Adam Zoll: I'm Adam Zoll for Morningstar. If you or a family member will attend college in the next few years, or perhaps many years down the road, you're probably well aware of how expensive college can be. Each year, hundreds of thousands of students graduate college, many of them owing tens of thousands of dollars in student debt. And while borrowing to pay for college may be unavoidable in some cases, planning ahead to tackle the high cost of higher education is needed now more than ever.
Today, I'm going to be speaking to you about different aspects of college planning to help you make smart choices, no matter where you are in the process. Let's take a look at the topics to be covered.
We'll start by taking a closer look at the high cost of higher education. Then, we'll move on to different college-saving strategies. We'll give you some advice about choosing a 529 college-savings plan. Then, we'll talk about the important topic of financial aid and student loans. And finally, we'll discuss why college is still worth it.
Our first slide looks at how the cost of college has been increasing over the past few decades. As you can see, the light-blue line represents private four-year college tuition, fees, room and board. And the black line represents the same information for public four-year colleges. These are inflation-adjusted numbers, which means that this increase you are seeing is not due to overall inflation--it's inflation above and beyond the overall rate of inflation.
So, for the 2014-15 school year, the average tuition, fees, room and board at a private school was more than $42,000. And at a public four-year college, it was nearly $19,000.
The good news, if you want to call at that, is that that's the sticker price for public and private universities on average, and not everyone is going to pay that full sticker price. Once you factor in financial aid--grants and scholarships, in particular--you or your student may actually end up paying quite a bit less.
The next chart that we have looks at the average net price for public and private colleges, and these charts are using in-state tuition, incidentally, for the public-tuition numbers. So, what we see here is, for a public four-year college, while the average sticker price was nearly $19,000, the average net price--what students actually were paying, on average--was closer to $13,000, just a shade under that. Whereas, for private-school tuition, fees, room and board, the average sticker price was in excess of $42,000; the average net tuition and fees was about $23,500. So, even a greater disparity there. That's why financial aid is such an important topic to understand--something we'll be covering later in this presentation.
Next, let's look at different ways to pay for college. Of course, current income is one potential source to pay for your college costs--your own income or the student's income, if the student has a part-time job or works in the summer. Savings, of course, is likely to play an important role. There are tax-advantaged ways to save for college and non-tax-advantaged ways that we'll discuss in a moment. And of course, financial aid also plays an important role for many people in attending college. And when we talk about financial aid, we're talking about not only grants and scholarships but students loans as well--and we'll also deal with that later in the presentation.
I think one of the most important questions that you can answer as you start along in the college-planning process is the question of exactly what you are trying to accomplish. And by that, I mean how much of your child's college expenses you are planning to cover. Some parents feel that it's their obligation to cover most, if not all, of their child's college-planning expenses. Others feel the opposite--that it's the child's responsibility to borrow and to pay for these college costs. Others land somewhere in the middle. I often hear parents say that they feel that they can cover at least the amount that it would cost to send their child to a public in-state college and anything beyond that will be the student's responsibility.
So, if he or she decides to go to a private school or an out-of-state school, that will be on the student's dime. There's really no right or wrong answer to this. It's a matter of personal preference and, of course, your own family resources, but it's a great way to start thinking about your ultimate goal and how much you hope to have saved up, ultimately.
It also bears mentioning at this point that, while you should certainly try to save for college if that is your intent, you should not do so at the expense of your retirement. You may think to yourself, "Well, I really don't want my son or daughter to have to borrow money to pay for college and be saddled with all that debt when they get out of school." But the fact is college loans are much easier to come by than loans to help fund your retirement. So, prioritize covering your own retirement; then after that, by all means, save for college.
In a pinch, you could technically tap your retirement savings to help pay for college. You could take a loan against your 401(k) from work or take out money from a Roth IRA, if you decide to do that. I generally don't encourage using retirement accounts as a college-savings vehicle, however. I think they are best utilized for the purpose that they are intended--which, of course, is to save for your retirement.
So, let's turn now to the subject of college-savings vehicles. There are a lot of different ways to save for college, and there are pros and cons to each. So, let's take a closer look at some of these different ideas. First, let's take a look at your garden-variety taxable account. When we say taxable account, we're taking about a bank savings account, a [certificate of deposit], a brokerage account, a mutual fund account--basically anywhere you can put money in the expectation or hope that it's going to grow.
And one of the pros of this particular approach is that you do have a wide variety of investment options. You can put the money in a safe asset like a bank savings account or a CD, or you can invest it in stocks, mutual funds, ETFs--however you please. Also, you've got flexibility in case you need the money for some other purpose. So, if your roof springs a leak and you have to tap into this money that you had hoped to use for your child's college, you can get at the money without having to pay any penalties associated with doing so.
One of the downsides here, of course, is that this is a taxable account. So, as the money grows each year, if there are capital gains distributions or income associated with the investment (when you go to sell the investment, there may be capital gains associated with it), you're going to pay taxes in any of those eventualities.
Also, if the taxable account is held in your child's name, there is a negative financial-aid implication with that, as opposed to if the taxable account is held in the parent's name. I'm going to explain that in greater depth a little bit later, but it's something to be aware of when discussing taxable accounts.
Our first tax-advantaged account type that can be used as a college-savings vehicle is a custodial account also known as a UGMA or UTMA, which stands for Uniform Gifts to Minors Act or Uniform Transfers to Minors Act. One of the advantages here, too, is that a custodial account can be invested in a wide variety of different security types, including stocks, bonds, and funds. Here, the tax advantage is that the first $1,050 of earnings is income-tax-free each year. Then, the next $1,050 in earnings is taxed at the child's rate. So, assuming that the child is at a lower income tax rate than the parents are, there is likely to be a tax-savings associated with investing money in this type of account.
Now, let's turn to the downsides of using a custodial account. Number one is that the custodial account is considered a child-owned asset in financial-aid calculations. And as I mentioned, child-owned assets or student-owned assets count more negatively in need-based financial-aid calculations than parents-owned assets do.
Number two, it is an irrevocable gift. So, once the money is put into the custodial account, it cannot be removed unless it's done so for the benefit of the beneficiary. For example, if you put $1,000 in a custodial account with the intent of using it as a college-savings vehicle, let's say, and then decide you want to take that money out to help pay off your car loan, that would not be allowed under the UGMA/UTMA rules.
Third, the funds within a UGMA/UTMA account go under the control of the beneficiary at the age of majority. Depending on your state's law, it's either 18 or 21. So, let's say you have money saved in a custodial account for your son or daughter, and when he or she turns that age, the age of majority, he or she decides that they don't want to use the money to pay for college--they'd rather use the money to take a trip or for some other purposes. They are within their rights to do that because, at that point, they control the money--you don't. So, all of these are downsides to be considered before opening a custodial account as a college-savings vehicle.
Next, let's turn to the Coverdell Education Savings Account. One of the advantages of this account type is that gains and distributions that are used for qualified educational expenses are tax-free. So, once you put the money in, as those capital gains distributions and income flow into the account from various investment types or when you go to sell those assets, you are not going to owe any taxes on that money as long as you use it for qualified educational expenses.
One of the biggest advantages of the Coverdell Education Savings Account is that you can use it not only to save for college costs, but you can use it to pay kindergarten-through-12th-grade costs as well. So, families that have children who are attending private school or who need private tutoring, for example, can use this as a savings vehicle for pre-college costs as well.
And then finally, Coverdell Education Savings Accounts can also be used for a wide variety of investment types--again, including stocks, bonds, and funds. One downside to the Coverdell is that annual contributions are limited to just $2,000 per beneficiary. So, as a college-savings vehicle, this may be somewhat limiting to families that are hoping to sock away more than $2,000 a year for that purpose. Also, there are some income limitations. Taxpayers making more than $110,000 per year, or $220,000 per year if filing jointly, are not eligible to contribute to a Coverdell account. So, wealthier families may not be able to take advantage of this.
And finally, some major fund companies do not offer Coverdell Education Savings Accounts. You may have to do some shopping around to find one that does.
Next, let's talk about 529 prepaid-tuition plans. These are plans in which you basically purchase tuition credits at a price that is set today, and those credits can be used later on to cover tuition. So, for example, if you pay for a year's worth of tuition credits at today's price, when the student eventually enrolls in college, you can cash in, essentially, those credits and have that year of tuition covered.
One of the biggest advantages here is that it's a hedge against tuition-inflation risk. You don't have to worry about if the rate of tuition inflation continues to go up rapidly [because] you've already covered at least a portion of your tuition expenses. You are also not exposing the money directly to market risk. You are not investing in stocks and bonds. So, you can bypass that element of risk also.
Growth in the prepaid tuition plans and use of the tuition credits also is tax-free, and contributions may be deductible on your state income tax. Credits also may be used not only at your in-state university but at out-of-state universities and private colleges as well. The way this works is typically that if you have a certain amount of credits for your in-state public universities, an average of the in-state tuition is used and applied to your out-of-state tuition or private-school tuition. However, that is going to leave you, in all likelihood, with a shortfall that you're going to have to make up because your in-state college tuition probably is going to be less than an out-of-state tuition or a private-college tuition.
Among the downsides to the 529 prepaid-tuition plan is that they're not widely available--only about a dozen states offer them. As I mentioned, it may not cover the entire cost of tuition if the student enrolls in an out-of-state school or a private university. And they are only open to state residents. So, either the account owner or the beneficiary must reside in the state in which the prepaid-tuition plan is established.
Next, let's talk about 529 college-savings plans. These are more widely available and, therefore, are more widely used. Here, what you are doing is you are investing in a portfolio typically of mutual funds that you expect and hope is going to grow over time in order to help pay for college once the beneficiary reaches college age.
Here, the gains and distributions that are used for qualified college expenses are tax-free. And just to clarify: Qualified college expenses include not only tuition and fees but also room and board, as long as a student is enrolled at least half time--and also books and supplies. So, it can cover a pretty wide variety of college costs.
More than 30 states give you a tax break for contributing to their 529 plans. Usually, you have to be a state resident in order to get this tax break. Here, there is a potential to outpace the rate of tuition inflation because you are exposing the money to market risk, so there is the potential for the money to grow faster than tuition rates are increasing. For example, the last few years have been very strong for the stock market. If you had invested money in a stock portfolio within a 529 college-savings plan, you were probably happy that you did because the money grew much faster than it would have, for example, if you had invested it in a prepaid-tuition plan.
And last among the pros here: There is a low financial-aid impact if the 529 college-savings plan is owned by a parent or a dependent child. So, the 529, in those cases, is considered a parent-owned asset. It does not have as large of a negative financial-aid impact as a child-owned asset would.
Now, let's look at the cons of the 529 college-savings plan. One is that you are limited to the investment options offered by the plan. Typically, the plans offer sort of a menu of different portfolio types--stocks, bonds, cash equivalents--in different allocations and you would choose one of those portfolios; but you can't invest in just any stocks, bonds, and funds that you please, as [is the case], for example, with the Coverdell. Also, the assets must be used for qualified college expenses or they are subject to taxes and penalties. If you take the money out of the account and you can't show that you used it to cover the qualified expenses I just described, then any earnings on the money will be subject to ordinary income tax rates plus a 10% penalty.
And finally, there is also a risk that the value of your investment could decrease in value. If you are investing your 529 college-savings assets in stocks, for example, and the stock market takes a turn for the worst, then your account is going to also lose some value along the way. So, that's something you'd want to be aware of if you are considering this vehicle.
There are some misconceptions about 529 college-savings plans, and let's try to clear up some of those. Number one, the state of residence or the state of the plan or the state that the beneficiary ultimately attends college in is basically irrelevant. Anyone can open a 529 account in any state and the funds can be used to cover college expenses in any state. So, for example, if a grandparent in New York wants to open a 529 for a grandchild who lives in Virginia, and they want to use Utah's 529 plan, and the student ultimately goes to school in Colorado, that's all fine. The only time the element of the state ever really enters the equation is if you are hoping to get a state income tax deduction, which usually requires you to contribute to your own state's plan. However, you can open a plan in your state for the benefit of a beneficiary who doesn't live in your state and/or who plans to attend college in a different state as well.
Also, a beneficiary can have a 529 account in multiple states and have multiple accounts. Control of the 529 lies with the account owner, not with the beneficiary. So, it's the account owner who will decide how the money is invested and when and how it is ultimately used. There are no income restrictions regarding 529 plans--unlike the Coverdell account--so these are open to any families. There is a maximum total contribution, and these limits are generally rather high; in some states, it's as much as $300,000. However, contributions above $14,000 per year may be subject to gift tax implications.
Finally, unused funds in the account may be transferred to other family members' 529 accounts. So, let's say that your son or daughter still has money left over in their 529 account when they graduate and they have a younger sibling who is still in school and you want to use the money for their benefit. You can roll the money into a 529 for the benefit of the younger sibling and use it for that purpose. And even if there are no younger siblings who are still in school, even cousins and some other members of the extended family can use the 529 funds if the assets are rolled into accounts for their benefit.
Let's talk about ways to choose a 529 college-savings plan. What you usually want to do is start local. Look at your own state's plan. Does your state have a 529 plan? Nearly all of them do, so odds are the answer is yes. Next, what are the benefits to investing in your own state's 529 college-savings plan? Does your state offer an income tax deduction or a state tax credit? More than 30 do. Usually, it's either one or the other--a deduction or a tax credit. Some states offer matching grants for students who participate in their 529 plans and others offer scholarships.
Are those in-state benefits portable? Do you have to stay with an in-state plan in order to qualify for these things? And how much do you plan to save each year? What you're going to want to do is calculate the amount that you're saving each year versus the tax benefit that I just mentioned to get a dollars-and-cents idea about how much you are actually saving by keeping the money in your in-state plan.
529 plans are distributed in one of two ways. They're either advisor-sold or direct-sold--meaning there are certain plan types that you can only buy through a financial advisor and others that are sold directly to the public. Within the 529 plan, you will be asked to choose among various investment options.
One popular investment found in many 529 college-savings plans is the age-based portfolio. What this is is a portfolio of mutual funds that is usually heavily weighted toward stocks and their higher return and risk potential when the beneficiary is younger, and as that beneficiary ages, the allocation tilts away from stocks and more toward bonds and fixed income to ratchet down the volatility of the portfolio so that the money is there when needed when the beneficiary is ready to enroll.
There are also, however, static investment options found in most 529 plans. So, if instead of using the age-based portfolio, you want to have the ability to invest in a 100% stock portfolio or 100% bonds, 100% cash or a 50/50 stock-bond split portfolio, usually that is an option as well.
Some plans have multiple age-based portfolio tracks for investors with different risk tolerances. If you are an aggressive investor, then that glide path may have a higher exposure to stocks over time [while] a moderate or conservative [glide path] would have a lower exposure to stocks over time. Most plans' investment options, ultimately, are invested in mutual funds. Those are the basic building blocks of 529 college-savings plans.
Morningstar rates 529 college-savings plans using its five-pillar process, which is the same process used to rate mutual funds. So, first, we look at the people running the underlying funds within the plan. Are they experienced managers with strong track records? Also, the process they're using--how do they go about investing? Do they tend to favor growth or value stocks, for example, or stocks from a certain geographic region when investing internationally? Also, the parent company that offers the funds is important. Does it have a good stewardship record and a good record of advocating on the part of the investors? Performance, of course, is important. How has the fund performed over time? And last but not least is price. Are investors getting a good deal by investing in this 529 college-savings plan?
And it's important to note that you may be paying a few extra layers of fees by investing in funds through the 529 college-savings plan as opposed to investing in those same funds, let's say, in a taxable account. But because of the tax advantages of the 529 college-savings plan, along with potentially a state income tax deduction on your contributions, you may very well come out ahead. But it is important to run those numbers and make sure you are investing in a plan that is low-priced and that you have a good sense of how much of a tax advantage you are getting.
Morningstar also rates 529 college-savings plans using the medalist format that we use for funds. Gold, Silver, and Bronze funds are considered the best of the breed. Then, there are also Neutral- and Negative-rated funds. To give you a sense of the breakdown: As of October 2014, 29 of the 64 plans rated by Morningstar received Gold, Silver, or Bronze ratings; half--or 32--were rated Neutral, and three were Negative.
Morningstar expects that most state plans should deliver market-like, or better, returns after tax benefits. For a while, 529 plans were somewhat inconsistent in terms of quality; but in general, they have improved in quality, costs have come down, and the investment selections have improved. They are not all universally strong, so it is still important to do due diligence on your own state's plan.
If your state offers local benefits, think twice before [considering an out-of-state plan]. That's definitely the first place to start. If your state does not offer any local tax benefits or if the benefits are portable, then you want to look nationally for the best plans. And a great place to research your state's plan or any of the national plans is Morningstar's College-Savings Center under the Personal Finance tab on Morningstar.com. There, you will find all sorts of tools, including a screener tool, that can help you research 529 college-savings plans and find those that Morningstar analysts say are the best of breed.
So, let's turn now to the subject of financial aid, which I like to consider the college-planning wild card. As college costs have gone ever higher, I think that the importance of understanding financial aid--how it works, the likelihood that you or your student will be eligible--I think it's a crucial piece of the puzzle here.
So, if we look at this pie chart, you will see this is a representation of financial aid by source for the 2013-14 academic year. And I want you to notice, first, that the largest chunk of the pie here is actually federal loans. Most people say, "Well, federal loans are not financial aid--financial aid is supposed to be free money for college." However, loans are considered a form of financial aid and, indeed, when you get a financial-aid letter back from a college--assuming you applied for financial aid--you may very well find that loans are part of the package that you are being offered.
In fact, federal loans, in particular, make up the single biggest type of financial aid in the U.S. After that, 20% of financial aid comes from federal grants, which include Pell Grants and other grant types; 19% is institutional grants--these are grants from colleges themselves. After that we have a grab bag of different financial-aid types, including federal tax breaks for paying tuition and for college costs, private-employer grants, state grants, nonfederal or private student loans, as well as Federal Work Study.
So, how do you get a sense of whether you're going to be eligible for financial aid? Well, first, we're talking specifically here about need-based financial aid. This is financial aid that is based on the student's financial need. If you are applying to a public college, you're going to be asked to fill out the FAFSA, which stands for the Free Application for Federal Student Aid. And the way that the financial-aid formulas work--and I'm going to be speaking here specifically about the federal formula. There is another financial-aid regimen that is used by some private colleges that's a little bit different. But for the FAFSA, what it's going to be doing is calculating what's called an "expected family contribution," and that's going to be based on a number of variables. Think of the expected family contribution as what the financial-aid formula says the family should be able to pay in terms of that year's college costs for that student.
So, how does the formula arrive at this number? It looks at a variety of different factors, including parents' income, student's income, parental assets--not including retirement, small business, or primary residence--student assets, and also the number of family members in college. Now, I spoke a little while ago about the difference between parent-owned assets and student-owned assets when it comes to financial aid. To illustrate how this difference tends to play out, let's say that you have $1,000 that you want to put in a college-savings vehicle. You're not sure if you should save it in a parent-owned vehicle or something that's considered a student-owned vehicle, such as a custodial account.
The financial-aid formula looks at that $1,000, if it's in a student-owned account, and says that 20% of that money--or, in this case, $200--should be usable to pay for college costs. If the money is held in a parent-owned account, however, that percentage is much lower. It's in the neighborhood of 5% or 6%. So, the same formula, if the money is held in a parent-owned account, will say that out of that $1,000, only about $56 is available to be used to cover the student's college expenses. Again, that's if the money is held in a parent-owned account.
Also, I want to say a word about the number of family members in college. Having more than one student in college at a time may sound like a financial nightmare to a lot of families. However, there is a need-based financial-aid benefit to this because the formula looks at the family's resources and does not expect that the same amount of resources is going to be available for each student. It sort of divides those resources in two. So, there is actually a considerable financial-aid benefit to having multiple students in school at the same time.
So, if you're wondering how you can figure out how much financial aid you or your student may be eligible for, one way to take a test run is to go to the FAFSA4caster tool at fafsa.ed.gov and input your own income and asset information as I've just described, including the number of family members in college. That will help you determine what your current expected family contribution is. Once you have that number, you can visit financial-aid calculators on various colleges' websites, input that expected family contribution number and some other information that you'll be asked, and you will get an estimate of how much financial aid your student would be eligible for if they were enrolling in the current academic year. This is not an exact science by any means. It's an estimate. It's not a guarantee that you will get financial aid, but it is a good way to sort of ballpark whether financial aid is potentially going to be available to the student when he or she does enroll.
It's also important to remember that everything I have just described is how need-based financial aid works, but there is also merit-based financial aid that is not based on financial need. In some cases, [schools] may want greater diversity, racial, ethnic, or geographical diversity [within the student body]. They may offer merit-based financial aid on top of, or instead of, need-based financial aid, and filling out the FAFSA is the way to qualify for that. So, regardless of your family's income, I always encourage people to fill out the FAFSA; you or your student may qualify for financial aid that you did not know would be available.
Next, a few words about student loans; and if you have been reading the headlines, you are more than aware of just what a big issue student loans have become in this country. It is estimated that there are well in excess of $1 trillion in outstanding student loans, and this is a big deal for a lot of recent college graduates. In fact, about seven in 10 are graduating with loans of some kind, and the average amount owed is about $30,000 per year--which is a pretty significant financial headwind for someone who is trying to establish themselves financially, hoping to maybe save up to buy a home, buy a car, maybe start a family, and certainly save for their own retirement.
Basically, there are two main loan types. There are public and private loans. Private loans are offered by banks, credit unions, and other lenders. Federal loans fall into one of four categories. There are direct subsidized and unsubsidized loans, and there are also Perkins Loans and Direct PLUS Loans that are for parents. The direct subsidized loan is need based as is the Perkins Loan. The direct unsubsidized loan is not need based.
So, what are the differences between federal and private loans? Well, there are some distinct advantages to looking at federal loans first. First, federal loans generally offer lower interest rates than private loans. Federal loans use a fixed interest rate, whereas private loans are often variable. Some federal loans are subsidized, whereas private loans are not. And income-based repayment is available with federal loans, not with private loans. Income-based repayment basically caps the amount of your loan payment that you are expected to pay as you go along.
And there is also loan forgiveness available with federal student loans. So, for example, if you are making on-time payments on your loan over a certain amount of time--let's say, over 20 years--at that point, you may have the remainder of your loan forgiven. And for those who go into public-service jobs--such as the military, police, fire, teachers in some cases--they also can qualify for even more favorable loan-forgiveness terms.
So now, you've heard all about different ways to save for the high cost of college and maybe you're wondering, "Well, after all this, is it really still worth it?" And the short answer is yes; college is still very much worth it today, despite the high costs. The chart that you see in front of you shows the median earnings of workers age 25 and older by education level in 2011, and I'll draw your attention to the line for those with just a bachelor's degree, on average, that year made $56,500; those with just a high school diploma made $35,400 as a median. So, right there is about a $21,000 per year earnings difference. But more importantly, over the long term, it's estimated that those with a bachelor's degree will out-earn their counterparts with just a high school diploma by at least $1 million. So, there are some pretty clear long-term economic advantages to getting a college degree, even if the upfront costs can be rather high.
It's also important to remember that while a college degree has clear long-term value, the price you pay for that degree can vary greatly. Going to the most expensive school that will accept you or your student may not necessarily be the wisest financial move, and going to a less expensive public or private college may accomplish the same goals at a more affordable price that doesn't put a financial strain on your family.
Also, remember to think long term. If the student may want or need to attend graduate school one day, then overpaying for a bachelor's degree may not make good financial sense. The important thing is to be a savvy college consumer and planner. Hopefully, the information that you've heard here today can help you along that road.
For Morningstar, I'm Adam Zoll. Thanks for watching.