It's that time of year again! To celebrate the back-to-school season, this week's episode ofIndustry Focus: Financialsis 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.
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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.
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Gaby Lapera:Hello, everyone! Welcome toIndustry Focus,the podcast that dives into a different sector of the stock market every day. You'relistening to theFinancialsedition,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 todayis 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'snever too early to start with that. Pretty much from birth,you have the colleges and the educational institutionstelling you,there's going to be a big bill at the end of the day, andthe sooner you get started, the more you're going to have thatcompound interest working in your favor.
Lapera:Absolutely. Thereason 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 toreduce the student loan debtthat the kid is going to have at the end of college, if they already have money going into it. Thatbeing said, let's start with one of the most popular plans that there is out there, which is the 529 plan. These are calledqualified tuition plans legallyby the government. The reason they're called 529 plansby everyone else is because they are governed by section 529in the tax code. Do you wantto tell us a little bit about how those are structured, Dan?
Caplinger:Basically, 529 plansare generally offered byinstitutions authorized by each state. There's more than 50 different plans out there. Whatmany 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 thiseducational account. As a result of that, theinvestment income inside of the 529 doesn't gettaxed 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 forqualified educationalexpenses, you don't have to pay any taxes on any of theearnings. So, it's a really good deal for tax savingsin order to help you saveand invest long-term for that 18, 19 years thatyou're accumulating money to put your kids through college.
Lapera:Just to be clear,contributions are not deductible,but earnings are exempt from federal taxesand a lot of state taxes, that's going to vary from state to state.
Caplinger:That'sexactly right. It's not like a 401(k)in the sense that contributions don'tget you an up-front tax break. But what they do get you is, when you make those withdrawalslater on, you're going to be eligible for tax-free treatmentfor 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 statesactually do let you deduct yourcontributionor a certain amount of contributionagainst your state income tax,not against your federal tax, though.
Lapera:Yeah. Andjust 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. Itdoesn't really matter where you are,you can still use these plans.
Caplinger:Absolutelycorrect. The way that the 529 plan is,it'ssort of misleading and some ways, because those state namesmake 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 aretotally portable. They let you use the money forany 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 therea contribution limit on the 529 plans?
Caplinger:There arecontribution 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. Forpractical purposes,it's virtually unlimitedfor 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 taximplications. So, it's something you should pay attention to in terms of puttingmaximum amounts in on a yearly basis. That can get complicatedin 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 asignificant chunk of change. The other thing that's really importantto note about 529 plans is that you canonly use these for qualified education expenses. That means,if you were a really good saver, or maybe your kid gets a scholarshipand 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 isyou could change the plan into someone else's name,who might be going to college, or you could just leave it in thereif you think your kid is going to go to grad schooland 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 moneyfor educational purposes, and you withdraw it,then all the earnings become taxable, you get hit with thatextra penalty on top. But at some point,Congress figured out that it wasn't entirely fair topenalize people who were fortunate enough to get scholarships. So, what they did in that case was they wave that 10% penalty. You'll still payincome tax on the earnings that themoney 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 istotally a matter of opinion, but are thereany 529 plans that you thinkare good to look into?
Caplinger:In general, the best 529 plans arethe ones that have the lowest costs. You'veheard us talk in previous shows about 401(k) plans, thatsome employers have have low cost 401(k)s, some employers have high-cost 401(k)s. Theexact 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 anannual fee that's based on a percentageof the amount of money that you have under management.
Thebest situation is one where you can keepthose expenses down to about 0.25% or less. I've seen some plans thatstart to approach 1% or even more,and that's something that you really need to be careful about. It canmake it smart to look at a state even outside of your own state,if you can end up saving money in the long run. Assmall as those percentages sound, over 15-20 years,they really do add up.
Lapera:Absolutely. Let'stalk about a couple other savings accounts that areavailable 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'sbasically something where you, the parent, haveinvesting 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.
Thereason why people like custodial accounts is,there's no limitation on what you can invest in. The529 plan itself dictates whatyour 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 dopretty much whatever you want.
The downside ofthe custodial account, there's a couple. One is, forfinancial 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 thecustodial account is, when the child reachesthe age of majority, usually 18 years oldin most states, the parenthas to turn it over to the child. Theparent 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 knownin my past. (laughs)
Caplinger:Exactly. That'sone 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 stillpretty 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 isprobably 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 popularis 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 IRAcontributions, other sorts of contribution. Forwhatever 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 withthe much higher contribution limitslets you make a real dent inhow much the total costof college is going to be. We're up to several hundred thousand dollarsover 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, youcan't contribute to these at all. People havecircumvented that byletting the kids open it up in their own name, and then contributing to it. But it's just kind of a headache thata lot of people don't really need. But what's interesting to meis that certain elementaryand 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 areby the fact that even somemajor financial institutionsdon't even offer them anymore. It can behard to find a place that will let you open a new Coverdell account. Really, in general, you're stuck with either the 529 oropening up acustodial 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. Thefirst thing is to fill out the FAFSA, whichstands 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, andsophomore year, there was a rude awakening. You want to fill that out as soon as possibleafter January 1st. If possible, you want to file your taxes first.
Caplinger:Yeah. A lot of the information you'regoing to use on that financial aid formlooks 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 offas 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 tobe 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 acollege or university that doesn't use that form. Sometimes, they'llask for supplemental information that specific towhatever that college or university wants. Butit's pretty much uniform at this point whereeverybody expects that FAFSA. That's one of the reasons that thegateway 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. Thereason that we're harping on this so much is thatfederal loans, in general, are a much better idea than private student loans. That's becauseinterest 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'llactually 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. Mostprivate loans don't have that sort of thing. They might not make you make payments, but the interest is accumulating inthe 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, somequalifications for better treatment,and also some eligibility forvarious types of loan forgiveness programs,depending on what career path you decide to follow after you come out of school, thenloan forgiveness can be an option as well.
Lapera:Yeah, and let's chat about that really quick -- the three main programs that thefederal government offers for loan forgiveness --and this only applies to federal loans. So, ifyou 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 monthlypayments. That's 10 years worth of payments, while working full-time for aqualifying employer. Those tend to benon-profits, the government,they have a whole list of places thatyou can work where you would qualify for this.
There's Teacher Loan Forgiveness. You need to make fiveconsecutive yearsof payments. You need to work for at least five years inlow-income public schools, which is an option you can do. They offer up to $17,500 in direct loans orStafford 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.
Andthere's also the Perkins Loan Cancellation if you have a Perkins loan. Perkins loans are given to students who haveextraordinary 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'rewondering 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'salso been a lot of talk during the recent presidential election campaign aboutjust how overwhelming student loan debt is in general. There'sgoing to be a big political push,especially as the current generation ofstudents who are coming through school, who are five or ten years out of school. As they start to get politicallymobilized, I think you can expect to seea lot of pressureto try to expand some of these forgiveness programs.
The impact that thelarge amounts of debt that people are coming out of school with ishaving an impact on the economy. People are delaying buying homes longer than they did, they'reliving with their parents more. We're even sayingsome studies that say people aredelaying having familieslonger because they're buried under this debt,and they don't want to start a family untilthey 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 themat 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 amuch higher barrier to have student loan debt dischargedin bankruptcy. It's not100% never,but it's a lot harder toconvince a bankruptcy court thatyou can get them extinguished.So,for the most part, yes,even if you're successful and havingcredit card debt,car loan debt,that kind of thing extinguished in a bankruptcypreceding, the student loan lender isstill going to be able to come back and say, "Yes,you filed for bankruptcy, butbecause of this federalprovision, we're still going to be able to collect going forward on that."
Lapera:Yeah. This is why, at the beginning ofthe 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 isscholarships. It's never been easier to findscholarships, which means it's also probably harder to get them,because so many people are applying for them. Butif 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. Youhave 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 ofpeople 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? AndI've seen people make mistakes, and say, "This school gave me $40,000 and this other school gave me $30,000." But when youask them how much of it was loans and how much of it was grants,it turns out that they would have been better offtaking the smaller packagebecause more of it was an outright giftthat they would never have to pay back.
Lapera:Yeah. AndI just want to take a moment to talk to college students out there. Atthe 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 greatabout helping, but I would literallymeet you in a coffee shop,I would meet you after hours,I would give so much help.So,make sure thatyou do the work to get the good grades. Don'tblow 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 federalgovernment 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 applyafter you're through schooltrying 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 percentageof 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 isdesign to emphasize just how much more flexible that is. Looking at those two credits, it can make a big dent inhow much you're having to pay out of pocket,because the government is coming back and putting someback 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 thingwe wanted to touch on briefly is,you have your student loans, you'vegraduated from college. Whatever is not eligible for forgiveness or whatever, you have to pay off. Andsometimes people get overwhelmed with that. There are a few optionsyou have if you are overwhelmed. First andforemost, 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. Anyarrangements that they can makethat result in you makingsome payments is better than the reality of getting $0 back from you because you're justtotally overwhelmed and can't afford to deal with it.
Lapera:Yeah. And then, the other thing I really encourage you to think about isdebt 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. Youhave to be really careful with that,because there are reputable consolidation outfits, and there are unreputableconsolidation providers. The real questionthat you have to look at very closely iswhat the makeup of your loans is currently. If you're heavily with private student loans, theconsolidation 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.
Thequestions 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 loseinterest deferment? Are yougoing 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'regoing to want to really think twice before you consolidate and give those up all in exchange for what can be a smaller monthly payment.
Theother thing to look closely at is, mostconsolidation firms will offer you thesmaller monthly payment. But what they don't really highlight is, the way they get you the smaller payment is often byextending 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 payover the lifetime of your loans, itskyrockets after these consolidations,because you expended that period so much longer.
Lapera:Yeah, andpart of the reason you could potentially lose benefitsif 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'sgood consolidation companies and bad consolidation companies. Can you highlight what you should look for when you'relooking 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 providerreaches out to you to make consolidationrecommendations,they're going to have the big picture there. Because they've already been vetted by the federal governmentto 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 alwaysgoing to be looking for ways to get more of a loan balance under their umbrella, even if it'snot necessarily the best decision for you. Youcan'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 justbeing aware of the situation ...if you can sense that they understand the issues involved,that they understand that consolidationis not always the right answer,that's the best sign that you have that they're aprovided that can give you the consultation thatyou 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 toprovide some feedback on the length of our episodes --I know that they all vary widely acrossIndustry Focus. If you have any opinions, longer or shorter, just right like Goldilocks, that would be great. Just email us firstname.lastname@example.org by tweeting us @MFIndustryFocus. As usual,people on the program may have interests in the stocks they talk about, and The Motley Foolmay 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. Ireally 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'sshaking his head no.I'm relieved for him. Thank you, everyone, for joining us, and I hope everyone has a great week!
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