We all know the drill: The month before your baby is due, while the paint in the baby’s room is drying, you go to your broker’s office and get the paperwork to set up a college savings account of one type or another. This post was originally titled “Saving for College,” but as I learned more, I decided to focus on the Financial Aid aspect instead.
The financial aid process comes with its own acronyms, the first I ran into was FAFSA, (Free Application for Federal Student Aid, only use the Dot Gov site, other sites charge a fee). Next came EFC, the Expected Family Contribution. This chart, generated from the site FinAid is a great start to understanding the process:
This chart is based on parents’ income and assets. You can see that as income rises, the percent expected to be paid toward college rises from about 17% at $40K to over 30% right after $70K income level. Assets are not treated so harshly, rising from 2% to 4% as income increases. Equity in one’s home isn’t counted at all.
On the other hand, 50% of student income is expected to pay for college (ouch!) and 35% of student assets.
Parents’ retirement accounts are not considered in the equation, and a 529 account is considered a parent’s asset, not the student’s.
Before I discuss a few strategies to maximize the aid your child would receive let me observe that the average cost for a private four year school was $25,143 for the 2008-9 school year and the public four year cost averaged $6,585 (it was just announced that these numbers rose by 4.3% for 2009-10). Looking at the chart above you can see that for a public school an income above $60,000 will make aid hard to come by, as an income above $120,000 will support the full cost of private school.
A number of strategies that can make a difference in your EFC:
Fund your 401(k) until it’s max’ed. If you reduce your income from $60,000 to $50,000, you will save $2,350 in the EFC hit as well as $1500 in federal tax for a total $3,850. (See Fairmark to better understand your tax bracket.) After graduation, if you must withdraw the $10,000 you will only be hit with $2,500 in both tax and penalty. (Just making a point, save it till you retire.)
If you are sitting on an investment (non-retirement account) portfolio, and still have a mortgage, pay it in full. $100,000 in assets will be “taxed” at $3,000 per year at the $60,000 income level and $3,200 at higher incomes. If your mortgage is 5%, this translates to over an 8% return on the money each year for the four years of college.
Given the 35% of student assets expected to be used for college, I now understand why so many freshmen are driving expensive cars. Consider, $50,000 in the student’s name will be spent down to $8925 over four years, $41,074 expected to be used for college. In another case of “unintended consequences,” it actually makes sense to go buy a car and blow the money. A better choice would be to take advantage of tax sheltered retirement accounts, 401(k) if the student works a regular job while in high school, Roth IRA if working for a company with no retirement account. The IRA limit is $5000 this year. One can deposit up to 100% of their earned income into an IRA up to that $5000 maximum.
Other advice I’ve run across suggests having your children close together as the aid formula is kind to those with two or more students in college at the same time. If your two children are a year apart, perhaps the older one wants to take a year off before returning to school. These two suggestions are a bit extreme, but will increase your potential aid nonetheless.
Suggest to any helpful friends or relatives who with to help with the cost that they wait until graduation and apply that gift to any loans, but not gift it to the student while in school.
If you are well above the income levels that will qualify you for aid, congratulations, you’ll be paying your student’s way, but if you are in that middle, I hope these strategies help you. For more on this topic, see the article When Saving Means Losing.
Joe
Really interesting blog entry. We will share with the families playing free fantasy football at our site. They play for college savings prizes. Thanks for this great post. Good work. Looking forward to reading more from you on college savings and family finances.
Another advantage of siblings in the same age range is that it makes more sense that they go to the same college. This should make the living and transportation expenses cheaper.
This is a really excellent explanation of the process – thanks for posting this and explaining it all!
I’ve been a college aid consultant for 20 years. What a mistake to tell parents and students to go buy a car and, “Blow the money.” Are you out of touch on that one. How about putting the money into an account that doesn’t disqualify a student for aid? That way she will have it on graduation day to pay off any loans that college aid didn’t cover.
And telling parents to fund their 401(k) is a huge misconception as well. All retirement contributions are added back into the mix for the “base year” and any contributions thereafter. Check out college-financial-aid-info.com There are just too many misconceptions and myths out there. Oh, and the money that the child made and put into an IRA? Wrong again. That too will be added back into the mix. You really are misinformed.
Terry, thank you for the comment. I researched this topic and found multiple sources for each statement I made. So, while I’m open to being wrong, there must be significant bad info out there. I’d be more than happy to host a guest post setting the record straight should you be willing to provide one.
BTW – what type of account (besides retirement) is excluded from the aid calculations?
Thanks for publishing my last post, Joe. You are right, there is a ton a really bad and misleading information out there. I see and hear it from all walks of life, from friends and relatives to CPAs and even guidance counselors (thus the last paragraph in this letter).
The truth of the matter? There is no one out there that is willing to tell you where to “stash the cash.” That is, without getting paid. There are plenty of so-called college financial aid advisors selling all kinds of products for parents and students to put their money in, but they basically only have one thing in mind when you meet with them: How much commission will they make.
I am very weary of products that claim to help with tuition such as the 529 plans and other state-sponsored Tuition Assistance Programs. Although I have read many times that the money used from these accounts to pay tuition costs does not disqualify you for aid, I have called and talked to many financial aid officers in the past few years and they all seem to say the same thing, and that is basically that you need to put the asset on the financial aid forms and a determination will be made when all of the forms are filed.
What is the way I read into that? “YES,” it will be counted against you. And with college-financial-aid-info.com database of what colleges give in meeting need and the ratio of how much comes in “free money” (grants and scholarships) and how much comes in “self help” (work study and loans), when parents get their student’s financial aid package, it is obvious that these kind of investments do disqualify you for aid. They only way we can come to this conclusion, is to compare aid packages with similar families with similar circumstances excluding the college savings plans. It really can’t get any more scientific than that. The financial aid officers at colleges can determine your need any way they want to when they are awarding their own money.
I am not saying that they are discriminatory on a personal basis, but I am saying that if you show assets, it most likely will count against you.
Now, to first explain, everybody is different and has different situations, but if you show me a family with similar circumstances such as the same number in family, same income, same assets, same home equity, etc., I can show you two totally different EFC’s with tens of thousands of dollars separating them. The reason is that family ‘A’ did not take steps to protect assets and shelter home equity and family ‘B’ did their homework and safeguarded all equity and assets allowing for a much lower EFC affording them more financial aid.
What is the secret? There are many different accounts that you can transfer assets into that bulletproof you from the financial aid formulas. We use a highly specialized guaranteed annuity that was designed with the college financial aid process in mind that not only eliminates the money from the formulas, but gets an average 6% return. Not all annuities are created equal, so you must be careful and know the differences because one will not count in the formulas while a similar looking annuity will.
A good example of what I am explaining happened this year: A client with two high school children a year apart received over $645,000 in an insurance settlement. Obviously, with that kind of asset on paper they were not going to receive any aid. After I spoke to them, I showed them that by transferring the money into a financial aid eligible account, their EFC went from over $60,000 down to an affordable $12,000. Their student applied and was accepted to a private university that has a price tag of over $42,000 with the second child applying for the 2010-2011 school year to a similar costing university as this paragraph is being written. That’s a $240,000+ savings for that family plus they still have the asset and it is gaining interest at about 6.3% this year.
Now, if we add this all up, not only did the family save the $240,000 in tuition costs but they also have that money working for them. I see it as a $480,000 swing of events-not counting the interest the money is making.
The downside to our account strategy is: If you take the money out before age 59-1/2, there is a 10% penalty on the gain ONLY. So, that is to say that if you transfer money into this account, and over, say a 5 year period, your account grows by $20,000, you will pay a penalty of only $2,000 to the IRS. That’s a pretty good trade off considering the money that you saved.
The only other drawback is the surrender charge. Although we only use accounts that offer a 10% withdrawal of funds per year, if you were to cash out within the time frame that the account was set up for, (we use a 5,7, or 10 year account depending on family circumstances) there could be surrender charges. Families must be aware of any provisions in the account that restrict removal of funds. That is why I would only use an expert in the college aid field that has your interests in mind first.
For more information on the subject or to find out how you can bulletproof your portfolio, you can visit: http://www.college-financial-aid-info.com
Thanks again, Joe. I would like to write about the home equity myths and misconceptions that are out there circulating next time. A parent just told me these two yesterday: Myth #1: Our guidance counselor and/or visiting college representative told us at our high school college night that home equity doesn’t count in the formulas- and Myth #2- The FAFSA doesn’t ask for the equity in your home so it doesn’t count in determining your EFC. And this misconception that I hear from time to time- Myth#3: There is no way to eliminate home equity from the formulas without spending it.