The Best Strategies for Financing College

Forget all you’ve learned about helping to pay for college. The rules for most people aren’t what you’ve heard.

College is so expensive, especially at private schools, that most students get some form of financial aid. Some of the schools boast about the percentage of students who get aid. Even loans are financial aid, and they can be valuable tools – especially subsidized loans.

For many parents and students, the name of the game is to maximize financial aid. That is very different from maximizing savings for college. In fact, the tax and investment strategies that get widely promoted actually can be harmful in the financial aid process.

Who should care? More people than realize. The parents’ income and assets are the key factors. The grandparents’ resources don’t count. Parents with a joint income under $100,000 definitely should consider applying for financial aid. Even parents with incomes up to $200,000 might qualify, because more than income and assets are considered.

Other factors affecting aid include the cost of living where the parents reside, the number of children, the student’s grades, and the type of assets. What if the parents are divorced? Then the income and assets of the custodial parent and any stepparent are examined. The financial position of the non-custodial natural parent usually isn’t considered at all.

Here’s a summary of what parents and grandparents need to know to increase college financial aid. It is much like completing your tax return and doing some tax planning.

The first rule is that the calendar year before the child enrolls in college, known as the base year, is what counts. For a college freshman, the schools look at Jan. 1 in the second half of the student’s junior high school year through Dec. 31 of the first half of the senior year. Then the situation might be re-examined each year. You can shift income, expenses, and assets to other years to make you look most needy in that first year.

Most schools use the same application, the Free Application for Federal Student Aid (FAFSA). Some schools, especially private schools, also will require a Financial Aid Profile, which asks for additional information. A few schools will ask for supplemental data. The earliest you may complete the forms is January of the child’s senior year.

The schools will compute an Expected Family Contribution (EFC). A contribution will be expected from both the parents and the student. The EFC should be roughly the same from all schools, but it doesn’t always work out that way.

Here are the key formulas. Parents are expected to contribute up to 47% of disposable income and up to 5.6% of assets. The student is expected to contribute 50% of income and 35% of assets. There are many variables that determine whether you pay the maximum percentage or a lesser amount. The best advice is to use all the strategies you can, apply for aid the first year, and see what happens. Here are details and strategies.

• The income for the parents generally is federal adjusted gross income from the tax return for the base year. Parents should consider deferring bonuses and raises until the following year, avoiding capital gains, delaying cashing in savings bonds, and avoiding distributions from IRAs or other retirement plans. It also helps to avoid receiving a big state income tax refund that year, because it will count as income. 

• Business losses reduce income. If you can turn a hobby into a business that loses money or get an existing business to generate tax losses, your odds for getting financial aid will increase. 

• Expenses for adjusted gross income are deducted on the financial aid form. But contributions to retirement plans are treated as income. Most itemized deductions, other than some medical expenses, aren’t considered for financial aid. You do get a deduction on the financial aid form for federal income taxes paid, so you can benefit by bunching federal taxes into the base year. 

• You also get an Income Protection Allowance, based on the size of your family and the number of children in college. The amount is determined by the federal government each year and is based on the cost of providing the basics of living at the poverty level. 

• It can pay to spend down your cash and rearrange your debts.
  Liquid assets, mutual funds, stocks, bonds, trusts, business interests, and real estate other than your home are assets that count toward your expected contribution. But insurance policies, annuities, retirement accounts, and your home don’t have to be listed as assets. Automobiles also don’t count. 

• Most schools, other than exclusive private schools, don’t count the value of your primary residence. Of those that do, most cap its value at three times the parents’ income. 

• Most debts aren’t considered by the colleges. You get credit for margin loans that aren’t used to buy investments; passbook loans; and loans against your homes if those homes are considered assets by the college. Credit cards, personal loans, and existing student loans don’t count. You also get an asset protection allowance, similar to the income protection allowance, which depends on the older parent’s age and number of children. This amount is determined by the Department of Education each year. 

• Because of these rules, it makes sense for you to spend down cash to buy assets that aren’t considered by the college or to pay down debt that isn’t subtracted from your net worth. That means making any major purchases for cash you’ve been considering and paying off credit cards and other personal debt. Make substantial contributions to retirement plans in the years before the base year if possible. Since home equity usually doesn’t count, it often makes sense to use liquid assets to pay down a mortgage if that will qualify you for financial aid. 

  Because a margin loan can count as debt, taking a margin loan against investment assets to pay for college makes you look less wealthy and increases your financial aid.

• Students get to exclude the first $2,300 or so of their income, then are expected to contribute 50% of each dollar earned beyond that. A private school, however, will expect a student to contribute about $1,200 to expenses and provides no excluded amount. A student who earned more than the minimum will be expected to contribute 85% of the money earned to a private college’s expenses. 

• The student’s assets are where the financial aid formula dramatically differs from the advice most people get. Students are expected to contribute 35% of their assets to education each year, while parents are expected to contribute only up to 5.6% of assets. For tax planning, it is better to have assets in the child’s name. But if financial aid is a possibility, it is much better to have the assets in the parents’ names. 

Families that have followed the traditional advice of using UGMA accounts and trusts to provide for education are at a disadvantage if the parents’ joint income and assets are low enough that they might qualify for financial aid. If financial aid is a possibility, grandparents should retain their gifts until the grandchildren graduate from college. Or the grandparents can pay tuition directly once college begins. Don’t set money aside for the child’s benefit until after graduation.

What if assets already are in an UGMA, trust, or section 528 account? You cannot take the money back in most cases. You can consider spending the money on things the child would need anyway but that don’t count against financial aid. These could include a computer, stereo or car. You cannot spend the accounts on necessities.   Those are your legal obligation. The laws on these accounts vary from state to state, so you’ll need local advice on the specifics that can be done.

The financial aid rules are very complicated, almost as complicated as the tax code. I’ve only touched on the basics here. Because of all the variables, it is impossible to say who will qualify for how much financial aid at each school. You’ll need additional help. You can buy Paying For College Without Going Broke by Kalman A. Chany. Also, check the web sites www.collegeboard.com (for official information), www.collegeaidcalculator.com (for software to help calculate your likely financial aid), and www.finaid.com (for lots of information).

In next month’s visit I’ll explain why almost every one should consider using student loans to pay college expenses for children and grandchildren. The following month I’ll wrap up with a summary of strategies that let grandparents and parents find the optimum way to finance college.