By Mark Kantrowitz
How should I structure my finances so that my child gets the maximum amount of aid for college? When should this process start?
Eligibility for need-based financial aid is based on the difference between the college's cost of attendance and the expected family contribution. The EFC is a measure of the family's financial strength and is based on the income and assets of the student and parents, the household size, the number of children in college at the same time and the age of the older parent.
The need analysis formulas are heavily weighted toward income. Most strategies that involve sheltering assets will not have much of an impact on the EFC. For example, cash in a bank savings account counts against you, while the formula ignores consumer debt such as credit card debt and auto loans.
Using money from the savings account to pay off credit card debt makes the money disappear, potentially reducing the EFC and increasing eligibility for need-based aid. But while paying off high-interest debt with low-interest savings may make a lot of sense from a personal finance point of view, the potential impact on the EFC is minimal.
Many parent assets are sheltered by the need analysis formula. The net worth of the family home (but not a second home) is ignored, as is money in qualified retirement plans, life insurance policies and any small businesses owned and controlled by the family.
There is also an age-based asset protection allowance that shelters a portion of other assets. For most parents of college students, with a median age of 48, this shelters about $50,000 in parent assets. In certain circumstances assets can be disregarded entirely. The remaining assets are assessed on a bracketed scale with a top rate of 5.64%.
So in a worst-case scenario, each $10,000 in parent assets will reduce eligibility for need-based financial aid by $564. Less than 4% of dependent children have any contribution from parent assets. If the parent assets are high enough to make a difference, usually the parent income is sufficient to eliminate aid eligibility on its own without the consideration of assets.
There is, however, one area in which assets can have a big impact without regard to income, and that's child assets. The student's assets are not sheltered by an asset protection allowance and are assessed at a flat rate of 20%. This means that each $10,000 in student assets will reduce aid eligibility by $2,000.
Thus shifting assets from the child's name to the parent's name can have a big impact on aid eligibility. You can't simply gift the money from the child to the parent, as that would be a breach of your fiduciary duty. But you can spend the child's money for the child's benefit while setting aside an equivalent amount of the parent's money to indirectly transfer the funds.
However, there is a much simpler solution, and that's to invest the child's money in the custodial version of a
529 college savings plan
. The federal need analysis formula treats such a 529 plan as though it were a parent asset. The investment in a 529 plan must be made in cash, so you'll have to liquidate any noncash assets such as stocks and mutual funds. This may lead to capital gains though, and that can affect aid eligibility, so the timing of the investment is important. (Certain types of savings bonds can be liquidated and rolled over into a 529 plan without incurring any taxable income.)
A 529 college savings plan owned by a third party, such as a grandparent, aunt or uncle, is not reported as an asset on the Free Application for Federal Student Aid. However, any distributions from such a 529 plan are treated as untaxed income to the student, which leads to a much greater increase in the EFC than reporting the 529 plan as an asset on the FAFSA. When relatives want to help, it is better for them to contribute to a 529 plan owned by the parent. If the relatives have already funded their own 529 plan, they should transfer ownership of the account to the student's parent.
Do not try to shelter assets in trust funds; most trust funds backfire. Only court-ordered trusts to pay for future medical expenses are ignored. Most voluntary trust funds, even ones that restrict access to the trust income and principal, must still be reported on the FAFSA. A restriction on access to principal just means that the trust will hurt eligibility for need-based student aid every year, instead of letting the family spend the trust's assets down to zero the first year.
Assets are reported on the FAFSA based on the most recent statement before the FAFSA application date.
A portion of income is sheltered by an income protection allowance and by an income tax allowance, but the "available" income after subtracting the allowances has a big impact on aid eligibility. Half of the student's available income and 22% to 47% of the parent's available income are factored into the EFC. The parent's contribution from income will be divided by the number of children in college at the same time.
There are also two important thresholds in need analysis, one at $30,000 and one at $50,000. If the parent income is less than $30,000 and the parents were eligible to file an IRS Form 1040A or IRS Form 1040EZ (or if they satisfy certain other criteria), the EFC is automatically set to zero, qualifying the student for a full Pell Grant. The $50,000 threshold instead causes all assets to be ignored.
Since income has such a big impact on aid eligibility, it is important to avoid artificially inflating income through bad timing of capital gains or bonuses. The calculation of the EFC for an upcoming award year (academic year) is based on the income during the prior tax year (calendar year). Thus any capital gains that are not offset by capital losses should be realized during the second prior tax year, not the prior tax year. For example, a student filing a FAFSA on or after Jan. 1, 2012, will have his or her EFC based on next year's tax-year income and so should try to realize any capital gains this year, not next year.
Before engaging in any strategy to maximize eligibility for need-based aid, check the impact with an EFC calculator such as the ones at
. These calculators let you play what-if games, to see if the strategies will yield enough of a change in the EFC to make it worthwhile. Keep in mind that most changes in the EFC will result in an increase in loans, not grants.
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Mark Kantrowitz is president of MK Consulting Inc. and publisher of
. He has testified before Congress about student aid on several occasions and is on the editorial board of the Council on Law in Higher Education.