EDU105 - FAQ: How Investments and Income Affect Financial Aid Eligibility

How Your Savings Can Affect Financial Aid

Presented by Tim Weller

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 percent of the student’s assets, such as money, investments, business interests, and real estate
50 percent of the student’s income
Up to 5.64 percent of parents’ assets, such as money, investments, business interests, and real estate, based on a sliding income scale (after certain allowances)
22 percent to 47 percent of parents’ 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. Retirement accounts (e.g., 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 may jeopardize financial aid in a future year. The entire withdrawal, including principal and earnings, counts as income on a future year’s aid application.

Different types of equity. The equity in your primary home, a family-owned business, insurance policies, and annuities is also excluded from your assets when determining the EFC.

Student assets. Assets that belong to the student result in a greater reduction in financial aid. Uniform Gift to Minors Act and Uniform Transfer to Minors Act accounts are counted as student assets. In addition, they 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 Education Savings Accounts (ESAs). These vehicles may be two of the better options to save for college without jeopardizing financial aid. They offer special advantages when it comes to aid eligibility:

If a parent owns the 529 account or ESA, up to 5.64 percent 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 percent 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 also treated advantageously. When 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 rule applies unless the withdrawals come from a grandparent-owned plan, in which case up to 50 percent of the withdrawal will be reported on the FAFSA. Grandparent-owned 529 plans are not countable assets, but a withdrawal for education expenses is considered nontaxable income to the student. Therefore, the family may want to delay using those funds until the beneficiary’s last two years of college. This is because the FAFSA uses the prior-prior year tax return to complete the income calculation.

Please note: 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 from 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 percent 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.

Tim Weller is a financial professional with Weller Group LLC at 6206 Slocum Road, Ontario, NY 14519. He offers securities as a Registered Representative of Commonwealth Financial Network®, Member FINRA/SIPC. He can be reached at 315-524-8000 or at tim@wellergroupllc.com.