When it comes to planning for college, there is a lot to cover. Students must choose a college or university, decide on living arrangements, and sometimes even select their major before the semester starts. But there’s another important element that can affect all of the above: college costs.
For most students approaching college age, the biggest question is, “How much will this cost — and how will I (or my family) pay for it?” The number one source of college funding for students is FAFSA, or the Free Application for Federal Student Aid. If you are a student expecting to take out loans for most of your college tuition, you’ll want to fill out the FAFSA with your family.
In this blog, we’re going to cover what FAFSA is, how it works, and maybe bust a few myths along the way. We’ll also cover a few college payment strategies and savings options outside of FAFSA so that you (and maybe your parents) can make an advised decision on college affordability.
What is FAFSA?
FAFSA, or Free Application for Federal Student Aid, allows colleges and universities the ability to consider a student for financial aid. The application itself says that it’s free and virtually anyone can apply. This form is for students to fill in, but is based on household income (both what you and your parents make if you have a job).
While there is no guarantee that you’ll get any financial aid, you won’t get any if you don’t fill it out. This is why most FAFSA experts recommend filling out this form every year while a student is in school. The entire application should take you about 30-ish minutes to complete and, contrary to what you might hear, you don’t have to have all your tax information at the ready.
Today, that process is automated in collaboration between the Department of Education and the IRS, making it very convenient!
How does FAFSA work?
When you fill out the FAFSA as a student, you are sharing your personal financial information, such as how much money you are earning and have saved up. Additionally, you are sharing your parents’/parent’s financial information, such as:
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- How much they earn
- What assets, if any, they might own
- How many dependents are in your family
Then, the Department of Education (DOE) takes that shared information about you and your parents and calculates your Student Aid Index, also known as SAI and previously called Estimate Family Contribution, or EFC. SAI is basically the amount of money that the DOE believes you (as the student) can financially contribute toward your college education costs. Then, they share that information with the schools you have listed on your application.
School officials will look at your SAI and what the recommendation is for your federal student aid, which typically comes in the form of grants, loans, and federal work study. Important note: The federal work-study is basically funds that would be “provided by” an on-campus job. However, there is no guarantee that you will find one, so pay attention to that number.
School officials will also look at the cost of attendance (tuition, housing, meals, books, transportation, etc.) and the amount of aid that you are eligible for through the federal government. Depending on your student profile (your college application) and what the school is trying to accomplish, as well as the timeline of your application, they may apply some institutional aid, typically in the form of grants and scholarships, to help further reduce the cost of attendance.
What is left is your responsibility to cover, which can be accomplished through jobs and working with your parents and family members to help cover the expenses that federal aid, private scholarships and grants, and institutional aid do not cover, which may or may not need to include private student loans or Parent PLUS loans. That’s the 10,000-foot level big-picture overview of the process.
What do you need to file your FAFSA form?
Many folks don’t know or understand what information from their tax returns is being examined or which returns are considered when filling out the FAFSA. So, let’s cover it!
FAFSA will look at what is known as “the prior-prior year” tax returns. That basically means that if you are applying for aid in 2024, they will look at 2022 tax returns. Obviously, in 2024 there is not much we can do to strategically think about our 2022 taxes, which is why proper preparation for college requires some advanced planning and strategy!
When should you start saving for college?
The short answer: Yesterday
Parents, this is why it’s important to start thinking about funding for college as early as humanly possible — and especially as your child approaches high school (9th grade).
Starting to save up early for college education costs means that we can leverage the power of compounding interest to make contributions over time. Think of compound interest as a snowball rolling down a hill, gathering more snow as it goes. It gets bigger and faster over time, and the sooner you start, the more hill you have to gain momentum and size.
Here’s an example:
Let’s assume you’ll need $100,000 to fund your college education. You can get a 6% per year return on your savings, and you contribute monthly towards this fund. If you start early and give yourself, say, 15 years, you’ll need to contribute roughly $415 per month.
However, if you start planning late and you only have 3 years, your monthly contribution will be a whopping $2,605. That’s 6 times more than you would have had to put away if you just started to plan earlier! This is why you’ll always hear financial planners push for early planning and saving. (By the way, the same math and concept works for retirement, too, just in case you were wondering!)
How can you start to save today for college education? Next up are different college savings options. Please note that these are not recommendations or financial advice, nor should they be taken as such. They are for educational purposes only. If you are needing assistance with these, please work with a trusted financial advisor.
College savings options
The traditional savings account
A good place to start your college savings? Starting a separate savings account. When interest rates are high, as they are right now (in spring 2024), you might be able to find a high-yield savings account that will pay you 5% interest or more. When interest rates are low, you could see a return of less than 1%, so do some research. It’s important to note, however, that putting money into savings means that you’ll get taxed every year on the interest that the account produces, which is not optimal.
Treasury Bonds
The next option you have is treasury bonds. These are bonds you buy directly from the US government and the interest accrues on them.
Depending on the ongoing interest rates and type of treasury bonds you choose, you may see a return between 1-6%, although these percentages are always changing. The benefit of treasury bonds is that interest earned from this option will avoid state tax, but you’ll still have to pay federal taxes.
You also have the option of savings bonds, which offer interest rates between 1% and 5%, depending on the ongoing interest rates. While there is no tax on the state or local level, you might be taxed at a federal level. However, if the funds are used to pay qualified higher education expenses, the interest is typically not taxed.
Stocks
Next up, we have a regular brokerage account where you can purchase and sell any stock, bond, ETF, future, option, forex, crypto, etc. The benefit here is that you truly have the freedom to contribute as much or as little as you’d like — and you can buy, hold, sell, and trade whatever you want while typically enjoying very low fees. The downside is that this will be a taxable account, but you can use proceeds for whatever you want. You are also responsible for making trades yourself, which can be overwhelming for anyone who is new to investing.
If you want investment advice and support, learn more about our ongoing financial planning services.
Education Savings Accounts (ESAs)
You can also open a Coverdell Education Savings Account (ESA). These accounts offer a low annual contribution limit (only $2,000 per year per beneficiary) and the money used from an ESA are tax-free if used for approved educational costs!
However, the money inside this account must be used up by age 30 and there are income limitations for contribution. Currently, ESAs are only available for single folks making less than $95,000 per year or married couples making $190,000 per year and filing jointly. Availability completely phases out for single people making $110,000 per year and married couples making $220,000 a year.
529 Plans
A 529 Plan offers tax-free withdrawals if used for educational costs. This plan does not have any contribution limitations, which is ideal for many individuals and families trying to save quickly. These are tax-advantaged accounts, meaning money is set aside tax-free and taxes are only applied if the withdrawn funds are not used for qualifying educational purposes. The specific rules vary state by state, so you’ll want to do full research for your own state and understand the options and specific rules that you’ll have to follow.
The downside of a 529 plan is that if the funds are not used for educational purposes, you will have to pay taxes on the gains plus a 10% penalty, which is definitely steep. Additionally, your investments will be limited, there may be higher fees associated with this account, and plans changes may be very limited. Again, make sure to research 529 plans that are available in your state!
Uniform Transfer to Minors Act and Uniform Gifts to Minors Act (UGMA & UTMA)
UTMA and UGMA accounts are taxable investment accounts set up to benefit a minor once they reach adulthood. Once they’ve become “of age,” the accounts transfer and the previous minor can begin to use those funds.
You have the option to create a UGMA or UTMA account (depending on what state you live in) with no limitation on what you can contribute or invest. Additionally, the beneficiary can use these funds for whatever they want, even if they’re not education costs. If you’re not sure that your child wants to receive a college education, these accounts may be a great option. However, these accounts are taxable and are always seen as the student’s asset, which is not ideal for FAFSA applications and lowering SAI.
Life insurance cash values
As part of some permanent life insurance plans, you may have a cash balance or cash value on your policy. In some cases, you can use that cash balance to put toward educational expenses. This is appealing for some because the cash balance does not count as an asset for either parent or student. However, you’ll have to qualify for life insurance (which can incur rather steep fees). Additionally, if you take money out of the account, you risk losing your life insurance, and if you borrow against it, you’ll have to pay interest.
Real estate income
Finally, let’s talk about using real estate to help you save for college. Income-producing real estate, like a rental property, allows you another form of income that can help cover college costs. Of course, real estate is illiquid, which means you will have to pay for taxes, insurance, and ongoing maintenance. There are also increased expenses related to property management, and there is no guarantee that the property value will appreciate (or that the tenant will pay regularly or on time).
As you can see, there are a number of options to help you save for college early. But what happens if you haven’t started saving and college is right around the corner?
How to pay for college if you haven’t saved early
As the proverb says, “The best time to have planned for this was yesterday. The next best time is now.” What happens if you don’t start planning for college costs earlier? We can’t turn back the time, so we’ll work with what we can today. We might not be able to save up the amounts mentioned in the example above, but that’s OK. We have other options.
So, let’s continue…
Lower your SAI number and increase college financial aid
We’ve talked about how the SAI formula uses a student’s income to calculate what they may have to contribute towards their education. In the simplest terms, the higher the income, the higher the SAI number (aka what you’re expected to contribute towards your college costs).
That means that, when planning for college, we should consider lowering our taxable income as much as humanly possible — legally and ethically, of course.
Don’t worry; you don’t have to quit your job(s) today. But it is important to under some of the ways you can divert money into different accounts to lower your annual income, which helps to lower that SAI number. Remember, though: FAFSA looks at the prior, prior year, so starting to work on income reduction plans at least two years before you start looking at college may be a good idea. We recommend working with a financial advisor to help you with this, especially if you have challenges doing it alone.
You also need to consider ownership of assets. Just like income is counted on FAFSA, so are any assets that a student or family possesses. You’ll want to be strategic about assets a student or parent may have well before seeking student aid (remember, they have a 2-year lookback!).
Look at all possible college payment methods
Typically, when you think about paying for college you have a few different options — and you can “mix and match” ways to pay for college without larger savings or investment accounts.
You might consider:
- Scholarships and grants — aka money that pays for a portion of your education costs without repayment.
- Your savings — perhaps you’ve been working over the past few years and saving some money to help pay for college.
- Working while in college — on- and off-campus jobs can help you cover college costs as you learn, or to cover living expenses so you can minimize loans
- Parent and family contribution — Parents and family members often assist students with paying for college through their income and savings
- Loans — this is money that you borrow and have to pay back after you are done with school.
If you want to dive deeper into planning for college costs, we offer you our Essential Guide to Paying for College. In this FREE resource, you will find information about:
- How income and assets are calculated when filing your FAFSA form
- The difference between FAFSA and CSS Profile
- Parent PLUS loans (and how they impact your retirement)
- What goes into the cost of college education (and how to plan for all expenses)
- What financial aid offer letters look like and how to interpret them
- And so much more
Interested in covering all your college cost bases? Grab The Essential Guide to Paying for College here!
A note about student loans
This wouldn’t be a complete blog about college costs if we didn’t at least mention student loans. We offer an in-depth look into student loans here.
When submitting your FAFSA form, you are, in effect, asking for the federal government to loan you money for education. You do not have to accept loans after filling out FAFSA, though. It just shows that you are just shopping around for options to help you cover college costs!
Of course, they are loans, which means you plan on paying them back at some point in the future. In fact, when you sign that loan agreement, you are promising that you will repay them within the agreed-upon loan term.
Once you submit your FAFSA, the schools you selected on the form will take a look at your SAI and send you a financial aid offer letter. When you get a financial aid offer letter from your school(s) of choice, you will have an opportunity to review it and select which aid you agree to accept. So, if your offer letter says $2,000 ABC College Grant and $3,000 Direct Unsubsidized Loan, you don’t have to accept any of those. Now, you might choose to take on the grant (money you don’t have to pay back) and forgo the loan, or you can choose both. Just understand that the $3,000 is what you’ll owe when you’re out of the school plus potentially any interest accrued.
What’s the difference between subsidized and unsubsidized loans?
- Subsidized – It is a government subsidy, meaning that the U.S. government will pay the interest on this loan while you’re in school.
- Unsubsidized – There are no subsidies, meaning that interest will accrue over time as soon as it’s distributed.
Direct PLUS loans
In addition to these two, you may also see something called Direct PLUS Loans. These loans are for graduate and professional studies students as well as parents of undergraduate students. The interest is not subsidized on these, either, and it begins accruing as soon as it’s distributed.
Private student loans
While federal loans are limited in the amount that can be borrowed (for undergraduate students), private loans will typically cover the cost of education fully. However, they are based on creditworthiness. Private student loans function pretty much like any other loan you may obtain from a bank or a lending institution, while federal loans offer many more protections and benefits, including income-driven repayment plans.
Your recap: College cost preparation
We’ve covered a lot of ground here and we know it’s a lot to think about. We’re here to help make college savings and payments clearer and easier to understand, so make sure to bookmark this blog AND our free Essential Guide to Paying for College!
To recap your next steps, here’s a quick reminder:
- Fill out the FAFSA every year that you’re in high school
- Review your assets and who the owner of those assets is (parent vs. child/student)
- Save for college education costs as early as possible
- Review all loan options before signing on the dotted line!
- Reach out for help if you need it!
We know that this can be a really stressful time in your life, whether you’re a student or a parent. We at Guiding Wealth know what a big deal planning for (and paying for) college can be!
Our one-time financial plan is the perfect way to get your finances in shape for this big decision.
When you book a one-time financial plan, you’ll work 1:1 with an experienced planner to discuss college costs and how to shop around for schools to find the best deal. We can also help you if you’ve got your heart set on a school and want to make the numbers work!
After your meeting, you’ll get a comprehensive roadmap with personalized advice based on where you are in the college savings journey. We might offer guidance on budgeting, income diversion strategies, tax planning, net worth, college application timelines, loan repayment strategies, and more. Learn more about our one-time financial plan and how it can help you prepare for college expenses today!
NEV KRAGULJEVIC, CSLP
Nev is a financial planner who has spent 25 years working for colleges and universities around the country. Over the course of his career, Nev has worked with close to 500,000 college students and parents navigating the intricacies of college education. He retired from his career in higher education to spend his early retirement year serving people as a financial planner, including students and families who want to understand their college affordability options! Learn more about Nev here!