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Parents Should Find Help Now to Pay for Kids' College Later

Shelly K. Schwartz, Special for CNBC.com
Monday, 3 Jun 2013 | 12:04 PM ET
Alyson Aliano | Taxi | Getty Images

Save what you can, and don't sweat the sticker price.

That's the message parents who are paralyzed by the rising cost of college tuition should be taking to heart, said Timothy Knotts, a certified financial planner with Hogan-Knotts Financial Group in Red Bank, N.J.

"Don't get too hung up about projections for what college is going to cost in the future," he said. "It's terrifying to see those numbers, and what usually happens is it shuts parents down. They curl up in the fetal position and say, 'I could never save that much.'"

With the help of cost containment strategies, financial aid programs and tax-friendly savings tools, however, there's a good chance they won't have to.

The following tips can help you give your kids a college education—or at least minimize the debt they'll graduate with—without derailing your own financial future.

Stretch Your Savings

Part of the trick, said Knotts, is to stretch your dollars as far as they'll go.

"It makes a great deal of economic sense for kids to go to a community college for the first two years when they're taking general education classes anyway," said Knotts, noting such strategy can cut tuition costs by more than half. "When you transfer to a larger university your degree won't say, 'first two years at a community college.'"

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According to the College Board, annual tuition and fees at a public two-year in-state school costs $3,131 per year, compared with $8,655 at a public four-year in state school, $21,706 for a four-year out-of-state school and $29,000 for a private nonprofit four-year school.

That does not include room and board, which bumps the annual sticker price for a public four-year in-state school to nearly $18,000 per year.

Another way to cut tuition costs down to size is to have your child attend a less prestigious undergraduate program if they intend to pursue a career that requires a graduate degree, Knott added.

"Employers in those fields only look at your graduate degree anyway," he said.

Myra Smith, executive director of financial aid services at the College Board, also suggests having your child live at home the first few years to eliminate room and board and encouraging them to take a full course load each semester to ensure they graduate on time. That may be the most effective way to contain tuition costs.

"They can even take summer courses at a community college and transfer those credits to their state school or university to help them finish their course work faster," she said.

Saving Smart

As you set money aside, it's also important to utilize tax-friendly tools that can help your savings grow.

By far, the most popular are section 529 plans for higher education expenses, into which American families have invested a record $190.7 billion, according to the College Savings Plans Network (CSPN).

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Such plans come in two flavors: the prepaid tuition plan and the more commonly used 529 savings plan.

Prepaid tuition plans allow for the purchase of future tuition units based on today's rate.

If you pay for one semester at the current tuition rate, for example, you can redeem those units for a semester's worth of classes when your child heads off to campus for no additional fee. The "return" on your investment is determined by how much tuition costs climb.

The more popular 529 option, however, is the savings plan, an investment-based account in which the earnings are based on the market performance of its underlying investments, which typically include mutual funds.

Such savings plans are administered by states and currently available in 49 states (with the exception of Wyoming), plus Washington, D.C., according to CSPN.

Contributions to 529 savings plans are made on an after-tax basis, and thus not deductible, but earnings grow tax-deferred. Better yet, distributions that are used to pay for qualified education expenses are free from federal income tax.

There is one significant downside, however, to 529 savings plans. Any withdrawals that are not used for qualified education purposes will not only be taxed as ordinary income, but also subject to a 10 percent penalty.

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So for those who qualify to contribute, a Roth IRA may be the better savings tool, said Matthew Saneholtz, a certified financial planner with Tobias Financial Advisors in Plantation, Fla.

"That way if your child gets a scholarship, or decides not to go to college, you've still funded your own retirement," he said.

Your Roth IRA principal (or the money you contributed) can be withdrawn penalty-free at any time for any reason, but the earnings are taxable and could be hit with a 10 percent penalty if you withdraw before age 59½, unless it's used for authorized expenses, including certain medical costs, the purchase of a first time home and college tuition.

According to the IRS, the contribution limit for a Roth IRA is reduced (or phased out) for married couples filing jointly at a modified adjusted gross income of $178,000, while those making $188,000 or more are not able to contribute at all.

Be aware, however, that Roth IRA distributions may potentially hurt your child's eligibility for federal financial aid down the road, said Joe Hurley, founder of Savingforcollege.com.

While your Roth IRA asset value is not reported on the Free Application for Federal Student Aid (FAFSA) form, he says, any tax-free withdrawals you make must be added back to your base year income on the following year's form.

"In some situations," said Hurley, "the use of the Roth to pay for college expenses will hurt a lot more" than a 529 in calculating the FAFSA expected family contribution.

Low Cost Loans

There are also public and private loans, of course, to help bridge the gap between your savings and expenses when your kid heads off to college.

The most popular and least expensive form of federal financial aid is the Stafford Student Loan.

Unsubsidized Stafford loans, at their current interest rate of 6.8 percent, are available to all students regardless of need, but subsidized loans (at 3.4 percent) are available only to those who can demonstrate financial need.

With a fixed 5 percent rate, federal Perkins loans are also only available to low-income undergraduate and graduate students who can demonstrate "exceptional" financial need.

And the federal PLUS Loan, with a fixed 7.9 percent rate, is designed for graduate students and parents of dependent undergraduate students with a favorable credit history.

Only after students and parents have taken full advantage of federal financial aid should they consider private loans through banks and other lenders because these loans are typically far more expensive after factoring in both interest rate and fees, and don't always offer favorable repayment terms, Smith said.

Keep It Real

While giving kids the gift of a college degree is a worthy goal, parents must remember to save for themselves first, Saneholtz said.

Never fund a 529 or any other college account at the expense of your own retirement, he said.

"There are no scholarships for retirement," Saneholtz said. "New parents, in particular, really need to be sure they have their credit cards paid off, have emergency savings in place and are contributing enough to their retirement accounts before they even start thinking about paying for college."

Remember, too, that it's not necessary, or even wise, to give your kids a free ride.

"I really believe that college students should have some skin in the game," said Saneholtz. "Let them take out a loan so they're responsible for paying for some of their expenses. Agree to pay for three years instead of four, for example, just so they know they're there to learn and grow."

Knotts agrees, noting he continued to provide car and health insurance coverage for his own kids after they graduated, but insisted they help to pay their student loans.

"You don't want your kids to think it's too easy," he said. "People value what they work for."

_ By Shelly K. Schwartz, Special for CNBC.com

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