Here are three financial-aid friendly strategies for preparing to meet future college expenses. The longer you have until the child goes to college, the better these will work, as long as Congress does not change the treatment of these assets in the federal financial aid formula. The strategies can be combined if more than one fits your needs.
* Fatten retirement savings first.
It might not appear that way at first glance, but focusing your efforts on saving for retirement instead of saving for college can be a smart move. The key is that you need to save a lot; setting aside a couple thousand dollars a year will not do.
Contribute as much as you can to individual retirement accounts and to employer-sponsored plans such as 401(k)s while your child is growing up. Then, the year before the child goes off to college, stop all contributions and redirect the money toward college expenses until graduation day arrives.
Retirement savings also get the best possible treatment from the financial aid standpoint. Retirement plan and IRA assets are not considered in determining your family's expected contribution. However, any pre-tax contributions you make to the accounts during the years you apply for financial aid will be added back into your income.
How much can you contribute? This year the law allows a contribution of up to $12,000 to a 401(k) and $3,000 to an IRA (more if you are 50 or older).
Of course you do not want to put every dime in retirement accounts. Make sure you keep some cash accessible to cover emergencies and pay college expenses.
In a real pinch, you might be able to borrow from your 401(k) plan or withdraw money penalty-free from an IRA to pay college expenses. However, IRA and other retirement plan withdrawals are considered income on financial aid forms and you will owe income taxes on most, if not all, the money. If you must take a withdrawal, wait until your child's senior year in college, when you are finished filling out financial aid forms.
* Pay down your mortgage
Paying down principal on your mortgage or paying off other debt increases your net worth just as readily as stashing the same amount of money in savings. How does this help for college? You build up your borrowing power.
The difference between the value of your home and the amount you owe on your mortgage is your equity. As your equity grows, you have the ability to take out a larger home-equity loan or credit line, which you could tap to pay college expenses. As a bonus, interest on a home equity loan of up to $100,000 is deductible on your income tax.
The federal financial aid formula ignores the value of home equity. Private colleges that use the "institutional methodology" for handing out financial aid consider it an asset, but vary in how they treat it.
One way to whittle down a mortgage is with a regular principal repayment program. Simply send in an extra check with a note asking that it be applied to principal, or call the mortgage company and ask about its preferred procedures.
While few families are able to pay off their mortgages by the time their children enter college, it may be possible to pay off other debt, such as car loans and credit cards. Eliminating one or more payments frees money to pay college expenses or to make payments on a home equity loan or a student or parent loan.
* Open a 529 college savings plan
Congress might have labeled the plans the "grandparents' college plan" because they offer a way to remove substantial assets from an estate without giving up control. The plans' investment earnings are tax-free if the money is withdrawn to pay college expenses. Income tax and a 10 percent penalty apply if money is withdrawn for other uses.
Most states now offer at least one version of a 529 plan and most plans are open to residents of any state. Florida launched the Florida College Investment Plan last year as an adjunct to the popular Florida Prepaid College Plan. The investment plan permits contributions of up to $283,000 per child and grows or shrinks with the performance of the investment accounts selected.
For financial aid forms, treat a 529 savings plan as an asset of the owner - the grandparent or parent who opened the account. As a parent's asset, no more than 5.65 percent of its value would be considered available for college expenses. As a grandparent's asset, it would not be counted at all. Prepaid tuition plans are classified as resources available to pay college expenses, which means withdrawals reduce financial aid dollar-for-dollar.
One drawback of 529 plans is that their future is uncertain. As with some other tax breaks, the ability to take tax-free withdrawals from 529 plans expires at the end of 2010 unless Congress chooses to extend it.
