The cost of college these days is ridiculous. We always encounter astonishment when we sit down with couples who just recently had a baby and we show them that if the cost of college rises at 5% per year over that child's life (which is actually quite a bit less than it has gone up over the past 15 years as shown here) they will need to save nearly $300,000 in order to pay for all of their kid's tuition, room and board.
I don't blame them. That is depressing. That means that for each child you have, you likely need to save somewhere around $700 per month and invest it in order to fully pay for college. For a family with multiple kids, this amount can start being on par with a mortgage payment. Not likely to happen for most of us.
So what do you do in life when you encounter a huge financial obstacle? You do what every good American does: Tap grandma and grandpa. Obviously.
Just kidding. The real answer is you are likely going to need financial aid.
If you have one of those super studious kids (hey, don't hate on us nerds), or incredibly athletic genes, some schools may throw money at you. But for most of us, we are going to need to look elsewhere for a source of funds to pay for our kids' college.
The best place to start is with the federal government. The federal government offers financial aid in the form of grants (which don't have to be repaid!), student loans and work-study programs. With any of the federal government's financial aid programs, the amount of aid is awarded based on financial need. So the strategies we employ are all focused around how to maximize the government's assessment of your financial need.
First, let's look at how they assess financial need. The government uses a standard form called the Free Application for Federal Student Aid (FAFSA) form (you can find the 2015-2016 form here) to gather basic information about your family and financial situation. Anyone and everyone applying for federal benefits is required to fill out this form. While the FAFSA can be daunting, it's really not all that long and we are happy to sit down with our clients and do it with them to make the process easier.
Once the government has received the form they calculate financial need as follows:
Cost of Attendance (COA) - Expected Family Contribution (EFC) = Financial Need
COA is simply the cost of tuition, fees, room, board, books, supplies, transportation and dependent childcare if the student is also a parent. Typically the school is the one that calculates this as a standard number for its students and provides the information to the government.
EFC is the amount of expenses that can be reasonably expected to be paid by the student and the student's family. This is calculated using a more complicated formula based on information obtained in the FAFSA form. Our financial planning strategies all center around how to legally and ethically reduce your EFC by understanding the way the EFC is calculated and putting assets in the right buckets to appropriately reduce the calculation of your EFC and therefore increase the calculation of your Financial Need.
The EFC worksheets the government uses can be fairly complicated and there are many nuances to the rules but let's focus on the main components. The following resources are counted towards the EFC (source):
- 50% of the student's income
- 20% of the student's assets
- Up to 5.64% of the parents' assets
- 22-47% of parents' income (based on sliding income scale)
Reducing Reported Student's Income: Strategies aimed at reducing student income are primarily focused on when you pull money from certain accounts and how that will impact the student's reported income. Parent withdrawals from 529 college savings plans are not counted as student income and are not reported as income at all on the FAFSA. Grandparent (or any other third party) withdrawals from 529 college savings plans to pay for college and parent withdrawals from Roth or Traditional IRA accounts are considered 100% student income in the year they are withdrawn.
President Obama recently signed into law a rule change that will look at the income of the student two years ago rather than simply one year ago when calculating the student's income (starting in the 2017-2018 school year). This has significant impact on the timing of certain financial planning items.
If your student is starting school in 2017 or later, this likely means that it will be most advantageous to take withdrawals from any parent 529 plans in the first two years and utilize grandparent 529s or retirement assets (Roth or Traditional IRAs) in the last two years of college as they won't count as income until the year after the student graduates (assuming the student doesn't need to go to extra years of school).
Timing of withdrawals and from what accounts makes all the difference when trying to reduce your student's reported income, and therefore it makes sense to work with an advisor to ensure you have the proper strategy.
Reducing Reported Student's Assets: Custodial accounts or UTMA / UGMA accounts are considered student assets. 20% will count as part of the EFC and any income / dividends / capital gains will be included in student income. Therefore, whenever possible, keep the assets in the parents' names rather than in the student's name as they will count at a significantly lower rate under the parents' names.
The primary reason many people setup a custodial account for their kids is to take advantage of the tax benefits. Namely, if the taxable income on the account is less than $2,000 in a given tax year, the account is taxed at the child's tax rate rather than the parents'. This can often be an advantage when the balance is small and usually when the child is young and still far away from college. As your child approaches high school or the balance begins to earn more than $2,000 in investment income, work with your advisor to consider how those assets might be reallocated to be more advantageous for financial aid. (Note: There are sometimes strict rules around how custodial assets can be used so ensure you have the proper advice from your advisor and/or attorney before attempting this.)
Reducing Reported Parents' Assets: Retirement assets are not reported on the FAFSA. Neither is home equity. Neither is the cash surrender value of a whole life insurance policy. These are places you can put your money to keep it from being counted against you in the financial aid calculations.
Roth IRA accounts are often a good option because they allow you to take the money out tax-free and penalty free if you have had any Roth IRA for at least 5 years and the money is used for higher educational expenses (or if you are over 59.5 years old). However, as noted above, when the money is pulled out, it is treated 100% as income of the student if it is used to pay for college. Therefore, we recommend only using this money for the last two years of school where the student's income lookback won't apply.
529 college savings plan will, in fact, count as parental assets on the FAFSA form. 529s have the benefit of all withdrawals being excluded from reported income, however. So in some situations, it may make sense to have money in both 529s and Roth IRAs to pay for college.
Reducing Reported Parents' Income: Strategies around reducing parents' income can become very complicated and specific to one family's individual situation. Most often, strategies revolve around timing certain income so as to minimize it during the years being reviewed (such as recognizing losses on certain assets during the reported years so as to minimize capital gains).
What is not reported as assets on the FAFSA form:
- Retirement assets
- Home equity
- A family owned business if it is owned at least 50% by your family, controlled by your family and has less than 100 employees
- Cash surrender value of whole life insurance policies
College is expensive and we all can use all the help we can get in the way of financial aid. As you have kids and begin to save for college, it makes sense to work with a financial advisor to strategize around how you might be able to increase your financial aid by simply putting your assets in different accounts and drawing on certain accounts in different time periods. We'd love to sit down with you and begin the conversation.
Disclosure: Nothing from the above should be construed as financial or tax advice. Please consult your financial advisor before implementing any of the above strategies. Everyone's individual situation is different and there are a number of exceptions and differences to the rules that could apply in your specific situation. Do your own homework.