Paying for college is a significant concern for many families. Federal financial aid may be a deciding factor in where a student goes to college, even for families who have been diligently saving. With proper planning, it’s often possible to develop a strategy to help maximize your family’s financial aid eligibility.
Whether you’re relying on aid, loans, or plan to self-fund, knowing the benefits and limitations of college savings vehicles can help you navigate your options.
Calculating projected federal aid is complex. This guide is not intended to be used as a calculation tool, but rather to highlight what assets and income are factored into the calculation, how they’re weighted and what strategies may be able to help students qualify for need-based financial aid.
What determines financial aid? Most families applying for financial aid only need to complete the Free Application for Federal Student Aid form. FAFSA is used to determine federal financial aid eligibility, grants and scholarships. The form also is used by many state and private institutions, as they often provide students additional aid, loans and merit-based awards.
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FAFSA considers a number of factors when determining need-based eligibility, including income and assets of the student and parents, as well as household size and the number of children attending college. These and other details are entered into formulas and ultimately combined to produce the expected family contribution. The EFC is calculated before each school year and drives the amount of award a family can expect to receive.
For dependent students, parent income counts for a large portion of the aid calculation. At a high level, a parent’s adjusted gross income from their tax return is used, minus certain deductions and allowances provided by FAFSA depending on income, before pre-tax contributions to qualified retirement accounts and health savings accounts are added back. The formula then subtracts federal, state and FICA taxes, and other employee allowances. The resulting available income can then be multiplied by a factor as high as 47 percent — which is counted as parent income on the FAFSA form.
It’s important to note that income is defined more broadly than traditional wages and salary. For example, distributions from a parent’s IRA or Roth IRA, as well as capital gains from any liquidated investment accounts, may also be considered income.
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Parent assets are counted much more favorably than assets in the student’s name. Assets in the parent’s name — including student-owned 529 plans — receive a maximum weighting of 5.64 percent annually. Parents also receive a savings allowance, which is determined by FAFSA. Retirement assets are not included, but cash, brokerage accounts and even investment real estate can be fair game.
Student assets are not given a savings allowance, so 100 percent of the value is considered; however, only 20 percent of assets are available for aid purposes. Student income weighs much more heavily on aid eligibility. Half of the student’s income is considered by the FAFSA program. The higher the income, the less financial aid he or she is likely to receive.
There’s a temptation to overlook the importance of student income, as many college-bound students aren’t high earners. It’s critical to understand what constitutes student income on the FAFSA. For the EFC calculation, qualified distributions to the student from a 529 plan owned by a non-parent, such as a grandparent or relative, is considered income to the student. Distributions from student or parent-owned 529 plans are not counted as income under the EFC calculation, as they were already listed as an asset.
Strategies to maximize financial aid benefits. Although both income and assets can limit financial aid eligibility, there are ways to strategically plan to maximize benefits.
Last September, President Barack Obama changed the income year for which the FAFSA determines aid eligibility. Instead of looking at the prior year’s income, aid will begin evaluating income in the “prior, prior year.” For students entering their freshman year in 2017, FAFSA will look at 2015 income.
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This change means families will need to begin looking at their complete financial picture even earlier, to determine what (if any) aid they could expect and where opportunities may exist to retitle assets or develop a liquidation plan for qualified distributions.
Liquidation and ownership of 529 plans. Consider using the funds in a parent-owned 529 plan before a grandparent or relative-owned plan. Since non-parent held plans are currently not considered by FAFSA as either income or assets of the college-bound family, these savings won’t have an impact on aid eligibility unless they are liquidated or retitled. Once liquidated, the amount is considered as income to the student, and 50 percent of the funds can be applied towards the EFC.
Another strategy, if permitted by the state where the 529 plan is held, is to transfer ownership of a non-parent 529 plan to the parent. Although the funds will now be considered an asset, recall that parent assets are only weighted at a maximum of 5.64 percent. Also, any distributions from the plan will not be counted as income, which is included at a much higher rate.
Finding the most efficient strategy to cover college expenses will vary for each family. For families with sufficient income and assets to cover gaps, it may also be beneficial to use non-parent owned 529 plan distributions in lumps — either in the first or last year of college. Spreading the distributions evenly over all four years could make some families ineligible for need-based aid each year, where using a lump sum in one year may only impact that year.
A Roth IRA provides flexibility. A Roth IRA can also be a good way to save for college as there is much more flexibility for use of the funds. For example, if an only child decides to forgo their college education, the parents may end up paying a 10 percent penalty in addition to income tax when they later withdraw the money. With a Roth IRA, those funds can instead be used as another retirement savings vehicle.
Assets in a Roth are not counted in the FAFSA calculation, which also makes it a good backup plan. If any portion of Roth funds were liquidated, the distribution would be considered parent income on the FAFSA. If income limitations prohibit Roth IRA contributions, work with your financial advisor to consider the potential merits of a Roth conversion. Timing the conversion will also be important as AGI will increase that year as a result. This strategy is best implemented the year before FAFSA-reported income, which would now be three years in advance.
Even for high-income families, college can be a significant expense. As a family’s wealth increases, it is still just as important for families who wish to help their children with education expenses to be saving. Start working with a financial advisor when children are young to develop a strategy to save. As with any savings and investment strategy, diversification is the crux of a solid plan.
While 529 plans can offer tax-free growth, investment options and flexibility to use the funds can be limited. Having a plan early for savings, investments, and liquidations can help you find the best path for your family.
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Strategies to Maximize College Savings and Financial Aid originally appeared on usnews.com
