If you’re like many parents, you may be wondering whether saving too much for college will decrease your child’s chances of receiving need-based federal financial aid. Here’s an overview of how different types of assets fit into the financial aid equation.
The EFC calculation
First, let’s look at the Expected Family Contribution (EFC), a critical component of the Free Application for Federal Student Aid (FAFSA). The EFC—or the amount you’re expected to contribute toward your child’s education costs— factors in the following financial resources:
- 20% of the student’s assets, such as money in the bank, investments, business interests, and real estate.
- 50% of the student’s income (after certain allowances).
- 2.6% – 5.6% of the parent’s assets, such as money in the bank, investments, business interests, and real estate, based on a sliding income scale (after certain allowances).
- 22% – 47% of the parent’s income, based on a sliding income scale (after certain allowances).
Your assets and the EFC
Now, let’s examine how specific types of assets affect the EFC formula.
Retirement accounts, such as IRAs and 401(k)s, whether yours or your child’s, are not counted at all in determining the EFC for federal financial aid. Be careful, however, about taking money out of your IRA (or any retirement account) to pay for college. Though the tax law permits penalty-free withdrawals from a traditional or Roth IRA to pay for qualified college costs, doing so could jeopardize financial aid in the following year. The entire withdrawal, including principal and earnings, counts as income on the following year’s aid application.
Different Types of Equity
The equity in your primary home, a family-owned business, insurance policies, and annuities are also excluded from your assets when determining the EFC.
All assets that belong to the student result in a greater reduction in financial aid. which includes UGMA and UTMA accounts. In addition, these may increase the student’s included income to the extent that interest, dividends, or capital gains are reported on the student’s income tax return. Often, the income tax benefit of setting aside investment assets in a child’s name is offset by the reduction in the child’s financial aid package.
529 plans and Coverdell Educational Savings Accounts (ESAs)
These vehicles may be two of the best savings options for college because they do not jeopardize financial aid. 529 plans and Coverdell ESAs offer special advantages when it comes to aid eligibility:
- If a parent owns the 529 account or ESA, up to 5.6% of the value is included in the EFC as a parent asset.
- If grandparents own the account, none of the value is included. Distributions made from grandparent-owned 529 plans, however, will be considered untaxed income to the student for purposes of the following year’s FAFSA asset reporting. This means that 50%t of the value of the distribution will be counted as student income.
- A 529 account or ESA owned by a dependent student, or by a custodian for the student, is to be reported on the FAFSA as a parental asset.
- Withdrawals from 529 plans and ESAs are treated advantageously. When distributions are used to pay for college, such withdrawals are excluded from your federal income tax return and don’t need to be added back in when reporting family income on the FAFSA. This is unless the withdrawals come from a grandparent-owned plan, where up to 50% of the withdrawal will be counted for FAFSA in the year following the distribution.
Note to Remember
Some colleges calculate financial need using a different formula when offering their own grants and tuition discounts. The institutional methodology used by these colleges may count home equity, siblings’ assets, and certain investment accounts in a manner that differs from the federal methodology.
The fees, expenses, and features of 529 plans can vary state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee a college-funding goal will be met. Earnings must be used to pay for qualified higher education expenses to be federally tax-free. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and subject to a 10% penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer. Kelsey Dolfi, CPA is a financial consultant located at RiverStone Private Wealth Advisors, 7 Livingston St, Rhinebeck NY 12572. She offers securities as a Registered Representative of Commonwealth Financial Network®, Member FINRA/SIPC. She can be reached at 845-516-4440 or at email@example.com. © 2015 Commonwealth Financial Network®
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