Poor timing of 529 withdrawals can cancel tax benefits

529 funds must be withdrawn and used within the same year that expenses are incurred to preserve tax benefits.

Question: My daughter’s college is offering a discount if you prepay in year one for all four years. Can we use 529 funds to pay all of her tuition up front even though she’ll still be in school for another few years?

Answer: In general, 529 distributions must be used to cover qualified college expenses incurred in the same tax year in which the distribution is made; otherwise, taxes and a penalty apply. The scenario you describe falls into something of a gray area given that you would be using 529 assets to pay for tuition–a qualified expense–but paying for services to be provided not only during the current tax year but in future tax years as well.

Such a scenario isn’t specifically addressed in the IRS rules governing 529 expenditures, but Mark Kantrowitz, publisher of the college-planning siteEdvisors.com, says the way the rules are written suggests that it is not just when qualified expenses are paid that matters but when those expenses are incurred. “In general, the IRS interprets tax law as applying to income and expenses during the tax year except if explicitly stated otherwise,” Kantrowitz says.

The bottom line is you’d be wise to consult a tax professional before prepaying all four years. Even if he or she recommends only counting the current year’s tuition payment as a qualified expense, you could still pay all four years at once to take advantage of the discount. Just keep in mind that if doing so requires using additional 529 funds, you may end up owing taxes on the earnings portion of any nonqualified distributions plus a 10% penalty, and those costs could eat into–or erode entirely–the prepayment discount.

Morningstar offers more advice about avoiding the pitfalls in timing your 529 withdrawals.

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Adam Zoll, “529 Owners, You Must Remember This”, Morningstar, February 3, 2015.

How the ‘middle class’ saved 529 plans

Why did President Obama do such a quick about-face on 529 plans, first proposing to eliminate them and then a few days later dropping that proposal?  Although it was widely believed that this initiative had zero chance of getting through Congress, it appears Obama’s actions were due to the efforts of the elusive “middle class”.

Several news sources have pointed out how poorly this proposal polled, notably with Democratic voters.  It seems the administration could have predicted this reaction, but apparently they were blindsided.  Obama’s proposal would have penalized wealthy families the most, since 70% of 529 “tax benefits go to households earning more than $200,000”.  As such, “middle class” families would not be seriously hurt by this change.  But here’s the rub.  The vast majority of Americans consider themselves middle class, including many with household incomes well into the six-figure range.

Don’t tax me, tax that rich guy over there.

The first rule of modern tax policy is raise taxes only on the rich. The second rule is that your family isn’t rich, even if you make a lot of money.

President Obama’s State of the Union proposal to end the tax benefits for college savings accounts ran afoul of these rules, which is why he abandoned it, under intense pressure from both political parties, within a week.

Tax-free college savings accounts, like the mortgage interest deduction and the state and local tax deduction, principally benefit people who range from affluent to wealthy. In pushing its proposal, the White House pointed to Federal Reserve data showing that 70 percent of balances in the college accounts were held by families making at least $200,000 a year. In theory, tax reform is supposed to be built around cutting back preferences like these, in order to pay for some combination of lower tax rates and tax preferences aimed at people with lower incomes.

Politicians have met with strong resistance to increasing taxes on the “merely affluent”.

But in practice, politicians from both parties have made a point of holding the group you might call the “merely affluent” harmless from tax increases. If you make $150,000 to $225,000, you make about two to three times the national median income for a married couple. The list of occupations that can get you into this income bracket — government official, academic, lobbyist, journalist — can sometimes make it hard for people in political circles to remember that 92 percent of American married couples make less than $200,000 a year.

A lot of people in this category don’t think of themselves as rich, and they benefit from tax provisions like college savings accounts.

So how can politicians raise more tax revenue?  It’s a challenge.

… If you can’t go after tax provisions for the merely affluent, you are exempting almost everyone from tax increases. And if you can’t broaden the tax base, then you are very limited in how much you can finance tax reform.

Where else can they find the money?

Raising taxes on the very rich won’t raise enough revenue to balance the budget, and the bottom 50% of income earners — who only pay about 2% of all federal taxes — are not a likely source.

Peter Suderman of Reason believes the 529 debacle shows that the “existing welfare state is unaffordable”.  On the other hand, Reihan Salam of Slate laments that the upper middle class is ruining all that is great about America.  In essence, both may be saying the same thing.  It’s hard to finance expansive government programs because “eventually you run out of other people’s money”.

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Josh Barro, “A ‘Rich’ Person Is Someone Who Makes 50 Percent More Than You”, New York Times, January 29, 2015.

Completing the FAFSA

Students and parents often find the Free Application for Federal Student Aid (FAFSA) to be a little intimidating. The form asks more than 100 questions about family finances and demographic details. The FAFSA is slightly more complicated than the typical federal income tax return. Officially, the form should take less than an hour to complete, but most parents don’t have advanced degrees in economics. Some parents want help completing the FAFSA, because they worry that making a mistake on the FAFSA will affect their ability to pay for college, ruining their child’s life forever.

Don’t panic! Take a deep breath. Relax.

Edvisors offers an online Step-by-Step FAFSA Tutorial

… This step-by-step guide provides a tutorial overview of completing the Free Application for Federal Student Aid (FAFSA). It is based on the bestselling book, Filing the FAFSA.

The book is available for free download at the link.

The Federal Reserve Bank of St. Louis offers a video that guides you through completing the FAFSA.

FAFSA 101
Take a stroll through each screen of the online FAFSA to see what information you’ll need on hand to complete the application quickly and accurately.

Choice of major is likely to be biggest determinant of student loan burden

The Undergraduate Student Loan Calculator offered by the Hamilton Project allows you to illustrate what percentage of your future earnings are likely to go toward paying off your student loan.  Among other variables, you can select your major course of study.

Here’s an illustration comparing a petroleum engineering major with an ethnic studies major, showing a dramatic difference in outcomes, particularly in the first year after graduation.

 

The ethnic studies major starts out paying almost 26% of his earnings toward his student loans.

Year One:
Petroleum Engineer      Monthly Income: $3,816   Monthly Loan Payment: $277
Ethnic Studies              Monthly Income: $1,073   Monthly Loan Payment: $277

Income is based on the median earnings for that major.  The loan assumptions are based on average student debt of $26,500 as of 2012 and current federal student loan interest rate of 4.66%.

Run your own illustrations at the Hamilton Project site.

What to do if you have not saved up for college

Middle- and upper-income families who have not saved for college, and who cannot pay tuition from current income, will likely be taking out loans to finance their children’s higher education.

You are probably not going to get rewarded for having saved nothing. Everyone seems to know a family in their area with a big house, fancy passport stamps and no savings with a child who nevertheless got an amazing financial aid package from a top school. Don’t believe the stories. The details of financial aid are so complex that many families don’t understand their own packages, or the rumormongers transmit the details incorrectly. Income tends to matter in financial aid more than assets and savings, especially at public universities.

Grants typically pay only a relatively small part of the costs, except for the most selective colleges where money flows freely for everyone but the rich.

THE COLLEGES Most families with no savings will be hoping that at least some colleges they apply to will offer large grants and ask them to borrow less money than others. But popular, highly ranked schools tend to have a lot of applicants. Even if you do get in, many of them may not offer outsize rewards or be flexible if you appeal for more money once you get in. Apply and cross your fingers, but don’t count on generosity here unless the school is particularly well endowed.

Here’s a way to start.

THE DATA For families with little or nothing saved, the process has to begin with a crash course in how colleges make decisions about financial aid. First, you’ll want to use the calculator on the College Board’s website that estimates your expected family contribution, the number that the federal government will use in figuring out how much federal aid you are eligible for once you fill out the Fafsa (Free Application for Federal Student Aid) form later in a child’s senior year in high school. Colleges will also use this number, with additional tweaks in some cases, as a baseline for what you can pay each year, though it’s no guarantee that they’ll make up the difference with grants or work-study jobs and not a link to a bunch of loan applications.

There’s more information at the link below for families who face college without savings.  And check out this additional advice for parents of high schoolers facing the high cost of college.

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Ron Liebera, “College Financial Aid Guide for Families Who Have Saved Nothing”, New York Times, Oct. 17, 2014.hing.html?_r=0

What’s the hardest part about applying to college?

No surprise here.  Students think the standardized tests are the hardest part about applying for college, but parents seem more focused on the challenge of paying for college.

 

 

Other survey results can be found at “College by the Numbers, A Statistical Look at College Costs, Financial Aid and More”.

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Christina Lourosa-Richardo, “College by the Numbers”, Wall Street Journal, Sept. 21, 2014.

Is in-state college tuition a “handout to the rich”?

Affluent families benefit the most from taxpayer subsidies that lower tuition for in-state residents.

States across the country subsidize higher education for their residents by paying the difference between in-state tuition rates and what a college education really costs. This is so much a part of the American fabric that few stop to think about its regressive aspect.

“We are subsidizing affluent people,” says Sandy Baum, an expert on higher education finance and a senior fellow at the nonprofit Urban Institute. “Young people from affluent families are much more likely to go to college, and more likely to go to four-year colleges, and more likely to go to the flagship colleges.”

In Maryland, “the state appropriates $19,000 for each Maryland student to help pay for their education”.  Wallace Loh, president of the University of Maryland at College Park, questions the fairness of this policy.

“… We have a model of low tuition and low aid. So the state is subsidizing those who can easily pay higher.”…

“Should we do a little more redistribution in order to make this opportunity available to all people, which is the great equalizer in a democracy?” he asked.

This perspective is unusual, and it’s doubtful that any attempts to redistribute funds away from high-income taxpayers paying college tuition will gain much traction.  Many probably believe they subsidize other residents too much as it is.  But this generous subsidy should be understood for what it is, and could be considered in the same light as other tax benefits that disproportionately benefit wealthy individuals.

The subsidy for the rich hidden within in-state tuition mirrors other entitlements that are defended by both parties as lifelines for the struggling middle class. Billions of dollars in tax deductions for mortgages, charitable giving and state and local taxes, for example, go to the wealthy, and people from President Obama to conservative economist Martin Feldstein have proposed targeting those more sensibly. Congress hasn’t wanted to touch them, either.

Could it be that Congress doesn’t want to touch them because it would mean losing the currency politicians use to stay in power?

By the way, it should be noted that some tax deductions for the rich have been targeted by Congress.  For example, the Alternative Minimum Tax and the “Pease Limitation” significantly reduce mortgage tax deductions for high-income taxpayers.

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Fred Hiatt,  “In-state college tuition: A handout to the rich”, Washington Post, November 2, 2014.

Student debt doubled for high-income families

Borrowing for college among high-income families increased from 24% to 50% over the last twenty years.  Similar increases occurred among middle-income families.

… A new Pew Research Center analysis of recently released government data finds that the increase in the rate of borrowing over the past two decades has been much greater among graduates from more affluent families than among those from low-income families. Fully half of the 2012 graduates from high-income families borrowed money for college, double the share that borrowed in 1992-93.1.

 

These numbers show how college affordability is no longer just an issue for low-income families, but now affects families across the income spectrum.

What has changed over the course of roughly two decades then is the pervasiveness of student borrowing across income groups: In the early ’90s, only among graduates from low-income families did a majority of graduates finish college with student debt. Now, solid majorities of graduates from middle-income families (both lower-middle and upper-middle) finish with debt, and half of students from the most affluent quartile of families do the same.

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Richard Fry, “The Changing Profile of Student Borrowers”, Pew Research, October 7, 2014.

Colleges want students who ‘can pay full price’

Here’s a sobering reminder for students working on their college applications now.  It’s number 8 on the list of “10 things the college admissions office won’t tell you”.

We’d rather admit someone who can pay full price

All other things being equal, a full pay student often has a better chance of admission than a student who needs financial aid.

According to the College Board, 10% of college freshmen in 2013 were foreign students. One reason colleges woo these international scholars: Many are wealthy enough to pay the full price of tuition.

At publicly funded state universities, higher tuition for out-of-state students often helps subsidize education for state residents. For example, for an undergraduate at the University of California at Berkeley, in-state tuition is about $13,000 a year; for an out-of-state or foreign student, tuition is about $36,000 a year.

Full pay can be an admissions boost for marginal students.

The interest in full-pay students is so strong that 10 percent of four-year colleges report that the full-pay students they are admitting have lower grades and test scores than do other admitted applicants.

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Daniel Goldstein, “10 things the college admissions office won’t tell you”, MarketWatch, Oct 4, 2014.

Getting a college degree doesn’t seem as important as it used to be

Amid a national debate about the worth of a college education, a respected annual poll about the education views held by Americans has found that only 44 percent of Americans now believe that getting a college education is “very important” — down from 75 percent four years ago.

…. Similarly, in 2010, 77% of parents said it was somewhat or very likely that they would be able to pay for college for their oldest child. That percentage declined to 69% this year.

…
Interestingly, confidence in being able to pay for college dropped down to the same level seen in 1995 after rising in 2010.

I will be on the lookout for an update to the 2011 Pew Research survey that found 80% of parents believed paying for their child’s education is an extremely important (35%) or very important (45%) goal.

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Valerie Strauss, “Poll: Most Americans no longer think a college education is ‘very important’”, Washington Post, September 16, 2014.