As the cost of college continues to rise, it’s little wonder that parents view their ability to pay college costs with some apprehension. Yet, in all but the most affluent families, paying for college does not involve a 100 percent out-of-pocket contribution from parents. Rather, the average family uses a combination of strategies to pay higher education costs–savings, financial aid, education tax credits, out-of-pocket contributions, and other creative solutions.
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Hopefully, you’re one of the parents who have been saving money for their child’s college education on a regular basis. If so, now’s the time to use those funds. But in many cases, this won’t be enough to cover all the bills.
The majority of college-bound students qualify for some type of need-based financial aid (as opposed to merit-based financial aid like athletic scholarships), and this can supplement your savings. The largest provider of need-based financial aid is the federal government, followed by colleges.
Need-based financial aid consists of loans, grants, scholarships, and work-study jobs. Loans eventually need to be repaid by you or your child, while scholarships and grants do not. Work-study jobs are paid jobs performed by students and are subsidized by the federal government or the individual college.
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Every college that accepts a student will try to create a financial aid package for that student. Typically, loans make up the biggest portion of any financial aid package (approximately 60 percent), though the exact percentage will vary by student. Most students take out at least some student loans, which lessen the financial burden on their parents.
All students should apply for federal financial aid, even if they’re not sure they’ll qualify, because eligibility criteria may change slightly from year to year and filing the federal government’s aid application (called the FAFSA) is often a prerequisite for obtaining other types of aid, such as college aid.
After you become savvy about the financial aid process, you can learn about legitimate steps to take to position your income and assets in a way that maximizes your child’s ability to obtain financial aid. Though it’s best to become familiar with these steps while your child is still in high school (allowing time to implement them), you can also take advantage of these suggestions while your child is in college because financial aid must be reapplied for every year.
One final note: Graduate students may not have the same breadth of financial aid programs available to them, or, conversely, they may have certain programs available to them that are not available to undergraduates. For example, the federal government’s grant programs are limited to undergraduates, but universities may offer special grant programs to graduate students that are not available to undergraduates.
Education tax credits and deductions
There are several education tax credits and deductions that can help families weather college costs–the Hope credit, the Lifetime Learning credit, the deduction for qualified higher education costs, and later, the student loan interest deduction. As a general rule, a tax credit is more favorable than a deduction because it results in a dollar-for-dollar reduction of taxes owed.
The Hope credit is worth up to $1,650 in 2006 ($1,500 in 2005) per student per year for the first and second years of a child’s undergraduate college education. The Lifetime Learning credit is worth up to $2,000 in 2006 per tax return (regardless of the number of family members who qualify) per year for undergraduate or graduate courses taken throughout a student’s lifetime. The catch is that the credits are mutually exclusive; that is, they cannot both be taken in the same year for the same individual. In 2006, a full tax credit (either Hope or Lifetime Learning) is available to single filers with a modified adjusted gross income (MAGI) below $45,000 ($43,000 in 2005) and joint filers with a MAGI below $90,000 ($87,000 in 2005). A partial credit is available to single filers with a MAGI between $45,000 and $55,000 ($43,000 and $53,000 in 2005) and joint filers with a MAGI between $90,000 and $110,000 ($87,000 to $107,000 in 2005).
In addition, for tax year 2005, a deduction for higher education costs is available to qualifying individuals. Individuals with an adjusted gross income (AGI) of $65,000 or less ($130,000 for married couples filing jointly) can take a deduction up to $4,000 in 2005. A maximum deduction of $2,000 is available for single filers with an AGI between $65,000 and $80,000, and for married couples filing jointly with an AGI between $130,000 and $160,000.
Unfortunately, the deduction cannot be claimed if the Hope credit or Lifetime Learning credit is taken for the same student for the same year. Also, the deduction cannot be taken for the same education expenses that were paid with a tax-free distribution from a Coverdell education savings account (formerly known as an education IRA) or a qualified tuition plan (commonly known as a 529 plan).
Finally, when it’s time for your child to repay student loans, he or she may be eligible for the student loan interest deduction, which allows an individual to deduct from gross income a portion of the interest paid on a student loan during the year. The maximum deduction in 2006 is $2,500.
Your child is eligible for financial aid, she has chosen an accelerated program that allows her to graduate in three years, and you will qualify for the Hope credit during her freshman year. But even with these cost-cutting measures, many parents will need to pay a portion of the college or graduate school bill (sometimes a substantial portion) from their own pocket.
The way you pay the bill from your own pocket can range from the simple to the complex. It may mean tapping funds from any number of sources–your current weekly paycheck, your savings and investments, your IRA or employer retirement plan, your home equity, other loan sources such as banks or brokerage houses, or other assets such as cash value life insurance. The commonality is that the money comes from you and is a drain on your financial net worth.
An important reminder: Paying for college out of pocket can conflict with other important financial goals, most notably saving for your retirement. You shouldn’t satisfy the former at the expense of the latter.
Other creative financial solutions to pay for college
Finally, there are other creative ways for parents to lower their college costs by lowering the actual cost of school. For example, a student could choose an accelerated program and graduate in three years instead of four; a cooperative education where education is interspersed with paid internships; or a live-at-home arrangement where money is saved on room-and-board costs. Use our budgeting calculator at the top of this page.