Making Financial Aid Pay Off (Part One)

On May 22, Fastweb celebrated its 15th anniversary since first bringing scholarships to the internet in 1995.  Since its founding, Fastweb has helped over 50 million students pay for school, and today there are more than 9 million active members.

To celebrate this milestone, we sat down with Mark Kantrowitz, publisher of Fastweb, to answer the top questions parents and students need to know about planning and paying for college (first in a series):

Q: Should parents dip into their 401(k) retirement savings to help fund college?

Parents should not take distributions from their retirement plans to pay for college. The net financial benefit is minimal. There are better ways to save for college that don’t sacrifice retirement savings.

Parents may make a hardship withdrawal from their 401(k) plans to pay for college costs. However, the withdrawals will be subject to federal income tax plus a 10% tax penalty. (A hardship withdrawal from an IRA to pay for education is not assessed the 10% tax penalty, but is still subject to federal income tax.) In addition, distributions from a retirement plan will be included in adjusted gross income on the next year’s financial aid applications, reducing eligibility for need-based financial aid. Depending on your tax bracket, you may end up netting as little as 18 cents on the dollar.

Another option is to take a loan from your 401(k). However, this loan must be repaid within five years. If you lose your job, the loan may need to be repaid immediately. While you will effectively be paying the interest to yourself, that merely substitutes for the money you could have earned had your money remained invested in the 401(k). In contrast, the Federal PLUS loan has an interest rate of 7.9% with a 10-year repayment term, and repayment can be deferred while the student is in school and for six months after graduation.

Q: Is it too late to begin a 529 college savings plan once your child is heading off to college?

As parents, your greatest asset is time. The sooner you start saving for college, the more time you’ll have for your investment to grow. For example, if you start saving at birth in an account that earns 5% interest on average, more than a third of your savings goal will come from interest. If you wait until your child enters high school to start saving, less than a tenth of your savings goal will come from interest.

However, you should start saving as soon as you can, since that will help you spread the cost of college over a longer period of time. It is also literally cheaper to save than to borrow. If you save $200 a month for 10 years at 6.8% interest, you’ll accumulate about $34,400. If you borrow this amount at 6.8% interest, you’ll pay $396 a month for 10 years. The difference is that when you save, you receive the interest, but when you borrow, you pay the interest.

If you live in one of the 32 states that offers a state income tax deduction for all or part of your contributions to the state’s 529 college savings plan, there can be a valuable short-term financial benefit to savings. The deduction is like getting a discount on your college tuition bill at your marginal state income tax rate. State income tax rates range from 3% to 10%, so this can be a worthwhile discount. However, some states require you to keep the money in the 529 college savings plan for at least one year before taking a distribution in order to qualify for the state income tax deduction (e.g., the deduction is based on contributions net of distributions within the tax year).

Q: What advice do you have for parents whose 529 college savings plans took massive hits due to the downturn in the economy over the past two years?

During any 17-year period, the stock market will drop significantly at least 2-3 times. This is why families should use age-based asset allocation schemes within the 529 college savings plans, so that the 529 plan shifts to a less risky mix of investments as the savings grows and college approaches. The 529 plan should bottom out at no more than 20% in aggressive investments like stocks the year before the child enrolls in college.

After a big drop in the value of your investments, you should remain invested. If you pull the money out, you will lock in the losses and miss out on the recovery. You should also continue to contribute to the college savings plan regularly, as dollar-cost averaging works well when the stock market is volatile. In fact, after a big loss you should increase your monthly contribution to compensate for the loss.

Parents whose children are college freshmen and sophomores may wish to delay taking a distribution by a year or two, if possible, to allow the 529 plan time to recover. Unfortunately, current law does not let you use a 529 plan distribution to pay down student loans. But you’ll be able to use the loans to qualify for the Hope Scholarship tax credit of up to $2,500.

To be continued…

Listen to Mark Kantrowitz discuss what parents and students need to know about finding scholarships online and making financial aid pay off

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