How to Pay for College

Where does the money come from?

Take heart. Between financial aid and personal funding techniques that won’t break the bank (much), this major expense can be paid for if you plan carefully.


Financial Aid Options

Parents and students who do not have the financial resources to pay for college themselves may pursue other options for educational funding. These include scholarships, grants and loans, plus several other options you may not have thought of.


Scholarships are free money. They do not need to be repaid. Most are awarded on merit, be it academic, athletic, or other skill or talent. Some are based on need or disadvantage. Others are based on connection to an organization. They are offered by the federal government, some states, the college/university and public or private organizations (which can be for-profit companies or non-profit institutions). There are literally hundreds of different scholarships that are available, waiting to be tapped. You just have to find them. A book or reference guide on the subject can help you with this endeavor.


Grants are also free money, offered by the same groups as scholarships. These are generally based on need or disadvantage. The most widely known grant program is the Pell Grant.

The Pell Grant is a federally funded program. Millions of dollars are awarded each year on the basis of need.  Most go to households whose incomes are below $50,000 per year. Pell grants are only available for undergraduate studies, except for post-baccalaureate teacher certification in some cases. Only one per student is granted per year. The amount awarded depends on need and costs, whether or not the student is full-time or part-time, and whether or not the student attends the full academic year or only part of it. It is also determined by the federal budget and the size of the applicant pool, making this grant a relatively undependable source of college funding.

Another grant is the Federal Supplemental Educational Opportunity Grant (FSEOG). This grant is for undergraduates who demonstrate exceptional need. The amount ranges annually from $100 to $4000. It can be awarded in addition to the Pell Grant.


The federal government, some states, and banks offer various loans for college funding. The federal government may subsidize certain student loans if financial need is demonstrated.

Stafford loans are available for undergraduate and graduate studies. These loans can be subsidized or unsubsidized, and have maximum amount limits. Stafford loans have fixed interest rates, and loan proceeds are paid directly to the school. The student must attend at least part-time. Subsidized Stafford student loans used to be available through a variety of institutions, but as of July 1, 2010, they are offered only through the federal government.

Subsidized Stafford loans offer a slightly lower interest rate than unsubsidized loans. Interest does not accrue while the student is in school and during the deferment period. Payment can be deferred until up to six months after leaving school. Subsidized loans are based on need and require a FAFSA.

Unsubsidized Stafford loans are available to any student regardless of need. Interest accrues from the date disbursed, but payments can be deferred while enrolled. This increases the size and cost of the loan.

The Federal Perkins loan program is available for undergraduate and graduate studies. This low interest loan is granted by the college or university and reimbursed by the federal government. This loan is given based on need. All or part of the loan may be forgiven for certain public, military, or teaching service.

PLUS loan is a student loan offered to parents of students enrolled at least part-time at eligible institutions. Interest is fixed at 7.9% (higher than for Stafford loans) for the life of the loan, and begins to accrue from the date of first disbursement. Repayment plans can vary. Repayment begins 60 days after the final disbursement, or can be deferred until six months after the student ceases to be enrolled at least half-time. PLUS loans can be obtained for amounts that cover up to the entire cost of education, including living expenses, less other financial aid. A PLUS loan is a commitment of the parent, not the student. Parent must have a good credit history to be eligible. A PLUS loan is also available to graduate and professional students directly; in this case, the student is responsible for repayment and must have his/her own good credit history.

Private student loans are available through banks and other commercial financial institutions.  Rates, amounts and eligibility criteria can vary.

Work Study

The federal work-study program offers part-time work on campus for compensation that is applied towards college expenses. The federal government reimburses the compensation paid out by the school. Total payments cannot exceed the size of the federal grant to the school.

Direct Aid from Colleges

Colleges and universities often have their own budgets for scholarships and other aid, often provided by alumni gifts and endowments. Criteria for award and amounts vary by school.

Armed Forces

Examples of funding sources available through the armed forces include the GI Bill, ROTC scholarships, and Congressional appointments to a military academy. These require a specified term of service.


Employer sponsored scholarships are awarded to dependents of the employee. For the employee himself/herself, employers may provide up to $5250 per year reimbursement for employee educational expenses not related to the employee’s job function. This reimbursement is not reportable as income to the employee.

Applying for Financial Aid

For many financial aid programs, families need to complete the FAFSA form (Free Application for Federal Student Aid). This form should be completed as early in the tax year as possible, and needs to be submitted to the U.S. Department of Education. After review, the department issues and SAR (Student Aid Report) and copy of the EFC (Expected Family Contribution) to each school listed on the FAFSA.

The EFC is the amount the family and student are expected to personally contribute towards the cost of higher education. The EFC measures family financial strength, and is used to determine the eligibility for federal student aid. Based on a 1965 formula, financial aid need equals cost minus EFC.

Personal Funding

There are several options available for parents or other individuals to personally pay for a student’s college education, either in whole or in part (the expected family contribution). Tax treatment differs for each option, and should be carefully evaluated to determine the best option(s).

Private Investment Accounts

Private investment accounts are typically the least tax efficient option for funding education. The advantages include no maximum on the amount contributed, absolute control over use, and unlimited flexibility in how assets are managed. However, with each disbursement, earnings and capital gains taxes are realized. This disadvantage with private accounts is often larger than the disadvantages of lower flexibility, contribution limits and control of assets of other options.

Custodial Accounts (UTMA/UGMA)

Custodial accounts allow minors to have assets titled in their name but managed by an adult (the custodian) until age 18 or 21, depending on the state. At the age of majority, the child gains full control of the assets. The advantages are that the custodian maintains full control until the child reaches the age of majority, and earnings generally get more favorable tax treatment than parents’ private accounts.

At the age of majority, however, the child assumes full control of both the investment decisions and the disbursements. The child can choose how to spend the money – either on college (as earmarked by the donor) or on anything else the child wishes. Also once set up, the parent cannot give assets to another child.

Contributions to a custodial account are considered gifts and are therefore subject to gift tax rules involving maximum limits to avoid the gift tax. If the donor and the custodian are the same person, the donor/custodian is considered to have sufficient control over the assets so as to have the assets included in the custodian’s estate until the student’s age of majority.

Coverdell Education Savings Accounts (ESAs)

Coverdell ESAs operate much like IRAs in terms of tax-deferred treatment; however the maximum contribution per year is currently limited to $2000 per year. Earnings are exempt from taxes if used for qualified educational distributions; therefore, earnings grow faster than in private accounts. Qualified distributions include expenses for primary, secondary and higher education. Individuals direct the investments. All assets must be distributed by 30 days after the student reaches age 30. Participation is limited based on income; higher income earners are not able to use this type of account for education savings.

529 Plans

529 plans are another alternative for tax-advantaged savings, and are the most popular. Set up by states, 529s offer higher contribution limits, and greater donor control over the assets. There are no adjusted income limits. However, if allowed by income, savers can do both the 529 and the Coverdell.

There are two basic types of 529 plans. The first are 529 savings plans. In these plans the contributor makes contributions and selects investments from those offered within the plan. The donor takes on the investment risk as to whether or not there will be enough money to pay for school. The second type is prepaid tuition plans. In these plans the contributor makes contributions to cover future higher education expenses. Amounts are determined by a number of factors, and there are no investment options to choose from. In this case, the school/state takes on the investment risk. If the student attends an in-state public school, he or she does not have to worry if there will be enough money to pay for college.

In either plan, sponsorship is limited to eligible state programs and eligible private institutions. They can be set up by the state/state agency or by the educational institution. States offer savings plans or prepaid tuition plans. Schools only offer prepaid tuition plans.

Contributors may be family members or non-family. Contributors are able to change the beneficiary, but only to another family member of the beneficiary (prepaid plans may adjust the premium in this case).

Students must be enrolled at least half term. Eligible institutions include most colleges, universities, community colleges, vocational schools, and even some foreign institutions.

Contributions are made in cash. This prevents attempts to avoid capital gains taxes by contributing appreciated assets. In the case of 529 savings plans, rollovers are allowed from other 529 savings plans, UTMA/UGMA and Coverdell accounts, or certain US savings bonds issued after 1989.

Contributors are allowed to invest in a 529 savings plan from most any state regardless of the state in which the student resides (some states do restrict this). However, it may be of some tax benefit to choose the plan in the home state. The contributor would need to compare the tax benefit of the home state’s plan with the investment opportunities available in another state’s plan.

Contributors are not allowed to individually direct investments outside of the choices available within the plan. Assets cannot be used as collateral to secure a loan.  Plan contributions are limited to the cost of five years at the most expensive schools in the U.S.

There are several advantages to these plans. Investment earnings are tax deferred, accelerating growth potential. Qualified distributions are not taxed. In some states, contributions are tax deductible. Contributors are able to take advantage of accelerated gift tax treatment, which equates of tax free transfers in one year up to the annual gift tax limit times five.

If withdrawals are not used for qualified educational expenses – tuition, fees, books, supplies, equipment, or room and board – earnings will be subject to ordinary income taxes plus an extra 10 percent penalty. An exception to the penalty only is made in the event of death or disability of the beneficiary or receipt of a scholarship; ordinary income taxes still apply on the amount withdrawn. In the case of a scholarship, this penalty exception only applies to the amount of the scholarship.

For prepaid tuition plans, the contract is purchased for a specific price, which defines the specific costs for a specific student. These plans may guarantee to pay tuition and fees at in-state public schools. For out-of-state or private schools, these plans typically pay the average of in-state public tuition; the family must make up the difference. When the student starts school, the plan pays out at the level required at that time.

Prepaid contract expected contributions are based on a number of factors. 1) Current cost of in-state public school tuition and fees. 2) Age of prospective student. 3) Number of years of education to be purchased; Time period over which contract will be paid (i.e., lump sum or 10-year installments, etc.). 5) Actuarial assumptions on how much tuition and fees will be in the future and future return on investments.

Series EE Government Bonds

These bonds are issued at half of the face value.  Interest accrues each year until maturity. Interest can be partially or fully federal tax-free when used to pay qualified higher education expenses in year of maturity. Bond prices range from $50 to $10,000.

Use of Series EE bonds has certain requirements. The purchaser must be 24 years old on first day of the month purchased. Bonds must be registered in one or both parents’ names. Married parents must file jointly. Deductibility is phased out for higher adjusted incomes. Both principal and interest must be used for qualified expenses.

Trust Accounts

Instead of a custodial account, a 2503(c) trust can be established to pay for educational expenses. The trust is irrevocable once funded. The student is entitled to the principal at age of majority. Income can be retained or distributed; if distributed, amounts are taxed at the child’s tax rate, and are therefore subject to the “kiddie” tax. Contributions qualify for the annual gift tax exclusion.

IRAs and other Parental Retirement Plans

Yes, it is possible to sacrifice your own personal retirement needs to send your kids off to school in style. While you certainly would not use funds truly earmarked for your own retirement, you might consider opening an IRA for yourself that you personally designate as a college fund. Remember, this is in addition to what you are saving for your retirement. For employer-sponsored 401(k) and other retirement plans, loans and distributions are allowed for educational expenses.

Both traditional and Roth IRAs can be used for this purpose. All IRA/Roth rules apply. However, for a traditional IRA, amounts used for qualified higher education expenses are exempt from the 10 percent early withdrawal penalty; ordinary income taxes on the full amount withdrawn still apply. For a Roth IRA, such expenses are also exempt from the 10 percent early withdrawal penalty. Ordinary income taxes are paid on earnings only.

Impact of Personal Funding on Financial Aid

Some forms of personal savings can impact the eligibility for financial aid. Whole books are written on this subject of how the FAFSA form gets evaluated, and we recommend that you take advantage of these resources. Here are a few major items to keep in mind, though:

Ownership of the assets has a great impact on the level of financial aid that gets awarded. Generally, it is better to have assets listed in the parent(s) names, as the expected contribution is calculated lower for parental assets than for student assets. The advantage of putting assets in the student’s name is to take advantage of the student’s lower tax bracket. However, this generally does not compensate for the amount of potential financial aid lost in doing this. Also, when the assets are in the student’s name, they have discretion on how the money is spent, and it may not be for education.

Retirement funds, pensions, tax-deferred annuities and life insurance are not considered assets in the need-based formulas. However, this exclusion only counts for contributions/premiums made before the base year (year of evaluation/first enrollment). Small businesses owned and controlled by the family are also excluded.

The only debt that counts in the needs analysis is debt secured by property; credit card debt is not included. So if you owe a lot on credit cards, it would behoove you to pay it down to protect your cash flow once you are paying for college.

Custodial versions of 529 savings plans, prepaid tuition plans and Coverdell education savings accounts are disregarded if the student can be claimed as a dependent.

If you are saving money for a big dollar purchase, make that purchase before submitting the FAFSA. Otherwise, that savings must be reported on the form, and it is assumed that money will be used to help pay for college. Related to this, student assets should be spent before spending parental assets. So when sending Junior off to college and he needs a vehicle, let him buy his own car.

Income Tax Benefits

There are several tax credits or deductions that may be available when using personal funding to pay for college. The American Opportunity Tax Credit applies to 100 percent of qualified tuition, fees and course materials for self or a dependent, up to a maximum of $2500 per student (up to $2000 plus 25 percent of the next $2000).  The student must attend at least half time. This tax credit can only be claimed for the first four years of higher educational expenses. Other credits or deductions cannot be claimed in the same year. This credit is phased out for higher adjusted income levels.

The Lifetime Learning Credit applies to qualified expenses at qualified schools for at least part-time studies to improve or upgrade job skills. This credit is limited to a maximum of $2000 per family (20 percent of the first $10,000). This cannot be claimed with others in the same year, and is phased out beyond certain income levels.

Interest paid on private or government-sponsored student loans are deductible from gross income to a maximum of $2500. This deduction is phased out beyond certain income levels.

Calculating College Costs for Personal Funding

There are several steps to calculating college costs. But first you need to identify several pieces of information.

Information Needed

The first piece is to determine what scale of college you’d like to fund. Do you want to send Juniorette to an Ivy League school, or will the local community college suffice? What about a state school versus private college? In-state versus out-of-state? The cost per year can vary widely depending on your preferences.

Current costs for the preferred type of college are easy to obtain. You then need to make some assumptions as to how much those costs are likely to increase each year.  The usual college cost inflation rate used is 6 percent.

The next piece is to identify how long you have until funds are needed, and how many years you’d like to fund. Age of the beneficiary answers the first question. The second involves whether or not you want to pay for just an undergraduate education, or if you’re willing to pay for a masters or professional degree.

The fourth piece is to determine how much you can afford to save, and how much you have saved already. This is a budget function. You may or may not be able to save the full amount you’d like to save. You also need to incorporate the current value of any assets already saved, and to estimate an annual return on assets.

The fifth piece is to consider what kind and what level of financial aid you expect Juniorette to receive. Expected financial aid would reduce the amount you would need to personally save. As stated before, some forms of personal savings can impact financial aid eligibility, and you would need to carefully take this into account in determining where to put your money.

The Actual Calculation

All this information is used in the actual calculation. The first step of this calculation is to determine the first year of college costs in the year of enrollment, based on the value of the cost at the time of enrollment adjusted by the annual cost inflation rate between now and then.

The second step is to determine the amount of capital needed to fund the number of years of college. This step uses the amount obtained in step one and an adjusted rate of return that incorporates the estimated investment return and the expected cost growth rate.

If any assets are already accumulated, we then solve for the future value of those assets for the year those assets are needed. This amount is subtracted from the amount obtained in the second step to determine the net amount needed to save.

The last step determines the savings needed now to pay for these future costs. The calculation can be solved for a lump sum amount to be invested, or for a monthly savings program.

A good financial advisor would be able to help you with these calculations.


College is an expensive endeavor, and it becomes more and more expensive each year. However, with careful planning, you’ll be able to send your child to college without sweating, at least about the paying for it part. You will still need to nag about grades and extracurricular activities. Sorry about that, and good luck!

By Published On: July 19, 2011

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