A Short Story
While meeting with Tom and Kathy during a recent meeting, we discussed their four children. Their oldest son, Royce, is in college and preparing for medical school. The second oldest daughter, Katie, is about to go to college at Central Michigan University this coming fall. Their third oldest child, Tom, is a freshman in high school. Their fourth oldest child, Nick, is in eighth grade.
Tom opened the conversation with some real anxiety, "We just finished paying for two years of college for Royce and it was much more expensive than we thought! Originally, he planned to attend Michigan State University, and the Pre-Med program with housing was supposed to cost $32,000.00 per year. By the time we finished paying all the extra fees, books, and paying for his car, car repairs, insurance, and so on, we probably ended up spending approximately $40,000.00 per year! We can't afford to do this for our next three children. Heck, we're not even sure we can finish paying for Royce's Pre-Med undergrad costs."
Kathy piped in, "Frank, I'm concerned that if we even try to help pay half of our kids undergrad college costs, and even if some of them go to community college, this is going to cause us to stop putting money into our 401(k) plans for the foreseeable future, and we'll even have to spend some of the mutual funds and stock accounts we set aside for our own retirement. Does this mean we're going to have to work until we're 80 years old, just to help the kids with college education costs and to retire at a sufficient income level? I'm really concerned about this!"
It was time for me to speak, "Tom and Kathy, when we talked about college education funding for Royce, Katie, Tom, and Nick, we didn't really establish a plan of action for limiting your out-of-pocket expenses, nor did we discuss in depth how this was going to impact your other planning, especially for retirement. It's time we do this now, better late than never. Tom and Kathy, let's first begin with a quick summary of how much you think it will cost to put the four kids through college, assuming they go to a Michigan, mid-range cost, university.
Kathy said, "Let's use Michigan State University tuition and housing prices, as this is more than Central Michigan University or a community college, but certainly less than the University of Michigan. If one or two of the children go to the University of Michigan, and one or two go to a community college or a lower cost university such as Michigan State University, it may all even out. How about we set our sights on $25,000 a year, and with the extra cost the kids will incur for living, transportation, etc., let's assume $30,000 per year."
"Okay," I said, "in today's dollars, you're looking at $120,000 per child in total costs, or $480,000 for all four, assuming they all went to college today. Are you willing to pay $480,000 out of your pocket, even if it's spread over 8 to 12 years?"
Tom said, "Heck no! There's no way we can afford to pay that without liquidating everything we have, including our retirement plans and mortgaging our home to the hilt. We've got to come up with a number we'll be comfortable with."
"Ok. How much have you already set aside for each child in college education savings plans, mutual funds, or other accounts?"
Kathy said, "Royce's accounts have already been spent. We set aside approximately $40,000 and blew through this in two years, and paid the rest out of our pockets. Katie has approximately $30,000 in her accounts, Tom has $23,000, and Nick has approximately $17,000. At this time, we're not making deposits into the college savings plans, but the grandparents are depositing approximately $2,000 per year per child, even for Royce."
"All right, how much discretionary cash flow do you have per year that you could allocate for college education costs right now?"
Tom said, "We figure that if we want to continue funding our 401(k) plans at the maximum limit of $17,500 each, we'll have approximately $12,000 per year of discretionary cash flow that we can use for college education costs."
"All right, it seems to me that between what you have on hand for each of the kids, other than Royce, and the discretionary cash flow you have, we could chart this out, and it also seems that you can cover 1/3 to 1/2 of the current costs of college for each child. Would you agree?"
Tom and Kathy said, "Yes, we agree. But Frank, we haven't really talked about the impact of taxes. At this time, if we liquidate accounts for the kids, other than the college savings plans, we'll have to pay capital gains or ordinary income taxes on the profits. Furthermore, the discretionary cash flow we have to pay towards college is out of our own pocket, after income taxes. Frank, you told us that in our tax bracket, we need to earn almost $18,000 of gross income before taxes just to net $10,000 after taxes. That means our tax costs on $12,000 of discretionary cash flow is approximately $10,000, right? That's pretty scary."
I replied, "You're right. Let's come up with a plan of action to mitigate the tax costs. But first, let's help you come to a conclusion as to how much of the college costs you'll pay. Base on what we just discussed, what do you think?"
Tom said, "We believe that we could fund 1/3 of each of their college education costs, assuming $40,000 per year in today's dollars, and assuming that we'll use existing college education accounts toward our share. But what does this mean to the kids? Will they end up with a boatload of student loans in order to make this work?"
"Tom and Kathy, how about a plan of action where you help the kids with approximately 1/2 of their college education costs, and perhaps they'll end up with student loans for approximately 1/4 of their college education costs, assuming they can work to earn the remaining 1/4? Does that sound reasonable?"
They reply, That sounds like something we can live with. Frank, can we do this and still continue to fund our 401(k)'s and Whole Life insurance policies without having to decrease contributions?"
I said, "This will be the goal that we'll try to achieve. Let's go ahead and map this out."
As a result of this conversation, we developed a plan of action to fund college education by following these steps and strategies:
- Contribution Plan. First, we asked Tom and Kathy to sit down with each of their children and discuss college education costs and what each child's responsibility will be. Tom and Kathy suggested to each of their children that they would have to work to earn enough money to pay for 25% of their college education costs. They'll then apply for student loans that cover 25% of total education costs, for which they will be responsible to repay once they graduate from college and are gainfully employed. The remaining 50% will be funded from Tom, Kathy, and existing accounts. So, in summary:
50% funding by Tom, Kathy & existing accounts
25% from student loans (to be paid back by each child after college)
25% from each child working while in college
Cash Flow Plan. We charted the cash flow needs for each of the children to fund college education costs in the future using a 5% inflation rate, as college education costs have risen dramatically over the last 15 to 20 years.
Once this was accomplished, we could then estimate how much was going to be needed to fund college education costs. Tom and Kathy will plan to help their children with college education funding through the following means:
- Withdraw Evenly. First, they will establish a withdrawal plan for each of the kid’s college education accounts or other investment accounts, evenly over the four years of college.
- Increase Contributions Each Year. They determined that they’ll plan to increase their discretionary contribution toward education funding by approximately 3% per year, approximately equal to their annual raises.
- Shift Appreciate Stock to the Kids. If additional funds are needed during some years of education costs, especially when some of the children’s years of college overlap, they will liquidate Tom’s Stock Savings Plan stock using the “Income Shifting Strategy”. Tom was able to purchase a great deal of his company’s stock over the years at a discount of 15%, and over the years, some of his stock has doubled, and even tripled, in value. When funds are needed for the children’s college education, Tom will shift the stock to an account in each child’s name. The child will then sell the stock and pay the capital gains tax or other tax on the gain in their income tax bracket.
- Saving $50,000 in taxes. Whether or not the children claim themselves as dependents or whether Tom and Kathy are claiming them as dependents, there are several tax planning strategies that each child may utilize to offset the tax on the gains, such as Education Tax Credits (Tom and Kathy earn too much income and are not eligible for these), tuition and fees deduction, standard deduction, etc. Each child may pay a much lower income tax on the gains, but in some cases, they’re paying very little tax due to the deductions for which they qualify. This strategy may allow Tom, under most circumstances, to shift $10,000 of his company stock to each of the children’s accounts, and in some cases avoid $3,000 to $4,000 of income tax by doing so. This certainly helps toward the college education costs! This tax savings strategy alone will probably save $50,000 in taxes over the 16 years of college education costs for the four children!
What This Story Means to You
Now that you've read this story, you'll have questions of your own. We've always said that there is never only one correct way for everyone to plan for college education costs. There are several strategies available, some of which may save a significant amount of income tax, and as a result, you may keep more of your money in your pocket for retirement. When you're ready, let's review these potential strategies:
- Is it possible to qualify for grants, scholarships, deferred student loans, or non-deferred student loans even if you earn a high income?
- What can you actually afford to pay for your kids' college education funds and still retire at a reasonable age? The answer to this question should drive your planning (or it may drive you crazy). Let us help!
- What strategies are available to help with your children's college education costs on a tax-favored basis, such as creating tax deductions, tax savings, or tax deferrals? Remember that taxes you save or defer may be considered additional savings for your retirement or perhaps extra cash flow to offset the college education costs for the children.
Please call us at (517) 323-2063 or email us at firstname.lastname@example.org to schedule a meeting. We look forward to speaking with you.