-expected jobs report on February 2, that helped drive the Dow down more than 2.5%, a significant decline considering the unusually low volatility in 2017 and the beginning of 2018. The economy added 200,000 jobs in January, marking the 88th straight month of job creation, the longest such run in U.S. history. Wages rose by 2.9% over the previous January, the highest year-over-year increase since the end of the recession in June 2009. And the unemployment rate held steady at 4.1% for the fourth straight month, the lowest level in 17 years.4

Although the report was great news for U.S. workers, on Wall Street the rosy jobs picture generated fears of higher inflation that might drive the Federal Reserve to raise interest rates more quickly than anticipated. At its December 2017 meeting, the Federal Open Market Committee signaled its intention to raise the benchmark federal funds rate three times in 2018, bringing it up to a range of 2.0% to 2.25%. Theoretically, these changes have been priced into the market, but the strong jobs report made it more likely that the Fed will follow through on its projection and possibly execute further increases if inflation heats up.5

Stocks, Bonds, and U.S. Debt

Higher interest rates rattle the stock market because investors are more likely to move assets out of risky stocks and into more stable bonds as fixed-income yields become more attractive. Higher rates not only mean increased yields on new bonds but also on existing bonds, as prices are pushed downward to make yields competitive. In addition, the prospect of inflation tends to push bond prices lower and yields higher, because inflation erodes the purchasing power of fixed-income payments.

One reason for the initial reaction to the January jobs report expanding into a full-blown correction is that bond yields were already rising due to other factors. The yield on the 10-year Treasury note — a bedrock of global financial markets — has been rising since tax legislation was proposed in the fall of 2017, and the yield reached a four-year high of 2.85% the day the jobs report was released.6-7 Although the Tax Cuts and Jobs Act was generally welcomed on Wall Street, bond traders have been concerned that increased Treasury sales to pay for the $1.5 trillion tax cuts will erode bond prices. This concern was exacerbated by the bipartisan budget deal that further increased deficit spending.8

The Treasury is working to finance higher debt at the same time the Federal Reserve is unwinding its recession-era bond-buying program. With the Fed reducing its bond portfolio, the Treasury must sell more bonds to the public to cover growing deficits. The Treasury recently announced the first increase in bond sales since 2009.9

The question is who will buy these bonds and what are they willing to pay for them? A weak dollar has made Treasuries less appealing to foreign governments, which hold more than 44% of U.S. government debt. With the Treasury market depending more on U.S. investors, supply may be outpacing demand — illustrated by a tepid Treasury auction on February 7.10

The Long View

Although mounting government debt is a serious concern, the stock and bond markets are both driven in the long term by the economy, and the United States looks to be hitting its stride after a long, slow recovery. The global economy, which has been even slower to recover, is coming back as well.

A correction may be disturbing, but it can strengthen the market in the long term by returning equity values to levels that are more in line with corporate earnings and less dependent on investor exuberance. A corrected market may also be less vulnerable to overreaction. On February 14, the Dow and the S&P 500 closed up more than 1.2%, despite a consumer report that showed higher-than-expected inflation. Even with higher prices in January, core inflation (which excludes food and energy prices) is running at only 1.8%, still below the Fed’s 2% target rate.11

Of course, no one can predict the future, and you might see volatility for some time. The wisest course may be to remain patient and avoid making portfolio decisions based on emotion.

The return and principal value of stocks and bonds fluctuate with changes in market conditions. Shares, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest.

The S&P 500 is an unmanaged group of securities that is considered representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results. Actual results will vary.

1, 3) Yahoo! Finance, 2018, Dow Jones Industrial Average and S&P 500 index for the period 2/8/2017 to 2/8/2018
2) Bloomberg, February 6, 2018
4-5) The Wall Street Journal, February 2, 2018
6) CNBC, January 11, 2018
7) CNNMoney, February 2, 2018
8) MarketWatch, February 12, 2018
9) Bloomberg, January 31, 2018
10) Bloomberg, February 7, 2018
11) MarketWatch, February 14, 2018

Filed Under: Financial Literacy, Financial News, Interest Rates, Retirement

The ABCs of Financial Aid

February 28, 2018 By SeaCure Advisors Leave a Comment

financial aidIt’s hard to talk about college without mentioning financial aid. Yet this pairing isn’t a marriage of love, but one of necessity. In many cases, financial aid may be the deciding factor in whether your child attends the college of his or her choice. That’s why it’s important to develop a basic understanding of financial aid before your child applies to college. Without such knowledge, you may have trouble understanding the process of aid determination, filling out the proper aid applications, and comparing the financial aid awards that your child may receive.
But let’s face it. Financial aid information is probably not on anyone’s top ten list of bedtime reading material. It can be an intimidating and confusing topic. There are different types, different sources, and different formulas for evaluating your child’s eligibility. Here are some of the basics to help you get started.

What is financial aid?

Financial aid is money distributed primarily by the federal government and colleges in the form of loans, grants, scholarships, or work-study jobs. A student can receive both federal and college aid. An ideal financial aid package will contain more grants and scholarships (which don’t need to be repaid) and fewer loans.

Financial aid can be further broken down into two categories: need-based aid, which is based on a student’s financial need, and merit aid, which is based on a student’s academic, athletic, musical, or artistic talent. Both the federal government and colleges provide need-based aid in the form of loans and grants. For merit aid, colleges are the main source, and they often use favorable merit aid packages to attract the best and brightest students to their campuses.

It’s worth noting that colleges can vary significantly in their generosity when it comes to merit aid; merit awards are typically related to the size of a college’s endowment and its unique objectives. College guidebooks and marketing materials generally provide statistics on the size of a college’s average aid award (both in dollar amounts and as a percentage of the typical aid package) and the family income thresholds necessary for different aid amounts. If you’re a family researching college choices, you can help your bottom line by targeting colleges that offer significant merit aid packages. For example, some colleges have made it a policy to replace loans with grants in their financial aid packages.

In addition to colleges, many businesses, foundations, and associations offer smaller merit scholarships with specific eligibility criteria and deadlines. Various scholarship websites allow your child to input his or her background, abilities, and interests and receive (free of charge) a matching list of potential scholarships.

How is my child’s financial need determined?

Financial need is generally determined by looking at a family’s income, assets, and household information. The federal government uses the FAFSA, which stands for Free Application for Federal Student Aid; colleges generally use the PROFILE form, or their own institutional form. The FAFSA uses a formula known as the federal methodology; the PROFILE uses a formula known as the institutional methodology. The general process of aid assessment is called needs analysis.

Under the FAFSA, your current income and assets and your child’s current income and assets are run through a formula. You are allowed certain deductions and allowances against your income, and you’re able to exclude certain assets from consideration. The result is a figure known as the expected family contribution, or EFC. It’s the amount of money that you’ll be expected to contribute to college costs before you are eligible for aid.

A detailed analysis of the formula is beyond the scope of this article, but generally here’s how it works: (1) parent income is counted up to 47% (income equals adjusted gross income or AGI plus untaxed income/benefits minus certain deductions); (2) student income is counted at 50% over a certain amount ($6,400 for the 2016/2017 school year); (3) parent assets are counted at 5.6% (home equity, retirement assets, cash value life insurance, and annuities are excluded); and (4) student assets are counted at 20%.

Your EFC remains constant, no matter which college your child applies to. An important point: Your EFC is not the same as your child’s financial need. To calculate your child’s financial need, subtract your EFC from the cost of attendance at your child’s college. Because colleges aren’t all the same price, your child’s financial need will fluctuate with the cost of a particular college.

For example, you fill out the FAFSA, and your EFC is calculated to be $25,000. Assuming that the cost of attendance at College A is $65,000 per year and the cost at College B is $35,000, your child’s financial need is $40,000 at College A and $10,000 at College B.

The PROFILE application basically works the same way. However, the PROFILE generally takes a more thorough look at your income and assets to determine what you can really afford to pay (for example, the PROFILE looks at your home equity and money you may have contributed to medical and dependent care flexible spending accounts).

What factors count the most in needs analysis? Your current income is the most important factor, but other criteria play a role, such as your total assets, the number of children you’ll have in college at the same time, and how close you are to retirement age.

Estimating aid eligibility ahead of time

Getting a ballpark estimate of financial aid ahead of time can be very helpful for planning purposes. There are two ways you can do this.

First, the federal government offers an online tool called the “FAFSA4caster” that you can complete to get an estimate of your EFC. Second, every college offers a tool called a “net price calculator” on its website that you can complete to get an estimate of how much financial aid your child might be eligible for at that particular college based on your family’s financial and personal profile.

Submitting financial aid applications

The best way to complete the FAFSA is to fill it out and submit it online (it can also be completed manually and mailed to the address listed on the form). The online route is more efficient because mistakes are flagged immediately and electronic FAFSAs take only one week to process (compared to two to four weeks for paper FAFSAs). In order to complete the FAFSA online, you and your child will first need to obtain an FSA ID, which you can also do online.

Starting with the 2017/2018 school year, families are able to file the FAFSA as early as October 1, 2016, using their 2015 tax return. Going forward, the FAFSA will rely on tax information from two years prior. The FAFSA has the ability to directly import your tax information using the IRS Retrieval Tool, which is built into the form. However, you will also have to answer additional questions.

The PROFILE (or individual college application) is usually submitted in late fall or winter but is typically required earlier if your child is applying to college early decision or early action. The specific deadline is left up to the individual college, so make sure to keep track of all college deadlines. In addition to the form itself, the CSS Profile will typically require you to submit tax returns, and possibly other financial documents, at a later date. If so, you’ll receive instructions on how to do this.

After your FAFSA is processed, your child will receive a Student Aid Report highlighting your EFC; the colleges that you list on the FAFSA will also get a copy of the report. When your child is accepted at a college, the college’s financial aid administrator will attempt to craft an aid package to help meet your child’s financial need. This is done using a combination of the following (typically in this order):

  • Federal Pell Grant (for students with exceptional financial need)
  • Federal Direct Stafford Loan (subsidized for students with financial need)
  • Federal Direct Stafford Loan (unsubsidized for all other students)
  • Federal Perkins Loan, Supplemental Educational Opportunity Grant (SEOG), and work-study (funds for these programs are allocated to colleges by the federal government for distribution to students; whether a student receives any of these funds depends on timing of application, financial need, and availability of funds)
  • College grant, scholarship, or tuition discount (at the college’s discretion)

Keep in mind that colleges aren’t obligated to meet all of your child’s financial need. In fact, it’s not uncommon for colleges to meet only a portion of a student’s need, a phenomenon known as getting “gapped.” If this happens to you, you’ll have to make up the shortfall, in addition to paying your EFC. On the flip side, if a college says it is meeting “100% of your demonstrated need” keep in mind that the college is the one who determines your need, not you, and that you’ll still have to pay your EFC.

Comparing aid awards

In late winter or early spring, your child will receive financial aid award letters that detail the specific amount and type of financial aid that each college is offering. When comparing aid awards, read each award letter carefully and make sure you understand exactly what the college is offering. The goal is to compare your out-of-pocket cost at each college. To do this, look at the total cost of attendance for each college and subtract any grant or scholarship aid the college is offering. If the grant or scholarship is merit-based, find out if it’s guaranteed for each year your child is in college and what requirements must be met in order to qualify for it annually. If the grant or scholarship is need-based, find out whether you can expect a similar amount each year as long as your income and assets stay roughly the same (and you have the same number of children in college), and ask the aid office whether it increases to keep up with annual increases in tuition, fees, and room and board.

The difference between the total cost and any grant or scholarship aid is your out-of-pocket cost or “net price.” Compare this figure across all colleges. Once you determine your out-of-pocket cost at each college, determine how much, if anything, you or your child will need to borrow. Then multiply this figure by four to get an idea of what your total borrowing costs might be. Armed with this information, you’ll be in a position to make the best financial decision for your family.

If you’d like to lobby a particular school for more aid, tread carefully. A polite letter to the financial aid administrator followed up by a telephone call is appropriate. Your chances of getting more aid are best if you can document a change in circumstances that affects your ability to pay, such as a recent job loss, unusually high medical bills, or some other event that impacts your finances. Your chances of getting more aid by asking one college if they’ll match a favorable aid offer from another college is a less reliable strategy, but may be worth a shot if the colleges are direct competitors.

How much should our family rely on financial aid?

With all this talk of financial aid, it’s easy to assume that it will do most of the heavy lifting when it comes time to pay the college bills. But the reality is you shouldn’t rely too heavily on financial aid. Although aid can certainly help cover your child’s college costs, student loans often make up the largest percentage of the typical aid package, not grants and scholarships. Remember, parents and students who rely mainly on loans to finance college can end up with a considerable debt burden that can have negative financial implications for years after graduation.

For all of our articles about college planning, please click here.

Filed Under: College, Financial Literacy

Coverdell Education Savings Accounts

February 21, 2018 By SeaCure Advisors Leave a Comment

college savingsA Coverdell education savings account is a tax-advantaged educational savings account that you can establish for a child under the age of 18 (this limit does not apply to beneficiaries with special needs). The child does not need to be your dependent. Contributions to a Coverdell ESA can total up to $2,000 each year. While contributions are made with after-tax dollars, distributions used to pay qualifying education expenses are not included in income.

The Basics

  • If you meet specified income limits, you can contribute up to $2,000 per child per year to a Coverdell ESA
  • Contributions must be in cash
  • Contributions can be made by April 15 of the year following the tax year for which the contribution is being made
  • The beneficiary must be under age 18 at the time you open the Coverdell ESA, unless the beneficiary is an individual with special needs
  • You don’t get a deduction for contributions that you make to a Coverdell ESA; the dollars that you contribute are after-tax dollars
  • Earnings in the Coverdell ESA grow tax deferred, and the earnings portion of any distributions are income tax free as long as they are used to pay qualifying education expenses (the contribution portion is also tax free because they are made with after-tax dollars)

Qualifying Education Expenses

For purposes of a Coverdell ESA, qualifying education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an accredited post-secondary school (college) that is eligible to participate in the federal student aid program. For students enrolled at least half time, qualifying education expenses also include room and board.

Qualifying education expenses also include elementary and secondary education expenses. In addition to tuition, fees, books, supplies, equipment, and room and board, qualifying elementary and secondary education expenses may include tutoring, computer equipment, Internet access, and software that is primarily educational in nature.

For purposes of taking distributions from a Coverdell ESA, qualified education expenses must be reduced by any scholarships or other financial aid received.

Requirements

You must meet income limits

If your modified adjusted gross income (MAGI) is less than $95,000 for single filers or less than $190,000 for joint filers, you can make a full $2,000 contribution to a Coverdell ESA. A partial contribution is allowed for single filers with a MAGI between $95,000 and $110,000 and joint filers with a MAGI between $190,000 and $220,000.

Contributions in the maximum amount have not already been made this year to a Coverdell ESA with the same beneficiary

You can establish and contribute to more than one Coverdell ESA (assuming you meet the income limits), but no more than $2,000 can be contributed in any calendar year on behalf of any one beneficiary.

You set up a Coverdell ESA for your five-year-old son. You also set up a Coverdell ESA for your three-year-old daughter. You can contribute the maximum amount to your daughter’s Coverdell ESA each year and the same amount to your son’s Coverdell ESA each year.

You establish a Coverdell ESA for your nephew Joe. Joe’s father also establishes a Coverdell ESA for Joe. Joe’s father contributes $1,900 to the Coverdell ESA that he established. You can contribute only $100 for that year to the Coverdell ESA that you established.

Beneficiary of Coverdell ESA has not yet reached age 18

When the beneficiary of a Coverdell ESA reaches age 18, no further contributions can be made. The exception is if the beneficiary is an individual with special needs, in which case there is no age limit.

Strengths

Distributions used for the beneficiary’s qualified education expenses are income tax free

For distributions (withdrawals) used to pay qualified education expenses, the earnings portion of the distribution is tax exempt (contributions are also tax exempt because they’re made with after-tax dollars).

Funds can be rolled over to another Coverdell ESA for a family member of the current beneficiary

A Coverdell ESA can be rolled over without tax or penalty consequences to another Coverdell ESA established for the same beneficiary, or for a family member of the original beneficiary.

Contributions are discretionary

You do not have to make a contribution to a Coverdell ESA in any given year or years. Except for limits on the maximum amount that you can contribute in a year, you can exercise complete discretion in determining how much and when to contribute.

You have control over investments

With a Coverdell ESA, you can control the underlying investments. This is usually not the case with a 529 college savings plan or prepaid tuition plan.

Distributions from a Coverdell ESA can be tax exempt in same year an education tax credit is taken

A beneficiary can take a tax-free distribution from a Coverdell ESA in the same year that he or she takes the American Opportunity credit or Lifetime Learning credit. (The result is the same if the beneficiary’s parent takes the credit.) However, the catch is that the same qualified education expenses can’t be used to qualify for the tax-free distribution and the credit.

Coverdell ESA considered parental asset for federal financial aid purposes

The federal financial aid formula counts a Coverdell ESA as a parent’s asset. This means that 5.6 percent of the funds must be applied to college costs each year before a student is eligible for federal financial aid. Also, distributions that are used to pay qualified education expenses aren’t counted as either parent or student income for federal financial aid purposes.

 

Tradeoffs

After-tax dollars are contributed

You receive no deduction for amounts contributed to a Coverdell ESA. Your contribution comes from after-tax dollars.

Ability to contribute depends on income

If your MAGI is $110,000 or more for single filers or $220,000 or more for joint filers, you can’t contribute to a Coverdell ESA. A partial contribution is allowed for single filers with a MAGI between $95,000 and $110,000 and joint filers with a MAGI between $190,000 and $220,000. If your MAGI is less than $95,000 for single filers or less than $190,000 for joint filers, you can make a full $2,000 contribution to a Coverdell ESA.

Distributions not used to pay qualified education expenses partly subject to tax and penalty

Distributions that are not used to pay qualifying education expenses are included in the beneficiary’s income to the degree that the distribution consists of earnings. All distributions are considered made partly from contributions and partly from earnings. Also, any portion of a distribution that is included in a beneficiary’s income is subject to an additional 10 percent penalty tax.

Any remaining funds in a Coverdell ESA must be distributed when the beneficiary reaches age 30

Any funds remaining in a Coverdell ESA when the beneficiary reaches age 30 must be distributed (except for beneficiaries with special needs). Funds distributed from a Coverdell ESA at such time are considered taxable income to the beneficiary to the extent of earnings.

Fees and expenses

There are commission costs and other fees generally associated with opening a Coverdell ESA account.

How to do it

Establish Coverdell ESA at a bank or other financial institution

Coverdell ESAs can be established at a bank or other financial institution approved by the IRS.

Make contributions

Contributions to a Coverdell ESA must be made by April 15 of the year following the year for which the contribution is made.

Tax considerations

Contributions to a Coverdell ESA are made with after-tax dollars

You receive no deduction for amounts contributed to a Coverdell ESA. Your contribution comes from after-tax dollars.

Qualifying distributions are tax free

If distributions are used to pay qualifying education expenses, the earnings portion of the distribution is tax exempt (the contribution portion is also tax free because they are made with after-tax dollars).

Portion of nonqualifying distribution is included in income and subject to 10 percent penalty tax

When a beneficiary takes a distribution from a Coverdell ESA but does not have qualifying education expenses in that tax year, the portion of the distribution that represents earnings is included in the beneficiary’s income. This portion of the distribution is generally also subject to an additional 10 percent penalty tax. However, this 10 percent penalty tax will not apply if the distribution is:

  • Made after the death of the beneficiary to his or her beneficiary or estate
  • Attributable to the beneficiary’s disability, or
  • Made on account of a scholarship, an educational assistance allowance, or a payment of the designated beneficiary’s educational expenses that is excludable from gross income

Coverdell ESA may result in taxable income upon death of beneficiary

If a Coverdell ESA is transferred upon the death of the beneficiary to anyone other than a surviving spouse or family member, the Coverdell ESA ceases to be a Coverdell ESA, and whatever portion of the account represents earnings is income to the recipient.

A contribution to a Coverdell ESA is considered a completed gift

Contributions that you make to a Coverdell ESA are considered completed gifts. However, unless your Coverdell ESA contribution and other gifts you make to the same beneficiary (in the same year) total more than the annual gift tax exclusion, there is no federal gift and estate tax liability. And, gift tax due on gifts in excess of the annual gift tax exclusion may be offset by your applicable exclusion amount.

There may be state gift tax consequences as well.

Coverdell ESA is not included in calculating estate tax

Because money contributed to a Coverdell ESA is considered a completed gift to the beneficiary at the time of the contribution, such money is no longer part of the contributor’s assets once it has been contributed to the Coverdell ESA. Therefore, the money contributed would not be included in the contributor’s estate upon his or her death. However, if the beneficiary dies before using up all of his or her Coverdell ESA money, the remaining balance in the Coverdell ESA may be included in the beneficiary’s estate for estate tax purposes, depending on the value of the estate at the time of death and the year in which he or she dies.

Rollovers

A Coverdell ESA can be rolled over without tax or penalty consequences to another Coverdell ESA established for the same beneficiary, or for a family member of the original beneficiary. This can be done once every 12 months. Like IRAs, there is a 60-day window in which funds may be rolled over.

Transfers

If the beneficiary dies while there is money in a Coverdell ESA, and the Coverdell ESA is transferred to a surviving spouse or other family member, there is no taxable transaction. Similarly, if a Coverdell ESA is transferred to a spouse or former spouse as the result of a divorce decree, there is no tax consequence. However, if upon the beneficiary’s death, the Coverdell ESA is transferred to anyone other than a surviving spouse or other family member, the Coverdell ESA stops being a Coverdell ESA, and the portion of the account that represents earnings is considered income to the person who receives the funds.

Questions & Answers

How much can you contribute if your income falls in the phaseout range?

The most you can ever contribute to a Coverdell ESA for a single beneficiary in a year is $2,000. If your MAGI is between $95,000 and $110,000 for single filers or $190,000 and $220,000 for joint filers, your ability to contribute to a Coverdell ESA is limited. This limitation is calculated as follows:

MAGI between $95,000 and $110,000:

  1. Subtract $95,000 from your MAGI (if your MAGI is less than $95,000, you can contribute the maximum). If the result is $15,000 or more, stop–you cannot contribute to a Coverdell ESA.
  2. Divide the result from line 1 by $15,000.
  3. Multiply the result from line 2 by $2,000.
  4. Subtract the result from $2,000.

This is the maximum amount you can contribute to a Coverdell ESA.

MAGI between $190,000 and $220,000:

  1. Subtract $190,000 from your MAGI (if your MAGI is less than $190,000, you can contribute up to $2,000). If the result is $30,000 or more, stop–you cannot contribute to a Coverdell ESA.
  2. Divide the result from line 1 by $30,000.
  3. Multiply the result from line 2 by $2,000.
  4. Subtract the result from $2,000.

This is the maximum amount you can contribute to a Coverdell ESA.

Are there restrictions on taking distributions from a Coverdell ESA?

Yes and no. Generally, contributions that you make to a Coverdell ESA are considered gifts. Once you contribute to a Coverdell ESA, distributions from the Coverdell ESA can only be made to the beneficiary (except for withdrawals of excess contributions). Distributions can be made from Coverdell ESAs at any time, but only qualifying distributions qualify for tax-free status.

Qualifying distributions are tax exempt if they are used for qualifying education expenses and if they do not exceed the expenses incurred by the beneficiary during the year.

Nonqualifying distributions are distributions made for noneducation expenses, and they are partially included in the beneficiary’s income and may be subject to a 10 percent penalty. Distributions are considered to consist partly of original contributions and partly of earnings. Only the portion of a distribution that represents earnings is included in the income of the beneficiary.

The part of the distribution that represents contributions (and is therefore not included in income) is calculated by multiplying the amount of the distribution by the ratio of contributions in the Coverdell ESA (prior to the distribution) to the total balance in the Coverdell ESA prior to the distribution. The remainder of the distribution represents earnings.

A Coverdell ESA has a total balance of $5,000. The $5,000 consists of $4,000 in contributions and $1,000 in earnings. A $1,000 distribution is made to the Coverdell ESA beneficiary, but none of the $1,000 is used for qualified education expenses. Because 80 percent of the entire value of the account at the time of the distribution consists of contributions, 80 percent of the distribution ($800) is considered to represent original contributions, and only 20 percent ($200) is considered to be earnings includable in income.

A special calculation is required when you have qualifying education expenses but the distribution exceeds these expenses.

What happens when a beneficiary has $5,000 in qualifying education expenses but receives $6,000 as a Coverdell ESA distribution?

Any time that a distribution from a Coverdell ESA totals more than the qualifying education expenses, a beneficiary must make a special calculation to determine how much of the distribution must be included in income:

1. Enter total qualifying higher education expenses.

2. Enter total amount of distribution.

3. Enter portion of distribution that represents earnings.

4. Divide line 1 by line 2.

5. Multiply line 4 by line 3. This amount must be excluded from income.

What happens if you contribute too much money to a Coverdell ESA in a given year?

If you contribute more to a Coverdell ESA than you are allowed in one year, you have until May 31 of the following tax year to withdraw the funds, along with any earnings attributable to the funds. Any over contributions remaining after this date are subject to a 6 percent excise tax.

The 6 percent excise tax is also assessed if total contributions to all Coverdell ESAs for any one beneficiary exceed the maximum $2,000 amount.

To read all of our articles about college planning, please click here.

Filed Under: College, Financial Literacy

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