June 16, 2016 Financial Aid Impact
Financial aid is money given to a student in the form of a loan, grant, scholarship, or work-study job in order to help the student pay for college. It comes in two forms: need-based and non-need-based financial aid. The majority of financial aid is need-based, meaning it is based on your family's ability to pay.
Need is not a concept determined by you or your child. Instead, need is determined by the federal government and colleges that distribute the aid. The federal government is the largest dispenser of student financial aid.
The federal government uses a special formula to determine your child's financial need. This formula is referred to as the federal methodology. The formula tabulates a family's income and assets to arrive at a monetary amount that the family is expected to contribute to college costs before financial aid is awarded.
How can you predict if your child will qualify for financial aid?
There is no way to predict whether your child will qualify for financial aid, especially when your child is still several years from college. It's a fact that some families with incomes of $100,000 or higher may qualify for aid, while those with lesser incomes may not.
Many parents mistakenly believe that income alone is an accurate predictor of aid eligibility, but income is only one factor. Other factors include: the size of your family, your assets, the number of family members in college at the same time (this includes parents, as long as they attend at least half-time), and any special personal or financial circumstances existing at the time you apply for aid (such as a job loss or the death of a parent).
In addition, your income and/or assets may increase significantly in a way that was not foreseeable. For example, your spouse may land a coveted job or you may receive an unexpectedly large inheritance in the year you apply for aid.
Further complicating matters, Congress may modify the federal aid programs from time to time. Certain programs may be expanded and income limits may be raised, or the reverse may happen. The point is that nothing is ever set in stone until the year you actually apply for aid.
You can attempt to get an idea whether you will qualify under today's guidelines by running a financial aid analysis. This can be done with the help of a financial aid software program or with the help of a financial planner who specializes in education planning. The bottom line is that many families end up qualifying for at least some type of financial aid.
Overview of the federal methodology for financial aid
In order to qualify for federal financial aid, families must complete a form called the Free Application for Federal Student Aid (FAFSA).
The FAFSA examines both your assets and your child's assets and current income in a given year to arrive at a monetary figure that your family will be expected to contribute to college costs before any financial aid is awarded. This figure is known as the expected family contribution (EFC). The EFC remains constant no matter what college your child attends. The difference between the EFC and the cost of your child's particular college (a variable) equals your child's financial need.
It's under the asset section of the FAFSA that most of your advance planning comes into play. Under the formula, the federal government expects parents and children to contribute a certain percentage of their assets toward college costs each year. However, the percentages for each are not the same. Parents are expected to contribute 5.6 percent of their assets each year, whereas children are expected to contribute 20 percent of their assets each year. For instance, $50,000 in a child's bank account results in a $10,000 contribution to college costs, but the same $50,000 in the parents' account results in a $2,800 expected contribution--a difference of $7,200.
In calculating your EFC, the federal government excludes some assets from consideration:
- Home equity
- Retirement plans (e.g., IRAs, 401(k), 403(b), Keogh plans)
- Cash value life insurance
The Carlin family has $20,000 in Series EE bonds (which may also be called Patriot bonds), $30,000 of XYZ stock, an IRA worth $1 million, and a $500,000 cash value insurance policy. Under the federal methodology, their total assets are $50,000.
The federal methodology also grants parents an asset protection allowance, which allows them to exclude a certain portion of their assets from consideration. The asset protection allowance varies depending on the age of the older parent at the time the child applies for aid. Children are not given an asset protection allowance.
How can the federal methodology impact your long-term savings decisions?
The federal methodology may impact the way you choose to save for college based on the rules discussed above. Thus, even when your child is still years away from college, you may want to start thinking about which assets to accumulate and who should own certain assets.
Accumulation of assets
Under the federal methodology, assets are either counted or not counted, regardless of who owns them. The more countable assets you own, the higher your expected family contribution will be. The higher your expected family contribution, the less financial aid your child is eligible to receive.
One strategy parents may wish to consider is to save money in countable assets (e.g., stocks, mutual funds, real estate) up to the level of the parents' asset protection allowance. This allowance can range from roughly $25,000 to $80,000, depending on the age of the older parent at the time the child applies for financial aid and whether there are two parents or one.
Then, over the amount of the asset protection allowance, parents may wish to consider investing in assets that are not counted under the federal methodology--home equity, retirement plans, cash value life insurance, and annuities.
One important point to remember is that the world of federal financial aid is not static. It continues to evolve and change as Congress passes new laws. If you decide to change your savings strategy completely and, for example, fund an IRA due to its favorable treatment under the federal methodology, it would be wise to review this formula from time to time to make sure this asset is still excluded from consideration.
Many private colleges delve deeper into a child's financial background than the federal government in deciding which students have the greatest need for campus-based financial aid. In doing so, these colleges often include assets that the federal methodology excludes, like home equity and IRAs, and may expect parents to borrow against these assets (particularly if they're substantial) to help fund their child's college education.
Under the federal methodology, parents are expected to contribute 5.6 percent of their assets every year, whereas children are expected to contribute 20 percent of their assets every year. In addition, only parents receive an asset protection allowance.
For these reasons, most planners recommend that parents consider holding assets in their own names rather than in their child's name. This is true even though in nearly all cases parents are taxed at a higher rate than their child on income earned by the assets.
Suppose Mom and Dad give Junior $1,000 every year for 18 years. If the money is invested at 8 percent under Junior's ownership (15 percent tax bracket), the account would be worth nearly $35,000 after 18 years. However, if the parents had held the money for 18 years, the account would be worth roughly $28,500, due to the higher tax rate (35 percent bracket, including state taxes).
Yet come financial aid time, under the federal methodology, Junior would be expected to contribute 20 percent of his assets every year. After four years, these contributions would total more than $20,000. By contrast, if the parents had kept the money in their own names, they would be expected to pay only 5.6 percent per year, which equals approximately $6,000 over four years.
(Note: The above example is hypothetical and does not reflect the performance of any specific investment. This example assumes the reinvestment of all earnings and does not consider taxes or transaction costs.)