Introduction

Are you prepared to pay the cost of a college education for yourself or a family member? If graduate or professional school follows, can you afford those costs as well? How will you meet the expense -- through current income, savings, student loans or grants?

This topic reviews various ways to finance the cost of a college education. At the top of each screen appears the subtopics where you can click to learn more about each option.

One thing is certain: If you have the time, you should . . . PLAN, SAVE, and INVEST.

There is no "right" way to fund an education. How you choose to pay for school will depend on your financial situation and personal goals and the number of years before the costs will be incurred.

Unless you are one of the fortunate few to benefit from a full scholarship, you will generally be expected to use your personal assets to pay some or all of the costs. Generally, the personal assets of the student and parents will affect the student's qualification for federal and state grants and loans.

Pay As You Go

The "pay-as-you-go" option to college funding is to pay for college as and when the need arises without advanced planning. While some families can afford this approach, most cannot. A part-time job can help the student defray some costs, but may not cover everything. A full-time job is usually not the answer because of the strain on the student's time -- perhaps keeping the student from participating in athletic or extracurricular activities. Practically speaking, the "pay-as-you-go" approach may leave you short of funds when you need them most.

Even if you are comfortable with this option because you have enough funds to pay for college, it may pay to look at the long-range planning opportunities for college funding. For example, parents may obtain certain tax advantages (both estate and income tax) from making gifts to college-bound kids.

Also, state and federal legislation has created tax benefits for certain kinds of investments in order to encourage saving for college. These benefits, combined with the power of long-term compounding of earnings from investments, make long-range planning highly desirable.

Gifts

A popular method of saving for a child's education is to make periodic gifts. Gifts can take many forms, including bank certificates of deposit, savings bonds, custodial accounts with brokerage firms and trust accounts.

Before making a gift, parents should learn about how to set up a child's account and inquire about the types of investments which are most appropriate.

There are limits on how much a parent can give to a child without incurring a gift tax liability. The federal tax rules provide that each person may make gifts of up to $10,000 per recipient, in any calendar year without incurring gift tax liability. This is referred to as the "annual exclusion" amount. No gift tax return needs to be filed in order to take advantage of the annual exclusion. Gifts are not deductible on the donor's income tax return and are not taxable to the recipient.

Gifts to a child offer several potential advantages.

Estate tax savings.  An estate tax advantage may be obtained by making a gift because the gift reduces the size of the donor's estate. While this benefit does not occur until the death of the donor, and even then only if his or her estate is taxable, the potential benefit is significant. For example, a $10,000 gift by an individual whose estate is taxed in the 55% estate tax bracket will save $5,500 in estate taxes.

Income tax savings.  An income tax advantage may result from transferring income-earning assets from a parent's portfolio to a child's education account. The income tax savings result from the fact that the parent's income tax rate is higher than the rate on the child's income. (However, be aware of the "Kiddie tax" rules.)

Two parents together may effectively transfer up to $20,000 per year to a child, but a caution should be noted. In certain situations, a gift tax return may have to be filed.

For example, suppose that a payment is made by a father from a brokerage account for a child's purchase of a car and the amount of the gift is $15,000. Technically, this gift is in excess of the annual exclusion amount and would have to be reported on a gift tax return. However, if the father and mother desire to treat the gift as having come from both of them (even though the check was written from the father's brokerage account), they may elect to "split the gift" by filing a gift tax return and claiming their separate annual exclusions.

An important exception to the federal gift tax rules relates specifically to tuition expenses. Any person may pay another person's tuition payments (part-time or full-time student), and the payment will be completely disregarded for purposes of the gift tax rules. The payment must be made directly to a qualifying educational organization and not directly to the student. This exclusion does not apply to payments for books, supplies, room or board.

Borrowing

Many people need to borrow money to pay for school. Apart from federal student loan programs (which are discussed later), common methods of borrowing include:

Personal Loans.  A personal loan for educational purposes, whether taken out by a parent or a student, does not necessarily have to be a secured loan. An unsecured loan is one in which no specific collateral is security for repayment. A secured loan is one with collateral such as a home, car, stocks or bonds.

Home Equity Loans.  While federal programs are desirable because of low interest rates and repayment terms, the interest on an education loan (even if under a federal program) is not deductible for income tax purposes. A deductible alternative might be a home equity loan. If all the requirements are met (primarily that the home is the principal residence and the loan is secured by the residence), the interest on up to $100,000 of a home equity loan is deductible for income tax purposes.

Qualified Plan Loans.  If the plan permits, a loan from a qualified plan (like a Keogh account) may have a lower interest rate. Plus, you're effectively paying interest to yourself as the owner of the plan. However, the interest on such loans is not deductible, the amount available for borrowing is usually limited by the terms of the plan, and any loan must be repaid within 5 years.

Most borrowing for education is expensive. In addition, given the current climate surrounding government sponsored programs, reliance on the availability of federal loan programs is risky. Other sources of funding should be sought as well.

Government

The U.S. Department of Education sponsors several types of educational aid programs. These programs require that the student have a high school diploma or GED, be a U.S. citizen, and be enrolled at least "half-time" in an eligible program. There are three classes of federal programs:

• Loans
• Grants
• Work-Study Programs

All of these programs can be applied for with the Free Application for Federal Student Aid (FAFSA) form by May 2 of each year before to the beginning of the school term. Click here to go to a list of the addresses and numbers of each state education agency.

An important consideration with many of the federal educational aid programs is that they are generally need based. Several non-need based loan programs are mentioned later in this program.

The following is an outline of how to determine need for purposes of federal educational loans and grants. If you would like to skip this section, press here.

Step 1: Determine the Cost of Attendance

Cost of Attendance. The cost of attendance is the total amount it will cost a student to go to college expressed as a yearly figure. It is based on a formula established by the U.S. Congress and includes: tuition and fees, room and board, allowances for books and supplies, dependent care expenses, costs related to disabilities and other costs. Click here for a Sample University of Cincinnati Budget.

The Cost of Attendance (COA) is a term of art used in the Federal Student Guide as a measure of education costs based upon the direct and indirect costs of school. Some parts of the formula are based upon the school's expenses, like tuition, and other parts are not. So, the COA differs from school to school.

Step 2: Use the Expected Family Contribution to Determine Need

The student's resources as well as family resources are considered in determining how much is expected from them. The combined resources and income are used in a federal formula to determine how much is expected from the family. If the "expected family contribution" (EFC) is below a certain amount, you may be eligible for a Federal Pell Grant.

The federal Pell Grant program is available to undergraduates only and is dependent upon enrollment status. The maximum amount available is $2,300 per year (as of 6/30/95). In addition, a student is not eligible unless the "Expected Family Contribution" as defined by federal formulas is $2,100 or less.

If the EFC is less than the Cost of Attendance, the remaining amount is the "Financial Need."

Step 3: Subtract Grants From Financial Need

If the combination of a Pell Grant and/or State Grant is not sufficient to cover all of the costs, there will be a "remaining need" to plan for. Please remember, too, that the federal formula may not precisely reflect your personal financial situation, so your actual remaining need may be higher or lower as a result.

Step 4: Subtract Loans and Other Grants to Compute any Unmet Need

The "remaining need" after a Pell Grant or State Grant is typically covered by a combination of Supplemental Education Opportunity Grants (SEOG), loans or work-study arrangements. The unmet need after considering these programs must be met by other sources of funding.

The following chart summarizes the eligibility requirements, terms and conditions of the available federal loans:

Campus

"Campus-based programs" include programs approved by the school as well as the federal work-study program and certain federal loan programs. These programs are called "campus-based" because they are administered directly by the financial aid office at the participating school. Not every school participates in every program. These campus-based federal programs are:

• Federal Supplemental Educational Opportunity Grants (SEOG)
• Federal Work Study (FWS)
• Federal Perkins Loan Program

The actual amount of aid available under these programs will depend on need, other aid received, and availability of funds at the school. The school is the lender and sets the application deadlines.

The following chart summarizes the principal eligibility requirements, the annual maximum benefits, and the repayment terms of these three federal programs.

Scholarships

The programs previously discussed are not the only sources of aid. You should also investigate the many scholarships and grants that are available from other sources. Places to contact include:

• Your employer
• School financial aid administrator
• State higher education agencies
• Foundations, community organizations
• Specialty, organizations (e.g., AMA, ABA)

• Veterans educational benefits

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