Paying for College Without Going Broke, 2017 Edition - Princeton Review, Kalman Chany (2016)
Part II. How to Take Control of the Process
Chapter 3. Short-Term Strategies for Receiving More Financial Aid
A “Snapshot” of Your Financial Picture
Each year your son or daughter is in college, the school will ask you to fill out a form reporting income and assets—in effect a snapshot of your overall financial picture. You’ve probably noticed that snapshots can be very misleading. In one picture, you may appear youthful and vibrant. In another, you may look terrible, with a double chin and 20 extra pounds. Perhaps neither photograph is exactly correct. Of course, when you are deciding which picture to put in the scrapbook, the choice is easy: throw away the one you don’t like and keep the one you do.
In choosing which financial snapshot to send to the colleges, the object is a little bit different: send them the worst-looking picture you can find.
To be very blunt, the single most effective way to reduce the family contribution is to make your income and your assets look as small as possible.
Well, This Is Not Revolutionary Advice
After all, you’ve been trying to do this for years.
We’re sure you and your accountant are generally doing a fine job of keeping your taxes to a minimum. However, certain long-term tax strategies that normally make all kinds of sense, can explode in your face during college years. Neither you nor your accountant may fully grasp how important it is to understand the ins and outs of the financial aid formulas.
How College Planning Affects Tax Planning
There are two reasons why tax planning has to change during college years.
First, the FAOs (unlike the IRS) are concerned about only four years of your financial life. Using strategies we will be showing you in the next few chapters, you may be able to shift income out of those four years, thus increasing your financial aid.
Second, financial aid formulas differ from the IRS formulas in several key ways. Certain long-term tax reduction strategies (shifting income to other family members, for example) can actually increase the amount of college tuition you will pay. However, astute parents who understand these differences will find that there are some wonderful, legal, logical alternatives they can explore to change the four snapshots the college will take of their income and assets.
Tax accountants who do not understand the financial aid process (and in our experience, this includes most of them) can actually hurt your chances for financial aid.
The First Base Year Income
Colleges base your ability to pay this year’s tuition not on what you made this year; not even on what you made last year; they base it on what you made the year before that. This may seem like ancient history, but the colleges have their complicated reasons (which we’ll go into later). Thus the first financial aid scrutiny you will undergo will not be directed at the calendar year during which your child will start her freshman year of college, but two years before. That year is called the first base income year and is the crucial one.
The base income year (shaded in the diagram that follows) extends from January 1 of your child’s sophomore year in high school to December 31 of your child’s junior year in high school. This is when first impressions are formed. The college will get an idea of how much you are likely to be able to afford, not just for the first year of school, but for the remaining years as well. First impressions are likely to endure and are often very difficult to change. Thus it would be helpful to remove as much income as possible from this calendar year.
What If I’m Already Past the Base Income Year?
If you are reading this book and your son or daughter is already in the spring term of junior year in high school, then you have probably missed the chance to make adjustments to your income for the base income year—but don’t despair. First of all, there are three other years still to go; the strategies we outline below can be used to lower the appearance of income in the years to come. And second, you haven’t missed the chance to make adjustments to your assets. That snapshot gets taken on the day you fill out the forms. We’ll talk about assets a little later in this chapter.
What If I’m In the Middle of the Base Income Year?
If you are reading this book and you are still in the base income year, there are a bunch of very specific things you can do to minimize the appearance of income.
What If My Income Radically Changes Between the Base Income Year and When My Daughter Starts College?
If your income has gone up since the base income year, that’s great. No need to report the change, unless you are asked to by an individual college. However, if your income has gone markedly down since the base income year, you can always write to the colleges and explain. We’ll describe this process, called an “appeal”, later in this book.
I’m About to Get a Raise. Should I Say No?
It’s easy to get carried away with the concept of reducing income, and it may appear at first that you would be better off turning down a raise. However, the short answer to this question is,
“Are you crazy?”
More money is always good. Our discussion here is limited to minimizing the appearance of more money. Let’s say you get a raise of $3,000 per year. This will certainly reduce your eligibility for college aid, but will it negate the entire effect of the raise? Not likely. Let’s say you’re in the 25% federal tax bracket, your raise is still subject to social security taxes of 7.65%, and your income is being assessed at the maximum rate possible under the aid formulas. Looking at the chart that follows, you’ll see that even after taxes and reduced aid eligibility are taken into account, you will still be $1,170 ahead, though state and local taxes might reduce this somewhat.
what you keep:
My Spouse Works. Should He or She Quit?
The same principle applies here. More money is good. Not only are you getting the advantage of extra income but also under the federal financial aid formula, for a two-parent family with both parents working, 35% of the first $11,429 the spouse with the lower income earns is deducted as an “employment allowance”. (The same deduction is granted for a single parent household if that parent works.) Even if this increased income decreases your aid eligibility, you will still be ahead on the income. In addition, you will be creating the impression of a family with a work ethic, which can be very helpful in negotiating with FAOs later. FAOs work for their living, and probably earn less than you do. They are more likely to give additional aid to families who have demonstrated their willingness to make sacrifices.
Income vs. Assets
Some parents get confused by the differences between what is considered income and what are considered assets. Assets are the money, property, and other financial instruments you’ve been able to accumulate over time. Income, on the other hand, is the money you actually earned or otherwise received during the past year, including interest and dividends from your assets.
The IRS never asks you to report your assets on your 1040—only the income you received from these assets. Colleges, on the other hand, are very interested in your income and your assets. Later in this chapter, there will be an entire section devoted to strategies for reducing the appearance of your assets. For now, let’s focus on income.
The colleges decided long ago that income should be assessed much more heavily than assets. The intention is that when a family is finished paying for college, there should be something left in the bank. (Don’t start feeling grateful just yet. This works only as long as the colleges meet a family’s need in full.)
When considering their chances for financial aid, many families believe that the colleges are interested only in how much income you make from work. If this were the case, the colleges would just be able to look at your W-2 form to see if you qualified for aid. Unfortunately, life is not so simple. The college’s complicated formulas make the IRS tax code look like child’s play.
For financial aid purposes, the colleges will be looking at the same income the IRS does. For most of us, that boils down to line 37 of the 1040 IRS form: the Adjusted Gross Income or AGI. (By the way, if you use form 1040A, the AGI is found on line 21; if you use the 1040EZ form, it is on line 4. For simplicity’s sake, from now on, we will refer just to the 1040 long form and line 37.)
But for those who file a tax return, the colleges also look at certain other types of income that are not subject to tax, for example, child support, tax-exempt interest, voluntary contributions to a 401(k) plan or other tax-deferred retirement plan.
For those who don’t file a return, the colleges will still look at income earned from work plus other untaxed income.
Before we begin discussing the components of taxable and untaxed income, it is important to understand that even the decision as to which tax form to file (1040 long form vs. the 1040EZ or the 1040A) the student’s parents file can have a significant impact on your eligibility for financial aid.
Not All Tax Returns Are Created Equal
By filing one of the short forms (1040A or 1040EZ), and meeting certain other requirements, you may be able to have parent and student assets excluded from the federal financial aid formulas, which could qualify you for increased federal aid. This is a financial aid loophole known as the “Simplified Needs Test” (SNT). Here’s the way it works: If the parents have adjusted gross income below $50,000, (or for non-tax filers, have income from work which for most means wages reported on a W-2 form below $50,000), and the parent(s) in the household who file a tax return can use the 1040EZ or the 1040A form (or are not required to file any personal income tax return), then all your family’s assets will be excluded from the federal financial aid formulas. This means that eligibility for the Pell Grant, for undergraduate students, and the subsidized Stafford loan will be determined without regard to how much money the parent or the student has in the bank or in a brokerage account.
Click here to download a PDF sample of IRS Form 1040.
It can also be vital to parents with large assets but little real earned income. You can have $49,999 of interest income, and still possibly meet the simplified needs test—in which case even assets of several million dollars will not be used in calculating your EFC.
This can be particularly vital to parents with income below $40,000 but who have significant assets because they now may be able to qualify for the Pell Grant, which is free money that does not have to be paid back.
Of course, many colleges use the College Board’s institutional methodology (which does not utilize the simplified needs test) in awarding their own grant money. However, if you meet the Simplified Needs Test, they cannot use the family assets in determining eligibility for the Pell Grant, and subsidized Stafford loans. If you aren’t sure if you can use the short tax forms, consult the IRS instructions to the forms, or your tax preparer. A few examples of people who can’t use the short form: a self-employed individual, a partner in a partnership, a shareholder in an S corporation, a beneficiary of an estate or trust. In addition, if you had rental or royalty income and expenses, had farm income and expenses, took certain types of capital gains or losses, received alimony, or itemized deductions, you will have to file the long form if you are required to file.
However, for some taxpayers who could itemize deductions, but won’t save much money by doing so, it may still make sense to file the short form if otherwise eligible to do so. You’ll pay slightly higher taxes, but this may be more than offset by a larger aid package. Since this strategy requires a trade-off between tax benefits and aid benefits, we recommend you consult a competent advisor.
Unfortunately, even if you fit the simplified needs test, your accountant may unwittingly blow this lovely loophole for you by insisting on filing the wrong form.
Not All Accountants Are Created Equal
Many accountants are not aware of the aid laws and will try to talk you into using the 1040—simply because that is the only form their computer programs will print out. If you meet the simplified needs test, be prepared to insist that your tax preparer use the 1040EZ or the 1040A forms. It might not even be a bad idea to take this book along with you when you go for your annual appointment with your tax preparer. We have heard of some accountants who tell their clients that if they file the 1040 without itemizing deductions, it is the same as using the short forms. Unfortunately, for financial aid purposes, this is not necessarily true. The federal rules state that you can qualify for the Simplified Needs Test even if you file a 1040, provided you were eligible to file a 1040A or 1040EZ (or you are not required to file a personal tax return) and you meet the income guidelines. However, a representative at the U.S. Department of Education said that this is a “murky area” and that guidelines are still being developed to advise FAOs on how to determine if a family that filed a 1040 was eligible to file a 1040A or 1040EZ (or was not required to file a personal tax return). Since you may have to do a lot of explaining and go through a lot of red tape to convince the FAO (who is not a CPA) that you could have done the short form or were not required to file a personal tax return (and you may not be successful), we recommend that you use the 1040A or 1040EZ if you are eligible to do so (or not file a return at all if you are not required to do so). For your benefit, we have listed the headings of the different returns below so you can identify which are the short forms and which is the long form.
The long form (1040):
Besides the Simplified Needs Test, there is another favorable federal aid loophole known as…
The Automatic Zero-EFC
The federal government has a great break for parent(s) in the household who 1) have a 2015 combined adjusted gross income of $25,000 or less (or if non-tax filers, have combined income from work of $25,000 or less), and 2) can file the 1040A or the 1040EZ tax form (or are not required to file a tax form at all because they are not required to do so).
Note: Prior to the 2012-2013 award year, the income cut-off was considerably higher. However, as part of the December 2011 budget deal by Congress, new legislation reduced the income threshold.
Even if your child has substantial income, or you and your child have substantial assets, the student’s EFC will be judged to be zero if you meet these requirements.
Some accountants encourage retired, disabled, unemployed, or low-income parents to file the long form—which could be troublesome if you otherwise qualify for this break. Many of these parents could file the short form or may not be required to file at all, which will make things much easier when dealing with the FAOs.
Tip #1: There may be some financial aid advantages to filling out the short forms (the 1040A or the 1040EZ) if the IRS permits you to do so. And if you are not required to file a personal tax return but still file a 1040 form, you can still be eligible for the SNT or Automatic Zero-EFC.
Alternate Ways to Qualify
There is an additional way to qualify for the Simplified Need Test (SNT) or the Automatic Zero EFC: if, during the base income year, or the year after the base income year, the student, her parents, or anyone in the parents’ household receives benefits under a means-tested Federal benefit program (other than federal student aid), then they qualify for the Automatic Zero EFC and/or the SNT (provided parental income is below the thresholds mentioned above even if the IRS 1040 is filed). Such benefit programs normally include food stamps, supplemental security income, temporary assistance for needy families (TANF), certain school lunch programs, or certain supplemental nutrition programs for women, infants, and children (WIC).
A dependent student can also qualify for the SNT or Automatic-Zero EFC provided a parent who reports his or her financial information on the FAFSA is considered a “dislocated worker” on the date the FAFSA form is filed (and provided the parental income for the base income year is below the thresholds mentioned above even if the IRS 1040 is filed). A parent can normally qualify for this dislocated worker status by meeting at least one of the following criteria: being laid-off or receiving a lay-off notice from a job; receiving unemployment benefits (due to being laid off or losing a job, provided the person is unlikely to return to their prior occupation); was self-employed but is now unemployed due to economic conditions or natural disaster; or being a “displaced homemaker” (i.e. a stay-at-home mother or father who is no longer supported by their spouse, is unemployed or underemployed, and is having trouble finding or upgrading employment). The financial aid officer at the school will probably require additional documentation to prove such dislocated worker status.
Independent students can also qualify for the SNT and the Automatic-Zero EFC if they meet the same criteria mentioned above, though the Automatic-Zero EFC is not available to a single student or a married independent student without dependents other than a spouse.
A Parents’ Step-by-Step Guide to the Federal Income Tax Form
By reducing your total income (lines 7-21 on the 1040) you can increase your financial aid, which, you should remember, is largely funded by your tax dollars anyway. Let’s examine how various items on your tax return can be adjusted to influence your aid eligibility. The IRS line numbers below refer to the 2015 IRS 1040.
LINE 7—WAGES, SALARIES, TIPS, ETC.
For most parents, there is not much to be done about line 7. Your employers will send you W-2 forms, and you simply report this income. However, there are a few points to be made.
Defer Your Bonus
If you are one of the thousands of Americans in the workplace who receive a bonus, you might discuss with your boss the possibility of moving your bonus into a non-base income year. For example:
If your child is in the beginning of her sophomore year of high school (in other words, if the first base income year has not yet begun) and you are due a year-end bonus, make sure that you collect and deposit the bonus before January 1 of the new year (when the base income year begins). As long as the bonus is included on your W-2 for the previous year, it will not be considered income on your aid application.
The money will still appear as part of your assets (provided you haven’t already spent it). But by shifting the bonus into a non-base income year, you will avoid having the colleges count your bonus twice—as both asset and income.
If you are due a year-end bonus and your child is starting his junior year of high school, see if you can arrange to get the bonus held off until after January 1. Yes, it will show up on next year’s financial aid form, but in the meantime you’ve had the benefit of financial aid for this year.
Just as important, FAOs make four-year projections based on your first base income year. Your FAO will have set aside money for you for the next three years based on the aid your child receives as a freshman in college. Who knows what might happen next year? You might need that money. If the FAO hasn’t already set it aside for you, it might not be there when you need it.
Tip #2: Move your bonus into a non-base income year.
If You’ve Had an Unusually Good Year
Maybe you won a retroactive pay increase during the base income year. Or perhaps you just worked a lot of overtime. If you can arrange to receive payment during a non-base income year that would, of course, be better, but there are sometimes compelling reasons for taking the money when it is offered (for example, you are afraid you might not get it later).
However, unless you explain the details of this windfall to the colleges, they will be under the impression that this sort of thing happens to you all the time.
If the base income year’s income is really not representative, write to the financial aid office of each of the colleges your child is applying to, and explain that this was a once-in-a-lifetime payment, never to be repeated. Include a copy of your tax return from the year before the base income year, or from the year after, which more closely reflects your true average income. If helpful to your cause, you may wish to include a projection of your income for the “current year” - the calendar year that will end on December 31 in the middle of the academic year for which you are seeking aid.
Don’t bother sending documentation like this to the companies that process the standardized analysis forms. They are only interested in crunching the numbers on the form, and anyway have no power to make decisions about your aid at specific schools. Documentation regarding a change in circumstances should never be sent to the processing companies. Send it directly to the schools.
Tip #3: If you’ve had an unusually good year, explain to the colleges that your average salary is much lower.
Become an Independent Contractor
If you are a full-time employee receiving a W-2 form at the end of the year, you have significant unreimbursed business expenses, and you are otherwise ineligible for the SNT or the Automatic Zero-EFC, you might discuss with your employer the viability of becoming an independent contractor. The advantage to this is that you can file your income under schedule C of the tax form (“profit or loss from business”), enabling you to deduct huge amounts of business-related expenses before line 37, where it will do you some good. Note: if you are otherwise eligible for the SNT or Automatic Zero-EFC, filing schedule C will disqualify you from receiving such favorable aid treatment, unless you are not required to file a tax return or are eligible by meeting at least one of the two alternate criteria mentioned on this page.
A regular salaried employee is allowed to take an itemized tax deduction for unreimbursed employee expenses (in excess of 2% of the AGI). Unfortunately, because this deduction comes after line 37, it will have no effect on reducing income under the financial aid formula.
An independent contractor, on the other hand, can deduct telephone bills, business use of the home, dues, business travel, and entertainment—basically anything that falls under the cost of doing business—and thus lower the adjusted gross income.
You would have to consult with your accountant to see if the disadvantages (increased likelihood of an IRS audit, difficulties in rearranging health insurance and pension plans, possible loss of unemployment benefits, increased social security tax, etc.) outweigh the advantages. In addition, the IRS has been known to crack down on employers who classify their workers as independent contractors when they are really salaried employees. Like all fuzzy areas of the tax law, this represents an opportunity to be exploited, but requires careful planning.
Tip #4a: If you have significant unreimbursed employee expenses, consider becoming an independent contractor so that you can deduct expenses on schedule C of the 1040. However, be careful if you are otherwise eligible for the SNT or Automatic Zero-EFC.
Even better, you might suggest to your boss that she cut your pay. No, we haven’t gone insane. By convincing your employer to reduce your pay by the amount of your business expenses, and then having her reimburse you directly for those expenses, you should end up with the same amount of money in your pocket, but you’ll show a lower AGI and therefore increase your aid eligibility.
Tip #4b: If you have significant unreimbursed employee expenses, try to get your employer to reimburse these business expenses directly to you—even if it means taking a corresponding cut in pay.
If your employer won’t let you pursue either of these options, you should be sure to explain your unreimbursed employee expenses in a separate letter to the FAOs.
LINES 8A AND 9A—TAXABLE INTEREST AND DIVIDEND INCOME
If you have interest or dividend income, you have assets. Nothing prompts a “validation” (financial aid jargon for an audit) faster than listing interest and dividend income without listing the assets it came from.
For the most part, there is little you can do, or would want to do, to reduce this income, though we will have a lot to say in later chapters about reducing the appearance of your assets.
Some parents have suggested taking all their assets and hiding them in a mattress or dumping them into a checking account that doesn’t earn interest. The first option is illegal and dumb. The second is just dumb. In both cases, this would be a bit like turning down a raise. More interest is good. The FAOs won’t take all of it, and you will need it if you want to have any chance of staying even with inflation.
The one type of interest income you might want to control comes from Series E and EE U.S. Savings Bonds. When you buy a U.S. Savings Bond, you don’t pay the face value of the bond; you buy it for much less. When the bond matures (in five years, 10 years, or whatever) it is then worth the face value of the bond. The money you receive from the bond in excess of what you paid for it is called interest. With Series E and EE Savings Bonds, you have two tax options: you can report the interest on the bond as it is earned each year on that year’s tax return, or you can report all the interest in one lump sum the year you cash in the bond.
By taking the second option, you can in effect hold savings bonds for years without paying any tax on the interest, because you haven’t cashed them in yet. However, when you finally do cash them in, you suddenly have to report all the interest earned over the years to the IRS. If the year that you report that interest happens to be a base income year, all of the interest will have to be reported on the aid forms as well. This will almost certainly raise your EFC.
The only exception to this might be Series EE bonds bought after 1989. The U.S. government decided to give parents who pay for their children’s college education a tax break: low- or middle-income parents who bought Series EE bonds after 1989 with the intention of using the bonds to help pay for college may not have to pay any tax on the interest income at all. The interest earned is completely tax-free for a single parent making up to $77,550 or a married couple earning up to $116,300. Once you hit these income levels, the benefits are slowly phased out. A single parent earning above $92,550 or a married couple earning above $146,300 becomes ineligible for any tax break. All of these numbers are based on 2016 tax rates and are subject to an annual adjustment for inflation.
However, we still recommend that parents who bought these bonds with the intention of paying for college cash them in after the end of the last base income year (after January 1 of the student’s sophomore year in college). Whether the interest from these bonds is taxed or untaxed, the FAOs still consider it income and assess it just as harshly as your wages.
Thus if at all possible, try to avoid cashing in any and all U.S. Savings Bonds during any base income year. With Series E or EE bonds, you may be able to roll over your money into Series H or HH bonds and defer reporting interest until the college years are over. There is also no law that says you have to cash in a savings bond when it matures. You can continue to hold the bond, and in some instances it will continue to earn interest above its face value.
Tip #5: If possible, avoid cashing in U.S. Savings Bonds during a base income year, unless you’ve been paying taxes on the interest each year, as it accrued.
If You Have Put Assets in Your Other Children’s Names
Parents are often told by accountants to transfer their assets into their children’s name so that the assets will be taxed at the children’s lower rate. While this is a good tax reduction strategy, it stinks as a financial aid strategy, as you will find out later in this chapter. However, if this is your situation and you have already put assets under the student’s younger siblings’ names, there is one small silver lining in this cloud: The tax laws give most parents with children under age 18 (or under age 24 if the child is a full time student for at least 5 months during the tax year) the option of reporting their child’s investment income on a separate tax return or on the parents’ own tax return.
Either way, the family enjoys the benefit of reduced taxes due to the child’s lower bracket. The principal advantage of reporting the child’s income on the parents’ return is to save the expense of paying an accountant to do a separate return.
However, if you are completing your tax returns for a base income year, we recommend that you do not report any of the student’s or student’s siblings’ investment income (i.e. interest, dividends, and capital gains) on your tax return. By filing a separate return for those children, you remove that income from your AGI, and lower your Expected Family Contribution. (We’ll discuss reporting of the student’s income later in this chapter.)
Tip #6: During base income years, do not report children’s investment income on the parents’ tax return. File a separate return for each child.
An important way in which the financial aid formulas differ from the tax code is in the handling of the income from leveraged investments. You leverage your investments by borrowing against them. The most common example of leverage is margin debt. Margin is a loan against the value of your investment portfolio usually made by a brokerage house so that you can buy more of whatever it is selling—for example, stock.
Let’s say you had $5,000 in interest and dividend income, but you also had to pay $2,000 in tax-deductible investment interest on a margin loan. The IRS may allow you to deduct your investment interest expenses from your investment income on schedule A. For tax purposes, you may have only $3,000 in net investment income.
Unfortunately, for financial aid purposes, interest expenses from schedule A are not taken into account. As far as the colleges are concerned, you had $5,000 in income.
Of course you will be able to subtract the value of your margin debt from the value of your total assets. However, under the aid formulas, you cannot deduct the interest on your margin debt from your investment income.
During base income years, you should avoid—or at least minimize—margin debt because it will inflate your income in the eyes of the FAOs. If there is no way to avoid leveraging your investments during the college years, you should at least call the FAO’s attention to the tax-deductible investment interest you are paying. Be prepared to be surprised at how financially unsavvy your FAO may turn out to be. He may not understand the concept of margin debt at all, in which case you will have to educate him. In our experience, we have found that if the situation is explained, many FAOs will make some allowance for a tax-deductible investment interest expense.
Tip #7: During base income years, avoid large amounts of margin debt.
LINE 10—TAXABLE REFUND OF STATE AND LOCAL INCOME TAXES
Many people see their tax refunds as a kind of Christmas club—a way to save some money that they would otherwise spend—so they arrange to have far too much deducted from their paychecks. Any accountant knows that this is actually incredibly dumb. In effect, you are giving the government the use of your money, interest-free. If you were to put this money aside during the year in an account that earned interest, you could make yourself a substantial piece of change.
So Why Does Your Accountant Encourage a Refund?
Even so, many accountants go along with the practice for a couple of reasons. First, they know that their clients are unlikely to go to the bother of setting up an automatic payroll savings plan at work. Second, they know that clients feel infinitely better when they walk out of their accountant’s office with money in their pockets. It tends to offset the large fee the accountant has just charged for his or her services. Third, a large refund doesn’t affect how much tax you ultimately pay. Whether you have your company withhold just the right amount, or way too much, over the years you still end up paying exactly the same amount in taxes.
So accountants have gotten used to the practice, and yours probably won’t tell you (or maybe doesn’t know) that a large refund is the very last thing you want during base income years. Unfortunately, a large refund can seriously undermine your efforts to get financial aid. Here’s why:
If you itemize deductions and get a refund from state and local taxes, the following year you’ll have to report the refund as part of your federal adjusted gross income. Over the years, of course, this will have little or no effect on how much you pay in taxes, but for aid purposes, you’ve just raised your line 37. This might not seem like it could make a big difference, but if you collect an average state and local refund of $1,600 each year over the four college years, you may have cost yourself as much as $3,000 in grant money.
During college years, it is very important to keep your withholding as close as possible to the amount you will actually owe in taxes at the end of the year.
Tip #8: If you itemize your deductions, avoid large state and local tax refunds.
LINE 11—ALIMONY RECEIVED
Even though this may seem like an obvious point, we have found it important to remind people that the amount you enter on this line is not what you were supposed to receive in alimony, but the amount you actually got. Please don’t list alimony payments your ex never made.
In fact, if your ex fell behind in alimony payments, it’s important that you notify the college financial aid offices that you have received less income this year than a court of law thought you needed in order to make ends meet.
By the same token, if you received retroactive alimony payments, you would also want to contact the colleges to let them know that the amount you listed on this line is larger this year than the amount you normally receive. In a situation like this, you might be tempted to put down on the financial aid form only the amount of alimony you were supposed to receive. Please don’t even think about it. Your need analysis information will be checked against your tax return. By the time they’ve finished their audit, and you’ve finished explaining that this was a retroactive payment, all the college’s aid money might be gone.
LINE 12—BUSINESS INCOME
As we mentioned earlier, it can be to your advantage to become an independent contractor if you have large unreimbursed business expenses. A self-employed person is allowed to deduct business expenses from gross receipts on schedule C. This now much smaller number (called net profit or loss) is written down on line 12 of the 1040 form, thus reducing both taxable income and the family contribution to college tuition.
We will discuss running your own business in greater detail in the “Special Topics” chapter of this book; however, a few general points should be made now.
Many salaried people run their own businesses on the side, which enables them to earn extra money while deducting a good part of this income as business expenses. However, before you run out and decide that your stamp collecting hobby has suddenly become a business, you should be aware that the IRS auditors are old hands at spotting “dummy” businesses, and the colleges’ FAOs aren’t far behind.
On the other hand, if you have been planning to start a legitimate business, then by all means, the time to do it is NOW.
Tip #9: Setting up a legitimate business on the side will enable you to deduct legitimate business expenses, and may reduce your AGI.
Just bear in mind that a business must be run with the intention of showing a profit to avoid running afoul of the IRS “hobby loss” provision. The institutional methodology now adds back business losses to your AGI.
LINES 13A AND 14—CAPITAL GAINS OR LOSSES, OTHER GAINS OR LOSSES
When you buy a stock, bond, or any other financial instrument at one price and then sell it for more than you paid in the first place, the difference between the two prices is considered a capital gain. If you sold it for less than you paid in the first place, the difference may be considered a capital loss. We say “may be” because while you are required to report gains on all transactions, the IRS does not necessarily recognize losses on all types of investments.
When you sell an asset, your net worth really stays the same; you are merely converting the asset into the cash it’s worth at that particular instant. However, for tax and financial aid purposes, a capital gain on the asset is considered additional income in the year that you sold your asset.
During base income years, you want to avoid capital gains if you can because they inflate your income. When you sell a stock, not only does the FAO assess the cash value from the sale of the stock (which is considered an asset) but she also assesses the capital gain (which is considered income).
If you need cash it is usually better to borrow against your assets rather than to sell them. Using your stock, or the equity in your house as collateral, you can take out a loan. This helps you in three ways: you don’t have to report any capital gains on the financial aid form; your net assets are reduced in the eyes of the FAO since you now have a debt against that asset; and in some cases, you get a tax deduction for part of the interest on the loan.
Tip #10: If possible, avoid large capital gains during base income years.
However, there may be times when it is necessary to take capital gains. Below you will find some strategies to avoid losing aid because of capital gains. The following are somewhat aggressive strategies, and each would require you to consult your accountant and/or stockbroker:
✵If you have to take capital gains, at least try to offset them with losses. Examine your portfolio. If you have been carrying a stock that’s been a loser for several years, it might be time to admit that it is never going to be worth what you paid for it, and take the loss. This will help to cancel your gain.
✵You can elect to spread your stock losses and gains over several years. One example: The IRS allows you to deduct capital losses directly from capital gains. If your losses exceed your gains, you can deduct up to $3,000 of the excess from other income—in the year the loss occurred. However, net losses over $3,000 are carried over to future years. It might be possible to show net losses during several of the base income years, and hold off on taking net gains until after your kids are done with college.
✵The institutional methodology does not recognize capital losses that exceed gains. However, certain kinds of government aid are awarded without reference to the schools—for example, the Pell Grant and some state-funded aid programs. Because this aid is awarded strictly by the numbers, a capital loss can make a big difference. (Consult your state aid authorities and the individual schools to see how capital losses will be treated.)
✵If you are worried about falling stock prices but don’t want to report a capital gain, you should consult your stockbroker. There may be ways to lock in a particular price without selling the stock.
✵If you have any atypically large capital gain in a base income year that you must report on an aid form, you should write to the colleges explaining that your income is not normally so high.
The Sale of Your Home
The Taxpayer Relief Act of 1997 changed the way capital gains from the sale of a primary residence are treated. For any sale after May 6, 1997 you are permitted to exclude up to $250,000 in capital gains every two years on the sale of your home (up to $500,000 for a married couple filing jointly). To qualify, the home must have been your primary residence that you owned and occupied for at least two of the last five years prior to the sale. Any gains in excess of the exclusion limits would, of course, be subject to income taxes.
Representatives at the Department of Education and the College Board have stated that only gains above the excludable amounts need to be reported on the aid forms, since they are then part of your Adjusted Gross Income. If you sold your home and must complete the aid forms before you purchase another property, you’ll need to report the money you have from the sale as part of your assets on the aid forms. However, you should be sure to write a letter to the FAOs explaining that you will no longer have those assets once you purchase another property, if that is the case.
LINE 15—IRA DISTRIBUTIONS
This line on the 1040 form covers any withdrawals (called “distributions” by the IRS) made during the year from Individual Retirement Accounts (IRAs). Most financial planning experts advise against early withdrawals before retirement since one of the biggest benefits of an IRA is the tax-deferred compounding of investment income while the funds are in the account. In many cases, early withdrawals will trigger a 10% penalty (if you took out the funds before age 59 1/2) and you’ll have to pay income taxes on part or all of the money withdrawn. (Which part of the withdrawal will be subject to income taxes will depend on whether your prior IRA contributions were deductible or not.)
If that is not enough bad news to discourage you, consider the financial aid implications. Any IRA withdrawal during a base income year will raise your income in the financial aid formulas thereby reducing aid eligibility. The part of the withdrawal that is taxable will raise that all-important line 37 on your tax return; the portion that is tax-free will also affect your EFC, since the aid formulas assess untaxed income as well.
To demonstrate the negative impact of an early IRA withdrawal, let’s look at an example of a parent, age 55, who took funds out of an IRA during the first base income year. The family is in the 25% federal tax bracket and since all prior IRA contributions were tax deductible, the withdrawal will be fully taxable. After subtracting the early withdrawal penalties, income taxes, and reduced aid eligibility, there will be only about 35 cents on the dollar left. Get the point? Early withdrawals from IRAs should be avoided at all costs.
A legitimate rollover of an IRA (when you move your money from one type of IRA investment into another within 60 days) is not considered a withdrawal. You do have to report a rollover to the IRS on the 1040 form, but it is not subject to penalties (so long as you stick to the IRS guidelines) nor is it considered income for financial aid purposes.
Tip #11: Try to avoid IRA distributions during base income years.
Parents sometimes ask whether it is possible to borrow against the money in their IRAs. You are not allowed to borrow against the assets you have in an IRA. The IRS calls this a “prohibited transaction.”
Note: The Taxpayer Relief Act enacted in August 1997 provides for penalty-free distributions from IRAs after December 31, 1997 if the funds are used to pay for qualified educational expenses (tuition, fees, books, supplies, room and board for the undergraduate or graduate studies of the taxpayer, taxpayer’s spouse, or taxpayer’s child or grandchild). The words “penalty-free” only apply to the 10% early withdrawal penalty. As such, you should not assume that you will not be penalized in the financial aid process or that you will not owe any income taxes if you withdraw funds for qualified education expenses.
The Act also provides taxpayers the opportunity to convert an existing IRA into a Roth IRA, provided certain criteria are met. The major benefit of this type of IRA is the fact that almost all withdrawals from a Roth IRA after age 59 1/2 will be totally tax-free. While the 10% early withdrawal penalty will not apply to this conversion, income taxes must be paid on the entire amount converted unless part of the account represents prior contributions to a non-deductible IRA. If you converted your IRA into a Roth IRA in 2015 you must report this conversion as part of line 15a or 15b on the IRS 1040, thereby raising your income and your EFC in the aid formulas. However, it is important to notify the financial aid offices about any such conversion since the U.S. Department of Education has granted colleges the ability to adjust the family contribution for this unusual transaction. (We’ll discuss the IRAs and Roth IRAs in more detail in Chapter Ten.)
If You’ve Just Retired
As people wait until later in life to have children, it is becoming more commonplace to see retirees with children still in college. If you have recently retired and are being forced to take distributions from traditional IRAs, we suggest that you pull out the minimum amount possible. The government computes what this minimum amount should be based on your life expectancy (the longer you’re expected to live, the longer they are willing to spread out the payments). Because it turns out that the average American’s life expectancy is higher at 66 than it is at 65, it pays to get them to recalculate your minimum distribution for each year your child is in college. Obviously, if you need the money now, then you should take it. But try to withdraw as little as possible, since IRA distributions increase your income and thus reduce financial aid.
Note: You are not required to take distributions from Roth IRAs regardless of your age.
LINE 16—PENSIONS AND ANNUITIES
The same is true of pension distributions. Sometimes it is possible to postpone retirement pensions or roll them over into an IRA. If you can afford to wait until your child is through college, you will increase your aid eligibility. The money isn’t going anywhere, and it’s earning interest.
Note: Any unusually large or early distributions from IRAs or pensions should be explained to the college financial aid offices. Any “rollovers” should also be explained when you submit a copy of your taxes to the school. Since you must include “rollovers” as part of the amount you list on line 15a or 16a of the IRS 1040, some FAOs have been known to incorrectly assume that the family received the funds, but failed to report this untaxed income on the aid forms. If they make this error, the EFC they determine will be much higher than it should be.
LINE 17—RENTS, ROYALTIES, ESTATES, PARTNERSHIPS, TRUSTS, AND LINE 18—FARM INCOME
Like schedule C income, items coming under these categories are computed by adding up your gross receipts and then subtracting expenses, repairs, and depreciation. Be especially thorough about listing all expenses during base income years.
If you have a summer house or other property, you may have been frustrated in the past, because costly as it is to operate a second home, you haven’t been able to deduct any of these expenses. You could consider renting it out while your son or daughter is in college. The extra income might be offset (perhaps significantly) by the expenses that you’ll now be legitimately able to subtract from it. By changing how interest expense and real estate taxes are reflected on your tax return (from an itemized deduction on schedule A to a reduction of rental income on line 17) you reduce the magical AGI. There are special tax considerations for “passive loss” activities and recapture of depreciation, so be sure to consult your advisor before proceeding with this strategy, and remember that many private colleges and a few state schools will not recognize losses of this type when awarding institutional funds since the institutional methodology adds back losses to income.
LINE 19—UNEMPLOYMENT COMPENSATION
If you are unemployed, benefits received during the base income year are considered income under the aid formula. However, some special consideration may be granted to you. We will discuss this in more detail under the “Recently Unemployed Worker” heading in Chapter Nine.
LINES 20A AND B—SOCIAL SECURITY BENEFITS
Total social security benefits are listed on line 20a. The taxable portion of those benefits is listed on line 20b. Whether you have to pay tax on social security benefits depends on your circumstances. Consult the instructions that come with your tax return. For some parents who have other income, part of the social security benefits received may be taxable.
LINE 21—OTHER INCOME
Any miscellaneous income that did not fit into any of the other lines, goes here. Some examples: money received from jury duty or from proctoring SAT exams, extra insurance premiums paid by your employer, gambling winnings.
Gambling winnings present their own problem. The IRS allows you to deduct gambling losses against winnings. However the deduction can, once again, only be taken as part of your itemized deductions on schedule A. Since this happens after line 37, it is not a deduction as far as the need analysis computer is concerned.
Since gambling losses are not likely to provoke much sympathy in the FAOs, we don’t think there would be any point to writing them a letter about this one. During the college years, you might just want to curtail gambling.
This is the last type of taxable income on the 1040, but don’t start jumping for joy yet. The colleges are interested in more than just your taxable income.
We’ve just looked at all the types of income that the IRS taxes, and discussed how the financial aid process impacts on it. There are several other types of income that the IRS doesn’t bother to tax. Unfortunately, the colleges do not feel so benevolent. While the IRS allows you to shelter certain types of income, the colleges will assess this income as well in deciding whether and how much financial aid you receive.
Here are the other types of income the need analysis forms will ask you to report, and some strategies.
Untaxed Social Security Benefits
Any social security benefits that are not taxable are defined as “untaxed social security benefits” in the financial aid regulations. Untaxed social security benefits (as well as certain other untaxed income items that years ago were previously assessed as income in the Federal Methodology) do not need to reported as untaxed income on the FAFSA. Such excluded untaxed social security benefits could include any untaxed benefits paid for the student (whether such benefits are paid to the student directly or paid to the parent for the benefit of the student), untaxed benefits paid to a parent for other children, or the untaxed portion of any social security benefits paid for the benefit of the parent(s) themselves. Depending on other income received by the parents during the year, a parent’s own social security benefits may be fully tax-free or partially tax-free. Since any taxable social security benefits are part of the Adjusted Gross Income, they will continue to be assessed in the federal formula and the institutional formula.
Since the social security benefits for most students normally end before the student starts college (and are normally tax-free), the Institutional Methodology has excluded any untaxed social security benefits received for the student from untaxed income for a number of years. However, untaxed benefits paid to a parent for children other than the student and/or the untaxed portion of any social security benefits received by the parent(s) themselves will continue to be assessed in the IM.
We’ll discuss social security benefits in greater detail in Part Three, “Filling Out the Standardized Forms.”
Payments Made into IRAs, Keoghs, 401(k)s, 403(b)s, and TDAs
IRAs (Individual Retirement Accounts), Keoghs, 401(k)s, 403(b)s, and TDAs (short for Tax Deferred Annuities) are all retirement provisions designed to supplement or take the place of pensions and social security benefits. The tax benefit of these plans is that in most cases they allow you to defer paying income tax on contributions until you retire, when presumably your tax bracket will be lower. The investment income on the funds is also allowed to accumulate tax-deferred until the time you start to withdraw the funds.
The 401(k) and 403(b) plans are supplemental retirement provisions set up by your employer in which part of your salary is deducted (at your request) from your paycheck and placed in a trust account for your benefit when you retire. Some companies choose to match part of your contributions to the plans. Keoghs are designed to take the place of an ordinary pension for self-employed individuals. TDAs fulfill much the same purpose for employees of tax-exempt religious, charitable, or educational organizations.
IRAs are supplemental retirement provisions for everyone. Contributions to these plans are tax-deductible in many cases. For example, if an unmarried individual is not covered by a retirement plan at work or a self-employed retirement plan, she can make tax-deductible contributions to an IRA of up to $5,500 (up to $6,500 if age 50 or older) regardless of her income level. If a person is covered by a retirement plan, his contribution to an IRA may or may not be tax-deductible, depending on his income level.
Note: The tax bills enacted in August 1997 and June 2001 involve many changes to the IRA rules. Before making any new contributions, withdrawals, or changes to an IRA, you should be sure to consult IRS Publication 590 for the corresponding tax year (it covers the IRA regulations and is free from Uncle Sam), or seek the advice of a qualified professional who is familiar with the tax laws as well as the financial aid regulations.
Financial Aid Ramifications of Retirement Provisions
Retirement provisions are wonderful ways to reduce your current tax burden while building a large nest egg for your old age—but how do they affect financial aid?
The intent of current financial aid laws is to protect the money that you have built up in a retirement provision. Assets that have already been contributed to IRAs, Keoghs,
401(k)s, and so on by the date you fill out the standardized aid form do not have to appear on that form. In most cases, the FAOs will never know that this money exists. Thus loading up on contributions to retirement provisions before the college years begin makes enormous sense.
However, any tax-deductible contribution that you make into these plans voluntarily during the base income years is treated just like regular income. The IRS may be willing to give you a tax break on this income, but the FAOs assess it just like all the rest of your income, up to a maximum rate of 47%. Deductible contributions made to retirement provisions during base income years will not reduce your income under the aid formula. If you can still afford to make them, fine. Most parents find they need all their available cash just to pay their family contribution. Contributions to Roth IRAs or non-deductible Traditional IRAs are not considered untaxed income since they do not reduce your AGI.
These plans remain an excellent way of protecting assets. Try to contribute as much as you can before the first base income year. Parents sometimes ask us how colleges will know about their contributions to 401(k) or 403(b) plans, or to tax-deferred annuities. These contributions usually show up in boxes 12a-d of your W-2 form, codes D, E, F, G, H, and S. Don’t even think about not listing them.
A possible exception to this scenario would come up if contributions to these plans would reduce your income below the $50,000 AGI cut-off for the simplified needs test. For example, let’s say your total salary from work is $45,000, your only other income is $7,000 in interest income (from $500,000 in assets you have parked in Certificates of Deposit) and you don’t itemize your deductions. By deferring $2,500 for the year into a 401(k) plan, your adjusted gross income will now be $49,500, and your untaxed income will be $2,500—making you potentially eligible for the simplified needs test which will exclude your assets from the federal formula. Had you not made the contribution to the 401(k) plan, your AGI would be $52,000 and your assets would be assessed (at up to 5.65% per year for parental assets, and 20% per year for student assets).
Tax-Exempt Interest Income
Even though the government is not interested in a piece of your tax-free investments, the colleges are. Some parents question whether there is any need to tell the colleges about tax-free income if it does not appear on their federal income tax return.
In fact, tax-free interest income is supposed to be entered on line 8b of the 1040. This is not an item the IRS tends to flag, but there are excellent reasons why you should never hide these items. For one thing, tax law changes constantly. If your particular tax-free investment becomes taxable or reportable next year, how will you explain the sudden appearance of substantial taxable interest income? Or what if you need to sell your tax-free investment? You will then have to report a capital gain, and the FAO will want to know where all the money came from.
More Untaxed Income
Other untaxed income that is included in the federal financial aid formula includes but is not limited to the tax-free portion of any pensions or annuities received (excluding rollovers), the tax-free portion of IRA distributions (excluding rollovers), child support received, workers’ compensation, veterans noneducation benefits, the Health Savings Account (HSA) deduction (IRS 1040 Line 25), and living allowances paid to members of the military and clergy. Some other categories of untaxed income (for example, untaxed disability benefits) will need to be reported on the FAFSA form as well. There is little to do about this kind of income except write it down. As with alimony, child support reported should include only the amount you actually received, not what you were supposed to receive.
Note: The federal methodology excludes contributions to, or payments from, flexible spending arrangements. The institutional methodology will consider pre-tax contributions withheld from wages for dependent care, medical spending, and HSA accounts as part of untaxed income for the 2017-2018 award year. But along with the HSA deduction, schools will have the opportunity to exclude them. The tuition and fees deduction (IRS 1040 line 34, see this page) will still be considered untaxed income (but only in the institutional methodology). In addition, the following types of untaxed income (which previously were assessed in the federal formula, but are now not considered in the FM) will continue to be considered part of untaxed income in the IM: the earned income credit (IRS 1040 line 66a), the additional child credit (IRS 1040 line 67), welfare benefits, the credit for federal tax on special fuels, and the foreign income exclusion.
After adding up all your income, the need analysis formulas provide a deduction for some types of expenses. A few of these expenses mirror the adjustments to income section of the 1040 income tax form. Many parents assume that all the adjustments to income from the IRS form can be counted on the standardized financial aid forms. Unfortunately this is not the case. Likewise, many parents assume that all of the itemized tax deductions they take on schedule A will count on the financial aid forms as well. Almost none of these are included in the financial aid formula. Let’s look at adjustments to income first.
Expenses According to the IRS: Adjustments to Income
LINE 23—EDUCATOR EXPENSES
This adjustment to income involves educators in both public and private elementary and secondary schools who work at least 900 hours during a school year as a teacher, instructor, counselor, principal, or aide and who have certain qualifying out-of-pocket expenses. The maximum deduction for this item is $250 per taxpayer, and there are other criteria you need to meet. Prior to this item appearing on the 1040 form, educators could only take such expenses as part of miscellaneous itemized deductions on schedule A of the 1040. If allowable, it is to your advantage to take the deduction as an adjustment to income, rather than lump it with all your other miscellaneous deductions on schedule A. First, because it would reduce your AGI and EFC, and second, because it would be a sure tax deduction if offered. If your total miscellaneous deductions do not exceed a certain percentage of your AGI or you do not itemize, you won’t get a deduction for those expenses at all on your taxes.
LINE 26—MOVING EXPENSES
Job-related moving expenses are deductible as an adjustment to income. Years ago, these expenses could be taken only as part of your itemized deductions, and did not affect your aid eligibility. Since this item will both reduce your tax liability and potentially increase your aid eligibility, you should be sure to include all allowable moving expenses. There have been some recent changes to the tax law regarding what constitutes a moving expense (for example, pre-move house hunting trips are no longer deductible) so be sure to read the IRS instructions or consult a competent advisor.
LINE 27—DEDUCTIBLE PART OF SELF-EMPLOYMENT TAX
Self-employed individuals can deduct one half of the self-employment taxes they pay. The federal and institutional formulas take this deduction into account.
LINES 28 AND 32—IRA DEDUCTIONS AND SELF-EMPLOYED SEP, SIMPLE, AND QUALIFIED PLANS DEDUCTIONS
As we explained above, while these constitute legitimate tax deductions, contributions to deductible IRAs, SEPs, KEOGHs, and other plans that can be deducted on Line 28 or Line 32 will not reduce your income under the FM or IM aid formulas.
However, some forms of state aid (which do not use the federal methodology employed by the colleges themselves) may be boosted by contributions to retirement plans that reduce your AGI as some state programs are based solely on taxable income. We’ll discuss this in detail in Chapter Six, “State Aid.” As we mentioned earlier, contributions to an IRA could lower your AGI below the $50,000 cap for the Simplified Needs Test. Individuals who make contributions to plans that are deducted on Line 28 are either self-employed or a partner and therefore cannot meet the Simplified Needs Test.
LINE 29—SELF-EMPLOYED HEALTH INSURANCE DEDUCTION
This is another adjustment to income recognized by the FAO. If you are self-employed or own more than 2% of the shares of an S corporation, there are two places on the 2015 IRS 1040 form where you may be able to take medical deductions. On line 29, you can now deduct 100% of your qualifying health insurance premiums. It is to your advantage to take the deduction here, rather than lump it with all your other medical expenses on schedule A. First, because it will reduce your AGI, and second, because it is a sure deduction here. If your total medical expenses do not add up to a certain percentage of your total income, you won’t get a deduction for medical expenses at all on your taxes. In addition, high medical expenses (other than those included here on line 29) are no longer an automatic deduction in the federal aid formula as they were prior to the 1993-94 school year. We’ll describe this in detail, under “Medical Deduction” on this page.
LINE 30—PENALTY ON EARLY WITHDRAWAL OF SAVINGS, AND LINE 31A—ALIMONY PAID
If you took an early withdrawal of savings before maturity, which incurred a penalty and/or you paid out alimony, these amounts will be claimed here. The FM and IM aid formulas grant you a deduction for these two adjustments to income as well.
LINE 33—STUDENT LOAN INTEREST DEDUCTION
The Taxpayer Relief Act of 1997 created this adjustment to income. This can involve loans used to cover your own post-secondary educational expenses as well as those of your spouse or any other dependent at the time the loan was taken out. We’ll discuss more of the fine print in Chapter Ten. You should realize that any deduction claimed here will reduce your income under both the federal and the institutional formulas.
LINE 34—TUITION AND FEES DEDUCTION
With this deduction, you may be able to claim up to $4,000 in qualified higher education expense even if you don’t itemize deductions on your income tax return provided your income is low enough and you meet other criteria. Be aware that you can not claim this deduction if you claim the Hope, American Opportunity, or Lifetime Learning credits (see Chapter Ten) for the same student in the same tax year. Withdrawals from Coverdell ESAs and Section 529 plans as well as the claiming of tax-free interest from the sale of U.S. savings bonds can also affect this deduction so you’ll need to carefully read (or have your accountant carefully read) the tax return instructions. This deduction would reduce your income in the federal financial aid formula. For the institutional formula, this deduction is added back to income as part of your untaxed income.
LINE 24—CERTAIN BUSINESS EXPENSES OF RESERVISTS, PERFORMING ARTISTS, AND FEE-BASIS GOVERNMENT OFFICIALS; LINE 35—DOMESTIC PRODUCTION ACTIVITIES DEDUCTION; OTHER WRITE-IN ADJUSTMENTS NOT REPORTED ON LINES 23-35, BUT INCLUDED AS PART OF LINE 36
While each of these adjustments to income will lower your AGI—and therefore your EFC—they are not applicable for the vast majority of tax filers.
Other Expenses According to the Financial Aid Formula
You’ve just seen all the adjustments to income that the IRS allows. The colleges allow you a deduction for several other types of expenses for financial aid purposes as well:
Federal Income Tax Paid
The advice we are about to offer may give your accountant a heart attack. Obviously, you want to pay the lowest taxes possible, but timing can come into play during the college years. The higher the taxes you pay during a base income year, the lower your family contribution will be. This is because the federal income taxes you pay count as an expense item in the aid formula. There are certain sets of circumstances when it is possible to save money by paying higher taxes.
The principle here is to end up having paid the same amount of taxes over the long run, but to concentrate the taxes into the years the colleges are scrutinizing, thus increasing your aid eligibility.
Let’s look at a hypothetical example. Suppose that you make exactly the same amount of money in two separate years. You are in the 25% income tax bracket, and the tax tables don’t change over these two years. Your federal tax turns out to be $6,000 the first year and $6,000 the second year, for a total tax bill of $12,000 for the two years.
Let’s also suppose that you decide to make an IRA contribution during only one of the two years, but you aren’t sure in which year to make the contribution. You’re married, 52 years old, and neither of you is covered by a pension plan at work, so you are able to make a tax-deductible IRA contribution of $6,500. This turns out to reduce your federal taxes by $1,625 for the year in which you make the contribution. Since, in this case, your tax situation is precisely the same for both years, it doesn’t make much difference in which year you take the deduction.
total taxes over 2 years (if no IRA contribution made)
- $ 1,625
tax savings for IRA contribution
total taxes for the 2 years
Over the two years, either way, you end up paying a total of about $10,500 in federal taxes.
It’s All a Matter of Timing
Here’s where timing comes in. What if the second of the two years also happens to be your first base income year? In this case, you’re much better off making the contribution during the previous year. By doing so, as we’ve already explained, you shelter the $6,500 asset from the need analysis formula, and get a $1,625 tax break in the first year.
But much more important, by making the contribution during the first year, you choose to pay the higher tax bill in the second year—the base income year—which in turn lowers your Expected Family Contribution. Over the two years, you’re still paying close to the same amount in taxes, but you’ve concentrated the taxes into the base income year where it will do you some good.
Tip #12: Concentrate your federal income taxes into base income years to lower your Expected Family Contribution.
Obviously, if you can afford to make IRA contributions every year, you should do so; building a retirement fund is a vital part of any family’s long-term planning. However, if like many families, you find that you can’t afford to contribute every year during college years, you can at least use timing to increase your expenses in the eyes of the FAOs. By loading up on retirement provision contributions during non-base income years, and avoiding tax-deductible retirement contributions and other tax-saving measures during base income years, you can substantially increase your aid eligibility.
The above example assumed that tax rates would be the same from year to year. Should tax rates change from one year to the next, you will need to balance your tax planning with your financial aid planning to determine the best course of action
Large donations to charity are a wonderful thing, both from a moral standpoint and a tax standpoint—but not during a base income year. When you lower your taxes, you raise your family contribution significantly. We aren’t saying you should stop giving to charity, but we do recommend holding off on large gifts until after the base income years.
When you are asked questions about U.S. income taxes paid on the FAFSA, the government and the colleges are not interested in how much taxes you had withheld during the year, or whether or not you are entitled to a refund. Instead, they are interested in your federal income tax liability after certain tax credits are deducted, which happens to be the amount of line 56 minus line 46 on the 2015 IRS 1040 form. While most tax credits that you claim will eventually reduce your aid eligibility (since lower taxes mean lower expenses against income in the formulas), the tax benefits from these credits will be much greater than the amount of aid that is lost. As such, you should be sure to deduct any and all tax credits that you are entitled to claim on your tax return.
Be aware that under the federal formula, any education tax credits claimed (such as the Hope Scholarship Credit and the Lifetime Learning Credit) will not reduce aid eligibility. While any nonrefundable education credits claimed - for 2015, these would be claimed on line 50 of the IRS Form 1040 - will reduce the amount of U.S. income taxes paid, they will also be considered an “exclusion from income”, which in aid speak means a deduction against income. So in effect, any education credits claimed will reduce expenses and income by an equal amount, thereby allowing families and students the full benefit of the Hope Credit, the American Opportunity Credit, or the Lifetime Learning Credit. (Later in Chapter Ten, we’ll discuss some strategies to insure you get the maximum credits allowed by law; for now, we just want to focus on their aid impact.)
Unfortunately, the institutional formula has not been as benevolent. Since the nonrefundable education credits are not considered an exclusion against income, any amounts nonrefundable credits claimed will partially reduce aid eligibility. However, the College Board will give colleges the option of having any refundable education credits added back to the amount of U.S. income taxes paid, so that any impact on aid will be negligible.
Currently, the Federal Methodology reduces the amount of U.S taxes paid (reported on Line 56 of the 2015 1040) by the amount of any excess advance premium tax credit reported on line 46 of the return. And we went to press, the College Board had not yet decided for the IM if they would use the amount on line 56 of the 1040 for this item—or if they would mirror the FM and deduct any amount on line 46 from the line 56 amount. (For the IRS 1040A, the amount of the taxes paid reported on Line 37 is reduced by line 29.)
Both the FM and IM do not consider any refundable portion of the American Opportunity Credit to be untaxed income. These would be claimed on Line 68 of the 2015 IRS 1040 or Line 44 of the 1040A. A nonrefundable credit can only be claimed if a taxpayer has income tax liability, while a refundable credit can be claimed even if the taxable income is so low that there is no resulting income tax liability.
The Alternative Minimum Tax
Until recently, those families who were subject to the Alternative Minimum Tax were actually penalized in the aid formulas—for while they had to pay the tax, the formulas did not take this additional tax into account. The Alternative Minimum Tax (AMT) is an additional tax that is incurred if certain deductions or tax credits reduce the amount of U.S. income taxes paid below a certain level. Many of our readers don’t have to worry about the AMT since it usually impacts more individuals in the top income tax brackets.
But we have good news for those few readers who must pay the AMT. Federal income taxes paid in the financial aid formulas currently includes any Alternative Minimum Tax liability. This will generally reduce the EFC in both the federal and institutional methodologies for those subject to the AMT, since the amount of federal income taxes paid is a deduction against income in the formulas.
Deduction for Social Security and Medicare Taxes
The financial aid formulas give you a deduction for the Medicare and social security taxes (otherwise known as FICA) that you pay. Parents often ask how the colleges do this since there doesn’t seem to be a question about social security taxes on the financial aid forms. The deduction is actually made automatically by computer, but it is based on two questions on the financial aid form. These questions are in disguise.
On the FAFSA and the PROFILE, the two questions are “father’s income earned from work,” and “mother’s income earned from work.” At first glance these questions appear to be about income. In fact, for tax filers these are expense questions. If you minimize the amounts you put down here, you may cost yourself aid.
Therefore, you should be sure to include all sources of income from work on which you’ve paid FICA or Medicare taxes: wages (box 1 of your W-2), income from self-employment (line 12 of the 1040), income from partnerships subject to self-employment taxes (not including income from limited partnerships), deferred compensation (tax-filers only), and combat pay (for servicemen and servicewomen).
A Financial Aid Catch-22
Wages that you defer into a 401(k), 403(b), or other retirement plan are not subject to income tax by the IRS, but you still pay social security taxes and/or Medicare taxes on them. (Currently, income above $118,500 is exempt from FICA. However, there is no income ceiling on Medicare taxes.)
The strange thing is that, while the purpose of the questions regarding income earned from work on the financial aid forms is to allow the need analysis companies to calculate the social security and Medicare taxes you paid, the instructions for the forms don’t tell you to include deferred income. For example, if your income was $40,000 last year and you deferred $5,000 of it into a 401(k), the instructions tell you to put down $35,000 as your income from work.
Welcome to the Wacky World of Financial Aid
The instructions are wrong. It’s just that simple. Other aid professionals agree with us. So please ignore the instructions. If you contributed any pre-tax wage income (subject to Social Security and/or Medicare taxes) into tax-deferred retirement accounts, include it as part of the question on income earned from work on the FAFSA.
Will this make a real difference to your aid package? It depends on how much you defer. Say you and your spouse defer $5,000 each, and you are in the 47th percentile in aid assessment. By including this money as part of income earned from work, you could increase your aid eligibility by about $380 per year.
This might seem petty, but these small amounts—$380 here, $200 there—can add up. Put another way, this is $380 a year ($1,520 over four years) that you may not have to borrow and pay interest on.
Note: There are two situations when you should not include your tax-deferred contributions to retirement plans as part of income earned from work. If you do not file a tax return, your income earned from work will be treated as an income item when the data is processed. Since you must also include such contributions as untaxed income on the forms, your income will be overstated in this situation. You should also avoid adding such contributions to your income earned from work if this would disqualify you from otherwise meeting all the criteria for the Simplified Needs Test or the Automatic Zero-EFC (see this page).
State and Local Tax Allowance
This is another calculation that is done automatically by the need assessment computer. The computer takes the sum of your taxable and untaxable income and multiplies it by a certain percentage based on the state you live in to determine your deduction. The formula for each state is slightly different. (See Table 8.)
This works very well for people who live and work in the same state, but presents real problems for everyone else. If you live in one state but work in another where the taxes are higher, you may be paying more in taxes than the formula indicates. The financial need computer isn’t programmed to deal with situations like this, and people who don’t fit the program get penalized.
The only way to deal with this is to write to the individual colleges’ aid offices to let them know about your special situation.
Under the federal and institutional methodologies, if you are a single parent who works, or if you are part of a two-parent, two-income family, then you qualify for the employment allowance. In the 2015 base income year, under the federal formula married couples will get a deduction of 35% of the lower wage earner’s income earned from work up to a maximum deduction of $4,000. Single parents (i.e., separated, divorced, widowed, or never married) will get a deduction of 35% of their income earned from work up to a maximum deduction of $4,000. The employment allowance is figured out for you automatically by the need analysis computer based on three questions you answered on the FAFSA—namely father’s income earned from work, mother’s income earned from work, and of course, the question about the parent’s marital status.
As we’ve said before, while these questions look like income questions, they are actually expense questions for tax filers. It is in your interest to make these figures as big as possible if you will file a tax return. Remember to include all your sources of income from work. While the College Board will not be publishing the institutional methodology for 2017-2018, it is expected a similar deduction will be granted.
The Income Protection Allowance
Most parents find the income protection allowance (formerly known as the standard maintenance allowance) to be a bad joke. This is the federal financial aid formula’s idea of how much money your family needs to house, feed, and clothe itself during one year. According to the formula:
a family of 6 (one in college) can live on $38,010
a family of 5 (one in college) can live on $32,490
a family of 4 (one in college) can live on $27,540
a family of 3 (one in college) can live on $22,300
a family of 2 (one in college) can live on $17,910
The income protection allowance is based solely on the number of family members currently living in the household and the number of dependent children in college. It is determined by the U.S. government figures for the poverty line and does not take into account the cost of living in your part of the country. (See Table 10.)
Many parents assume that a portion of their monthly mortgage payments will be deducted from their income on the aid formulas in much the same way as it is on their taxes. Unfortunately, this is not the case. The income protection allowance is supposed to include all housing expenses.
We strongly recommend that you sit down and write out a budget of how much it actually takes to keep your family going, and send it to the individual colleges. Include everything. In many parts of the country, the income protection allowance is fairly ludicrous, but it is up to you to show the FAO just how ludicrous it is in your case.
The institutional methodology uses current consumer expense survey data to determine this allowance in the formula. While the formula is not available, in the past the numbers have been somewhat higher than in the federal formula.
Annual Education Savings Allowance
Recognizing the fact that parents should be saving for any younger siblings’ college expenses while simultaneously financing the older child’s college expenses, the College Board’s IM includes a deduction against income called the Annual Education Savings Allowance. The PROFILE processor will automatically calculate the amount of this allowance, which was 1.52% of the parents’ total income (up to a maximum of $2,770 for the 2010-2011 formula, which was the last year the IM was published) multiplied by the number of pre-college children, excluding the student applicant.
Under the federal methodology, high unreimbursed medical and dental expenses as well as elementary/secondary school tuition for the student’s siblings are no longer automatically deducted from income. However, you are probably going to have to answer questions about these categories anyway on both the PROFILE form and the school’s own aid forms—the reason being that under the institutional methodology or the schools’ own aid policies, these items may be considered as deductions against income.
Even if you are only completing the FAFSA (which does not ask about these items) it still makes sense to let the FAOs know about any high expenses they would not otherwise find out about. As we have already mentioned, information like this should be sent directly to the schools under separate cover.
Here are some tips on how to answer questions about medical and tuition expenses.
To be able to deduct medical expenses on your federal tax return, you must have expenses in excess of 10% of your AGI. However, college financial aid guidelines are not necessarily as strict. Some families who don’t qualify under federal tax law just assume they won’t qualify under the financial aid rules either, so they enter “0” for their medical expenses on the aid forms. This can be a costly mistake.
Here’s a quick example. Let’s say your family’s adjusted gross income is $50,000, and you had medical expenses of $3,000. As far as the IRS is concerned, you won’t get a medical deduction this year. Your $3,000 medical bills fall well short of 10% of $50,000 ($5,000). However, under the financial aid formulas, you may indeed receive a deduction against income. Under the federal methodology, the FAOs can use their discretion for this item. Under the institutional methodology, the rules for this expense category are more defined.
Therefore even if you don’t have enough medical and dental expenses to qualify under the federal tax law, don’t assume that it would be a waste of time to disclose these figures. Many colleges are using the institutional methodology which in the past has granted an allowance for unreimbursed medical expenses in excess of 3.5% of your income. If you are filling out the PROFILE form, there is a place on the form to report this information. Many of the schools’ separate financial aid forms ask for this information as well.
What Constitutes a Medical Expense?
There are more than 100 legitimate medical deductions. Here are just a few: doctors, dentists, prescription eyeglasses, therapists, after-tax health insurance premiums that were deducted from your paycheck or that you paid personally, medical transportation and lodging.
Note: Self-employed individuals and owners of more than 2% of the shares of a subchapter S corporation are better off deducting their health insurance premiums on line 29 of the IRS 1040 form.
Whose Medical Expenses Can Be Included?
You should include medical expenses for every single member of your household, not just the student who is going to college. When families come in to see us, they inevitably start out by saying that they do not have much in the way of unreimbursed medical expenses.
However, when we get them to write it all down, it often turns out to be a hefty sum. Keep careful records and include EVERYTHING. Did you take a cab to and from the doctor’s office? Did anyone get braces? Did anyone get contact lenses?
And If We Have Very Low Medical Expenses?
Congratulations, but keep records anyway. The schools who use the PROFILE form will still see the amount you put down, and you may have to answer questions about these items on the schools’ own aid forms. You might as well give the FAOs a realistic sense of what your monthly bills look like.
Last Medical Point
We recommend that if you don’t have medical expenses in excess of 3.5% of your total taxable and untaxable income each year, you might consider postponing some discretionary medical procedures and advancing others, in order to bunch your deductions together and pass the 3.5% mark during one particular year. This might seem at first to fly in the face of conventional wisdom. Facing the burden of college, many parents’ first thought would be to put off braces for a younger child, for example. In fact, if you are in a base income year, it makes much more sense to get them now. Once you reach the 3.5% threshold, each dollar in excess may increase your aid eligibility by 47 cents.
Finally, if you anticipate large medical bills in the near future, you should certainly let the colleges know what’s coming up.
Elementary and Secondary School Tuition
If the child going to college will have a younger brother or sister concurrently attending a private elementary or secondary school, you may be able to get a deduction for part of the tuition you pay for the private school during the academicyear. Neither the federal nor the institutional methodologies provide an automatic deduction, but the PROFILE form and many of the individual college aid forms do ask questions about this category. The FAOs are supposed to use their judgment in deciding whether to make any deduction for younger children’s tuition.
Obviously, you can’t include the private high school tuition of the child who is now applying to college, because next year the student won’t be there anymore. You are also not allowed to include the cost of pre-school (unless specified on the school’s aid form). Nor can you include college tuition of other siblings. (Don’t worry. If you have more than one child in college at the same time, this will be taken into account elsewhere.) When you write down the amount you pay in elementary and secondary school tuition, remember to subtract any scholarship money you receive.
In past years, the College Board’s IM was interested in payments for siblings during the calendar year. Beginning with the 2017-2018 version of the PROFILE, the questions will now pertain to payments made during a particular academic year.
Keeping Track of Information
What makes all this complicated is that some of the schools you will be applying to will require just the FAFSA (which does not ask about medical expenses and siblings’ tuition), others will also require the PROFILE form (which asks about medical expenses and siblings’ tuition), and others will have their own forms as well. It’s easy to forget which schools know what information.
If you apply to a school that requires only the FAFSA, they will not see any of the information you filled out on your PROFILE form. If that school does not ask questions about items such as unreimbursed medical expenses on their own aid form, and you consider this information important, you should send it to the school under separate cover.
In addition, some state grant aid programs will increase award amounts if you send them proof of high medical expenses.
Good News for a Few Parents
The IRS will not allow you to deduct child support payments from your taxable income (although they do allow you to deduct alimony payments). However, the colleges do allow a deduction for the payment of child support, under both the FM and IM (excluding support paid for children in the household). The same is true for any part of your taxable income that consists of financial aid received by a parent in school.
So Far So Good
Now that you’ve given the need analysis people all this information, they will add up all your taxable and untaxable income and then subtract all the expenses and adjustments they have decided to allow. What’s left is your available income.
Available income will be assessed on a sliding scale. If your available income is zero (or less), the parents’ contribution from income will be zero. If your available income is greater, the contribution will be greater. The parents’ contribution from income can go only as high as 47% of available income under the federal formula and as high as 46% under the institutional methodology.
If you are applying to colleges that require the PROFILE form (and thus use the institutional methodology) the parents’ contribution from income may be higher or lower than it would be under the federal methodology.
Income and Expenses: How the Methodologies Differ
✵Excludes medical/dental expenses
✵Income protection allowance based on poverty line figures from the 1960s, adjusted for inflation
✵Excludes all untaxed social security benefits, the earned income credit, the additional child credit, welfare benefits, the foreign income exclusion, and the credit for federal tax on special fuels
✵Provides an allowance for unreimbursed medical and dental expenses in excess of a percentage of income. (Based on historical data—as the formula is no longer published—which has been 3.5% for the past few years’ versions of the IM)
✵Excludes any untaxed social security benefits received for the student
✵Income protection allowance based on current consumer expenditure survey data
✵Provides a set-aside for younger siblings’ educational costs
✵Adds back losses that appear on lines 12, 13, 14, 17, 18, and 21 of the 2015 IRS 1040
✵Considers pre-tax flex-plan contributions for medical spending accounts and dependent care to be untaxed income. However, individual schools will have to option to exclude both from income—as well as deductible contributions to Health Savings Accounts (IRS 1040 Line 25)
✵Gives colleges the option of making an allowance for elementary/secondary tuition paid for the student’s siblings
✵No Automatic Zero-EFC or Simplified Needs Test
✵Education tax credits reduce aid eligibility, unless the school chooses to have them added back to U.S. income taxes paid
✵Considers the amount claimed for the tuition and fees deduction as untaxed income
ASSETS AND LIABILITIES
Now that the need analysis companies know about your available income, they want to know about your assets and liabilities. On the standardized financial aid forms, these two items are joined at the hip. Liabilities are subtracted from assets to determine your net assets. In a nutshell, the strategies you will find in this section are designed to make the value of your assets look as small as possible, and the debts against your assets as large as possible.
What Counts as an Asset?
Cash, checking and savings accounts, money market accounts, CDs, U.S. Savings Bonds, Educational IRAs, stocks, other bonds, mutual funds, trusts, ownership interests in businesses, and the current market value of real estate holdings other than your home.
None of these items appear directly on your tax return. However, your tax return will still provide the colleges with an excellent way to verify these assets. How? Most assets create income and/or tax deductions, both of which do appear on your 1040 in the form of capital gains, capital losses, interest, dividends, and itemized deductions under schedule A.
Assets in insurance policies and retirement provisions such as IRAs, Keoghs, annuities, and 401(k)s are generally not assessed in the aid formulas (though as we have already said, voluntary tax-deductible contributions to retirement provisions made during base income years must be listed as part of untaxed income). Cars are also excluded from the formula and don’t have to be listed on the form. Coverdell ESAs (formerly known as Education IRAs) and Section 529 plans have some interesting quirks which we’ll explain shortly.
What About My Home?
Under the federal methodology, the value of your home is not considered part of your assets. This is great news and will help many families who own their own home to qualify for a Pell Grant and other federal aid programs. However, many colleges are using the more stringent institutional methodology to award their own funds. Under this formula, the value of your home will not be excluded from your assets.
Which schools will exclude the value of your home? It’s safe to say that most state schools will do so. If a school asks you to complete the PROFILE form and/or asks you for the value of your home on their own aid form, then most likely the value of the home is going to be treated like other assets. You can bet that the highly selective private colleges that meet a high percentage of their financial aid students’ need, will be looking closely at home equity. Other private colleges may or may not.
However, even if you’re considering colleges that have decided to look at home value, the news is not all bad. Starting with the 2003-2004 award year, 28 highly selective private colleges and universities agreed to cap home value at 2.4 times the parents’ total yearly income. In other words, if you earn $50,000 for the year, at these schools the value of your home (for assessment purposes) will be considered to be no more than $120,000 ($50,000 × 2.4)—even if you own a home worth $200,000.
It appears that the actions by these schools has had a “trickle down” effect as more and more schools that used to look at the full value of the home have ceased taking the total home equity into account when awarding their own aid funds. Some schools, including a number of those 28 schools, have more recently decided to cap the amount of home equity at two times income, while others will no longer assess home equity at all or will not assess it if the family’s income is below a certain level.
One of the questions you may want to ask the FAO at any school you are considering is the way(s) they will treat home value—not at all, only if the income exceeds a certain amount, with the value capped at a certain percentage of income, with the equity capped at a particular percentage of income, or at full value.
Under the federal methodology, the definition of “home” is the primary residence. If you own a vacation home in addition to your primary residence, the vacation home will not be excluded from your assets. If you own a vacation home, and you rent your primary residence, the value of the vacation home will still not be excluded under the federal formula—as it is considered “other real estate.”
What About My Farm?
The value of your farm is not included as an asset under the federal methodology provided that the family lives on the farm and you can claim on Schedule F of the IRS 1040 that you “materially participated in the farm’s operation.” The Feds call this type of farm a “family farm.” We’ll discuss how to handle this situation in Part Three, “Filling Out the Standardized Forms.” Under the institutional methodology, the value of any farm property is considered an asset.
How Much Are My Assets Worth?
To repeat, the need analysis form is a snapshot of your financial situation. The value of most assets (with the exception of money in the bank) changes constantly, as financial markets rise and fall. The colleges want to know the value of your assets on the day you fill out the form.
Remember, This is One Snapshot for Which You Don’t Want to Look Your Best
When people sit down to fill out financial statements they have a tendency to want to put their best foot forward. After all, most of the time when you fill out one of these forms it is because you are applying for a credit card, or a bank loan, or hoping to be accepted by a country club or an exclusive condominium. Trying to look as fiscally healthy as possible has become almost automatic. However, you have to remember that in this case you are applying for financial aid. They aren’t going to give it to you if you don’t let them see the whole picture, warts and all. On the financial aid form, you don’t want to gloss over your debts.
What Counts as a Debt?
The only debts that are considered under the financial aid formulas are debts against the specific assets listed on the aid forms.
For example, you do NOT get credit for: unsecured loans, personal loans, educational loans like Stafford or PLUS loans for college, consumer debt such as outstanding credit card balances, or auto loans. If you have any debt of these types, you should realize that it will NOT be subtracted from your assets under the financial aid formulas.
It will be to your advantage to minimize these types of debt during the college years. In fact, you may want to convert these loans into debts that do get credit under the financial aid formulas.
You DO get credit for: margin loans, passbook loans, as well as home equity loans, first mortgages, and second mortgages on “other real estate.” Of course, you will only get credit for debts on your primary residence if the college has decided to look at your home value.
Tip #13: Convert debts that are not counted by the aid formulas into types of debt that do count.
Let’s go through the different types of assets you have to report and discuss strategies for minimizing the appearance of those assets.
Cash, Checking Accounts, Savings Accounts
The need analysis forms ask you to list any money in your accounts on the day you fill out the forms. However, you can’t list this money if it isn’t there.
We are not counseling you to go on a spending spree, but if you were planning to make a major purchase in the near future, you might as well make it now. If roof repairs are looming, if you can prepay your summer vacation, if you were going to buy a new car sometime in the next year, do it now, and pay cash. You were going to make these purchases anyway. By speeding up the purchase, you reduce the appearance of your cash assets.
Tip #14: If you were going to buy soon, buy now and use cash.
Another way to reduce assets in the bank is to use the cash to pay off a liability that the colleges refuse to look at.
If you have credit card debt, your need analysis form won’t give a realistic picture of your net worth, because as far as the colleges are concerned, plastic debt doesn’t exist. You could owe thousands of dollars on your VISA card, but the aid formula does not allow you to subtract this debt from your assets, or to subtract the interest on the debt from your income.
Any financial advisor will tell you that if you have any money in the bank at all, it is crazy not to pay off your credit card debt. Recently we had one parent say to us, “But it makes me feel secure to have $7,000 in the bank. I know I could pay my $2,000 MasterCard bill, but then I would have only $5,000 left.”
There are three reasons why this is wrong-headed thinking.
First, any way you look at it, that parent really did have only $5,000. It is a complete illusion to think that you have more money just because you can see it in your bank account at the moment.
Second, this guy’s $2,000 credit card debt was costing him a lot of money—12% each year. This was 12% that could not be deducted from income on his taxes or on his financial aid form. Meanwhile, the $2,000 he was keeping in the bank because it made him feel better, was earning all of 1% after taxes. He was being taken to the cleaners.
Third, and most important, by paying off his credit card debt he could reduce his net assets on the need analysis form, and pick up some more aid.
Tip #15: Use cash in the bank to pay off credit card balances. This will reduce your assets and thus increase your eligibility for aid.
Your Tax Bill
If you did not have enough tax withheld from your wages this year, and you will end up owing the IRS money, consider speeding up the completion of your taxes so that you can send in your return—with a check—before you complete the need analysis form.
If you are self-employed, you might consider prepaying your next quarterly estimate. The IRS is always pleased to receive the money early. You will lose out on the interest the money would have earned if it had stayed in your account a little longer, but this will probably be more than offset by your increased aid eligibility.
Tip #16: Use cash in the bank to pay off tax bills to reduce your assets and increase your eligibility for aid.
You will notice on the FAFSA that next to the item “cash, savings, and checking accounts,” there is no mention of debts as there is for the other asset categories on the form. For the most part, you can’t have debts on these kinds of assets. There is one exception.
With a passbook loan, you use your savings account as collateral for a loan. This is a legitimate debt against your asset. To get credit for the debt, you should include your savings account and the debt against it under “investments” (on the FAFSA) and under “investments” (on the PROFILE form).
IRAs, Keoghs, 401(k)s, 403(b)s
In most cases, money that you contribute to a retirement provision—such as an IRA, Keogh, 401(k), or 403(b)—before the base income years begin is completely sheltered from the FAOs. That money isn’t part of the snapshot; they can’t touch it.
However, as we stated in our section on income, contributions that reduce your Adjusted Gross Income (AGI) made during base income years are a different story. While the IRS may allow you to deduct retirement provisions from your income, the financial aid formula does not. During base income years, voluntary tax-deductible contributions to these plans will be assessed just like regular income; they will be considered as part of your untaxed income that will be added to your AGI to help determine your total income in the aid formulas. (Note: non-deductible contributions have no impact on aid)
This does not mean that retirement provisions are a complete waste of time during the college years. To see the big picture, it helps to remember that the aid formula assesses both your income and your assets. Let’s say a family had $30,000 in income last year. The FAOs will assess the $30,000 as income. Then, if any of that $30,000 is left in the bank on the day the family fills out the need analysis form, it will also be assessed a second time as an asset. However, if that family had made a contribution to a deductible IRA before filling out the need analysis form, the contribution would have been assessed at most, only once — as untaxed income (assuming the contribution reduced your AGI for a base income year. It would not be required to be listed as part of your assets on the FAFSA because the funds in retirement accounts are not a reportable asset category for purposes of that form. And while the CSS does include questions about the value of tax-deferred retirement accounts, funds in such accounts are not assessed as an asset in the IM; and the overwhelming majority of schools that require the PROFILE do not consider such accounts when awarding aid.
A tax deductible contribution to a retirement provision that reduces your AGI for a base income year will always be assessed as income, but it will never be assessed as an asset—so long as you make the contribution before you fill out the need analysis form.
Thus retirement provisions are still a good way to shelter assets while building your retirement fund and possibly getting a tax deduction all at the same time. If you can afford to keep contributing during college years, it will be to your benefit. But when during the year should you make the contribution?
Timing on IRA Contributions
The IRS allows you to make contributions to an IRA from January 1 of one year through April 15 of the following year. Many people wait until after they’ve done their taxes in March or April to make a contribution to an IRA for the preceding year. Unfortunately, if you make the contribution after you fill out the financial aid form, the money won’t be shielded from the FAOs.
In fact it makes sense to make retirement provisions as soon as possible in a calendar year. Not only will you shelter the money itself from assessment as an asset but you will also shelter the interest earned by that money: If you leave that money in a regular bank account for most of the year, the interest will have to be reported on the need analysis form as regular income. Your AGI will be larger, and your financial aid package will be correspondingly smaller. By making the contribution early in the year, the interest earned by that contribution will be out-of-bounds to the FAOs. How much money are we talking about? A married couple that makes an allowable IRA contribution of $6,405 on January 1 of a base income year instead of April 15 of the next year can increase its aid eligibility by as much as $400 each year.
Tip #17: Make your contributions to retirement provisions as early in the year as possible.
Other Retirement Provision Strategies
Let’s say it’s January of a new year. You go to see your accountant and she says, “You’ve got some extra money. Let’s make an IRA contribution. Which year do you want to take the contribution in?” Remember, the IRS allows you to make contributions to an IRA from January 1 (well, realistically January 2; the banks and brokerage houses are all closed on January 1) all the way through April 15 of the next year. That means there are three and a half months during which you can contribute to either the preceding year or the year you are in now. In which year do you make the contribution?
If Possible, Contribute to Both Years
The following section assumes that you have not yet completed the FAFSA form. Contrary to conventional wisdom, financial aid is not awarded by most schools and state agencies on a first-come first-serve basis. Later in Part Three of this book we will explain the optimal time for completing and submitting the forms - and those particular situations in which you should be filing the FAFSA as soon as possible once the FAFSA for the next school year becomes available on October 1st. If any of those specific situations is applicable for the student, then you should not delay filing the aid forms to be able to implement the strategy that follows in the next paragraph.
Let’s say this is your child’s senior year in high school. You are just about to fill out a FAFSA. From January 2 through April 15, you can contribute to the year that has just ended (in this case, the base income year) and the year that is just beginning. If you are married, you and your spouse can make an IRA contribution of up to $11,000 ($13,000 if you and your spouse are both 50 years of age or older) toward last year, and up to $11,000 ($13,000 if you and your spouse are both 50 years of age or older) toward the year that has just begun. By making these contributions before you sign the need analysis form, you can completely shelter up to $22,000 ($26,000 if you and your spouse are both 50 years of age or older) in assets from the scrutiny of the FAOs. This is such a good deal that you might even want to consider making an IRA contribution even if it isn’t tax deductible.
We Don’t Have $22,000. We Might Not Even Have Enough to Make IRA Contributions Every Year.
Many people don’t contribute the maximum allowed amount into their retirement accounts every year. Many people don’t contribute anything in a given year. Sometimes, of course, you just haven’t got it. Other times, it is a matter of which year it makes the most sense tax-wise to make the contribution:
During College Years, Some Tax Strategies Have to Change
Why shouldn’t you make retirement contributions based solely on tax considerations? It’s all in the numbers. Remember our IRA example from the “Expenses” section of this chapter? Given a choice of making a tax-deductible contribution to an IRA in a base income year or a non-base income year, you were better off making the contribution in the non-base income year. Tax-wise, there was no real difference, but by concentrating your taxes into the base income year, you effectively raised your expenses during the year the colleges were looking at it, and thus lowered your expected family contribution.
Parents and accountants find this hard to believe. “How could an IRA contribution possibly hurt a family’s chances for aid?” they demand.
Federal income tax is an expense that is deducted from your total income under the aid formula. A tax-deductible retirement provision contribution reduces your tax. Reduced taxes increase your available income, and thus increase the amount of money the colleges think you can afford to fork over for tuition next year.
You’re Saying Parents Should Try to Pay More Taxes?
Never. But by concentrating your taxes into the base income years, you can end up paying the same amount in taxes over the course of time while lowering the amount you have to pay for college.
The Big Picture
Extrapolating from this, if you were to load up on tax-deductible contributions to retirement provisions over the course of several years prior to the first base income year, and then avoided contributions to retirement provisions completely during the base income years, you could end up paying about the same amount in taxes over the years, but you would have made yourself eligible for far more financial aid.
Tip #18a: If you can, try to load up your contributions to retirement provisions in the years prior to base income years.
Let’s take the hypothetical case of Mr. Jones. Mr. Jones is doing pretty well: He has a substantial regular savings account, and every year he contributes $1,500 to his 401(k) plan at work. Over the next seven years, he figures he will be able to contribute $10,500 to the retirement provision. His daughter is entering college in five years. Before the start of the first base income year, Mr. Jones will have sheltered only $4,500 in his retirement plan. The FAOs will assess his entire regular savings account at the maximum asset rate. His pre-tax $1,500 401(k) contribution that effectively reduces his AGI for that base income year will lower his taxes a bit (thereby reducing his expenses against income in the FM and IM, but not his total income for aid purposes since the contribution is added back to one’s AGI as untaxed income.) This would mean that his available income (after expenses and allowances) in those aid formulas will be just a bit higher, which will raise the EFC.
Consider what would have happened if Mr. Jones had contributed the same $10,500 to his 401(k) but had arranged to lump it all into the three years before the first base income year. Over the seven years his total tax bill would turn out to be about the same as before, but everything else would be very different. Now he would have $10,500 sheltered in his retirement plan. In order to make the contributions over only three years, he would probably have to take some money out of his savings account—but that’s actually good news because it would reduce his assets in the eyes of the FAOs. During the four base income years, Mr. Jones wouldn’t have to contribute to his retirement fund at all—this means that amount of federal income taxes paid (which are an expense item in the FM and IM aid formulas) would be concentrated into these years that would lower his EFC.
Mr. Jones had only $10,500 to contribute over seven years. However, by changing the timing of his contributions, he made them much more valuable. This strategy will work only if your voluntary contributions to retirement provisions are tax deductible. If you won’t qualify for the tax break (because you contribute after-tax funds), you won’t be able to concentrate your taxes into the base income years. However, the expense item for the amount of federal income taxes paid won’t be reduced either.
The Big, Big Picture
Mr. Jones (like most of us) could not afford to contribute the maximum amounts allowed by the law to retirement provisions; therefore it made sense to plan the timing of the contributions to get the most aid. However, if you can afford to make maximum contributions to IRAs, Keoghs, 401(k)s, or 401(b)s in every single year, it is in your interest to do so. This will enable you to shelter the largest amount of assets, and also build a sizable retirement fund.
However, Before You Frame the Picture
The only reason not to follow the advice we’ve just given you is you Adjusted Gross Income for a base income year will be just over $50,000 and you are otherwise eligible to qualify for the Simplified Needs Test (SNT). In this case, by making tax-deductible and/or pre-tax contributions to retirement provisions during the base income years, you could lower your AGI to below the $50,000 magic number for the Simplified Needs Test. As we said earlier, anyone who meets the SNT will have all assets excluded for federal aid purposes. The same situation applies if such a contribution will lower your AGI below the $25,000 threshold for the Automatic-Zero EFC.
You would have to work out the numbers very closely on this to see if it really makes sense. Factors to consider: how much you have in the way of assets; does the school look at your assets anyway in awarding their own aid funds; the difference in your EFC with the SNT or Automatic-Zero EFC or not qualifying for those items. Since these factors are all pretty complicated, consider discussing this with a financial aid consultant.
Tip #18b: If a contribution to a retirement provision will lower your AGI for a base income to below the income threshold for the SNT or the Automatic-Zero EFC and you otherwise qualify for the SNT or the Automatic Zero EFC (see this page), you should load up your contributions to retirement provisions during that base income year.
Although the FAFSA doesn’t ask questions about the money in parents’ retirement provisions or insurance policies, a few private colleges ask for this information on their own forms. Short of refusing to apply to these colleges, there is nothing you can do but supply the information gracefully. Unless you have several hundreds of thousands of dollars of these assets, however, there should be little effect on your family contribution. (While the PROFILE now asks questions regarding retirement accounts, such assets are not assessed in the IM.)
They Won’t Give Aid to Us—We Own Our Own Home
One of the biggest myths about financial aid is that parents who own their own home will not qualify for aid. This is not the case at all. As we have already mentioned, the federal methodology (used to award Pell Grants and other federal aid programs) does not look at home equity anymore. While many private colleges and some state universities continue to use home equity in determining eligibility for their own aid programs, it has been our experience that most homeowners—even in this situation—do get aid. In some cases, this will be true even if they have several properties, if they apply for it in the right way.
Real Estate Strategies
Because we know that many of our readers will be applying to schools that assess home equity in awarding the funds under their own control, the next few sections of this chapter will suggest strategies that focus on both your primary residence and any other real estate you may own.
If none of the schools you are considering assess home equity, then the following strategies will apply only to your other real estate holdings.
Valuing the Property—Be Realistic
Figuring out the value of your home can be difficult. Is it worth what your neighbors down the street sold their’s for last week? Is it worth what someone offered you three years ago? Is it worth the appraised value on your insurance policy? Figuring out the value of other properties can be even more difficult, especially if you rarely see them.
You want to try to be as accurate as possible. The temptation to over-represent the value of your real estate should be firmly controlled. The forms are asking for the value of the property if you had to sell it right this minute, today—not what you would get for it if you had a leisurely six months to find a buyer. If you had to sell it in a hurry—at firesale prices—how much is it worth? Remember also that there are always attendant costs when you sell a property: painting and remodeling, possible early payment penalties for liquidating your mortgage, real estate agent’s commission. If the colleges want to know what your real estate is worth, these costs should be taken into account. Be realistic. Inflating the price of your property beyond what it is really worth will reduce your aid eligibility.
At the same time, you don’t want to under-represent the value either. The colleges have verification procedures to prevent parents from lowballing. One of the procedures: the PROFILE form asks when you purchased your home and how much you paid for it. The analysis computer will then feed these numbers into the Federal Housing Index Multiplier to see whether your current valuation is within reasonable norms. Some schools have also started to use zillow.com to value properties.
Ultimately, what your real estate is worth is much less important than how much equity you’ve built up in it. Your equity is the current market value of your real estate minus what you owe on it (mortgages, home equity loan balances, debts secured by the home). Let’s assume for a moment that two families are looking at a private college that considers home equity as an asset. All other things being equal, the family with a $100,000 house fully paid up would probably pay a higher family contribution to that college than the family with a $300,000 house with a $250,000 mortgage. Sounds crazy? Not really. The first family has built up equity of $100,000; the second family has equity of only $50,000.
Parents often don’t remember when they are filling out the need analysis forms that their first mortgage need not be their only debt against their property. Did you, for example, borrow money from your parents to make a down payment? Have you taken out a home improvement loan? Have you borrowed against a home equity loan line of credit? Is there a sewer assessment? All of these are also legitimate debts against the value of your real estate.
If you are a part-owner in any property, obviously you should list only your share of the equity in that property.
The Home Equity Loan: A Possible Triple Play
One of the smarter ways to pay for college is the home equity loan. A home equity loan is a line of credit, secured, most likely, by the equity in your home. Of course, it is also possible to get a home equity loan using one of your other properties as collateral. You draw checks against this line of credit, up to the full value of the loan, but you pay no interest until you write a check, and you pay interest only on the amount that you actually borrow.
There are three possible benefits to a home equity loan. First, in most cases you get a tax deduction for the interest you pay. Few other types of debt are now tax deductible. Second, you temporarily reduce the equity in your property, which, in turn, lowers your net assets, which lowers your family contribution—provided, of course, that the loan is taken against a property that is being considered an asset by the college. Third, because it is a secured loan, the interest rates are fairly low. As always, you should consult with your accountant or financial planner on this.
If you have any outstanding loans that cannot be used as a deduction under the financial aid formulas (personal loans, car loans, large credit card balances, etc.), it might make sense to use a home equity line of credit to pay off these other obligations. The interest rate will probably be lower, you will most likely be able to deduct the interest payments on your tax return, and the value of one of your prime assets may look smaller to the FAOs.
Which Property Should I Borrow Against?
If you have only one property, the decision is easy. Borrow against your one property. You’ll almost certainly get a tax deduction and a low interest rate. Whether you will reduce your equity in the eyes of the FAOs depends on whether they have decided to assess the value of the primary residence—and if so whether they are choosing to assess it at full market value or at a lower rate.
If your college is actually going to follow the federal methodology, a home equity loan on a primary residence would no longer help you to qualify for more aid (although the tax and interest savings still may make it a good idea). If you own two homes, take out the loan on the second residence instead.
If your prospective colleges are using the institutional methodology and electing to cap home value at 2.4 times income (and a number of private colleges will be), the effectiveness of our strategy will depend on how much equity you have in your home. Let’s take a family with income of $60,000 and a home valued at $200,000, with a $100,000 mortgage. At schools that choose to cap the home value at 2.4 times income, the maximum value of this family’s home would be 2.4 times $60,000 or $144,000. The colleges will subtract the $100,000 debt from the $144,000 asset and decree that the family has equity of $44,000 —which the colleges feel is available to help pay for college, and will assess at a rate of up to 5% per year. In this case, it would still make sense to take out a home equity loan of up to $44,000 to reduce the appearance of equity in the house.
However, let’s take a family with a combined income of $60,000, a home valued at $300,000 and a mortgage of $200,000. If the schools choose to cap home value at 2.4 times income, the maximum value for the house (for assessment purposes) is $144,000. The colleges then subtract the mortgage of $200,000. In this case, there is, in fact, no equity at all in the home as far as those colleges are concerned. Thus, if this family took out a home equity loan on their primary residence, their assets would not be reduced in the eyes of the colleges (since as far as the colleges are concerned, the family has no equity in the house in the first place). To reduce the appearance of their assets, this family could borrow instead against a second home, other real estate, or their stock portfolio.
If the schools you are considering either use a cap on home value or a cap on home equity, our tips #2 through #11 (which describe ways to lower the appearance of your Adjusted Gross Income) become even more important. Lowering your AGI will keep your capped home value or capped home equity down, and may thus protect more of the value of your home from the FAOs.
Tip #19a: Take out a home equity loan to pay for college and/or to consolidate debt not taken into account in the aid formulas.
A home equity loan is not something to be done lightly. Unlike unsecured loans and credit card balances, a home equity loan uses your real estate as collateral. If you default, the bank can foreclose. Nonetheless, if you have a low mortgage to begin with and your income seems stable, this is an excellent alternative.
A Home Equity Loan vs. a Second Mortgage
When you take out a second mortgage, the bank writes you a check for a fixed amount, and you begin paying it back immediately with interest. Parents sometimes ask, “Isn’t a second mortgage just as good as a home equity loan?” It depends on what you’re going to do with the money you get from the loan. If you put it in the bank to pay for college bills as they come due, then a second mortgage is not as good at all. Consider: You are paying interest on the entire amount of the loan, but you aren’t really using it yet. The money will earn interest, but it will not earn nearly as much interest as you are paying out. For financial aid purposes, the interest you earn will be considered income, yet the interest you are paying on the second mortgage will not be taken into account as an expense.
Even worse, if the money you received from your second mortgage is just sitting in the bank, the debt does not reduce your net assets either. The reduced equity in your house will be offset by the increased money in your bank account. Under these circumstances, a home equity line of credit loan is a much better deal. You pay interest only when you withdraw money, and you withdraw only what you need.
But if the school you select has opted not to look at home equity, then a second mortgage becomes the worst deal in the world. You will have taken an asset that the college could not touch and converted it into an asset with no protection at all. This could actually raise your EFC by several thousand dollars.
Should We Buy a House Now?
We’re all for it if you want to buy a house, but don’t think of it as an automatic strategy for reducing your assets in the eyes of the FAOs. If the school assesses home equity, then exchanging the money in your bank account for a down payment on a house just shifts your assets around, rather than making them disappear. Your net assets will be exactly the same with or without the house (at least until the house starts appreciating in value). On top of that, your monthly housing costs will probably increase. As you may remember from the “Expenses” section of this chapter, you don’t get credit in the aid formulas for mortgage payments.
However, if the school uses only the federal methodology or excludes home equity, then a first-time home purchase could make a lot of sense. You would be exchanging an unprotected asset for an asset that could not be touched.
By the same token, it might also make sense to prepay or pay down the mortgage on your primary residence since this will reduce your net assets in the federal formula. You will need to consider any prepayment penalties you may incur before you pursue this course of action.
Tip 19b: If the college your child will attend does not look at home equity, consider buying a primary residence if you currently rent. If you already own your primary residence, consider liquidating unprotected assets to prepay your home mortgage.
The Perils of Inheritance and Gifts from Grandparents
Many accountants suggest that elderly parents put assets in their children’s name. In this way, the elderly parents more readily qualify for government benefits such as Medicaid; they avoid having their investments eaten up by catastrophic illness; and, if they are wealthy, their heirs avoid having their inheritance eaten up by estate taxes.
If a grandparent is contemplating putting assets in the parents’ name, the parents should at least consider the possible financial aid consequences before accepting. Obviously, such a transfer will inflate your assets and possibly your income as well (the interest on monetary assets could be considerable). In many cases, while the grandparents may have transferred their assets to the parents, the parents do not feel that this money really belongs to them yet. When grandparents decide to move to a nursing home, or need health care not provided by insurance, the parents often pay the expenses. Since the money is not really yours to spend, you may feel dismayed when the colleges ask you to pony it up for tuition.
If it is possible to delay the transfer of assets until you no longer have to complete aid forms, you might wish to do so. Or perhaps the assets could be put in the name of another relative who does not have college-age children. If that is impossible, you should explain to the FAOs that this money really does not yet belong to you.
An even worse situation arises when grandparents transfer assets to the grandchild’s name. These assets will be assessed at a much higher rate than those of the parents (20% versus a maximum of 5.65%). If the only possible choice left to you is to put the grandparents’ gift in the name of the parent or the child, it is better to put it in the parents’ name.
While trusts have much to recommend them, their effect on the financial aid formulas can be disastrous. We are not speaking of the general feeling among FAOs that “trust fund babies don’t need aid” (although this is a pervasive feeling).
The real problem is that the FAOs assume the entire amount in the trust is available to be tapped even if the trust has been set up so that the principal can’t be touched. Let’s see how this works:
Suppose your child Johnny has a $10,000 trust, which has been prudently set up so that he can’t touch the principal, a common practice. He gets a payment from the trust every year until he reaches age 25, at which time he gets the remaining balance in the trust. Parents often set up trusts this way under the mistaken impression that the colleges will thus never be able to get at the principal.
However, because the money is in his name, it is assessed for his freshman year at 20% in the federal formula, or $2,000. Never mind that Johnny can’t get $2,000 out of the trust. He, or more likely you, will have to come up with the money from somewhere else.
Next year, the need analysis company looks at the trust again, and sees that it still contains $10,000. So it gets assessed at 20% again, and again Johnny gets up to $2,000 less in aid.
If this continues for the four years of college, and it will, Johnny’s $10,000 asset may have cost you $8,000 in aid. The trust may have prevented you from getting aid entirely, but couldn’t actually be used to pay for college.
Don’t Put Your Trust in Trusts
If you are counting on any kind of financial aid and you have any control over a trust that is being set up for your child, prevent it from happening. If a grandparent wants to help pay for schooling, the best way to do this is to wait until the child has finished college. Then the grandparent can help pay back the student loans when they become due.
If a trust has to be set up, make sure at least that it is set up so that the principal money can be withdrawn if necessary. You might also consider setting the trust up in your own name. Parents’ assets are assessed at the much lower rate of 5.65% each year.
Setting up a trust that matures just as your child is entering college would at least ensure that the money could be used to pay for tuition. However, if the trust is sizable, you may be jeopardizing any chance to receive financial aid.
If Grandmother wants to provide for Johnny’s entire education, but doesn’t want to wait until after graduation, perhaps a better idea would be for her to take advantage of one of the prepayment plans being offered by a growing number of colleges. We generally don’t think a prepayment plan makes economic sense (see Chapter Seven), but in this one case, it would be infinitely better than a restrictive trust.
Direct Payments to the School
If you are in the happy position of having a rich uncle who wants to pay for part of your child’s college education, he can avoid paying gift tax on the money (even if it is above the $14,000 annual limit) by writing the check directly to the school. However, he and you should realize that if your uncle is paying less than the entire amount of the tuition, this won’t necessarily save you any money.
If you are eligible for aid and you receive any money from a third party toward college, the FAOs will treat this money like a scholarship. They will simply reduce the amount of aid they were going to give you by the size of your uncle’s payment. Your family contribution will probably remain exactly the same.
If your uncle wants to be of maximum help, he could wait until your child is finished with college and then give you the money. If you were going to qualify for aid, this would ensure that you actually got it. You can then use your uncle’s money to pay off any loans you’ve taken out along the way.
Stocks, Bonds, Money Market Accounts, and CDs
The need analysis forms ask for the value of your assets on the day you fill out the forms. For stocks and bonds, you can find the prices online or by consulting your broker. Remember that bonds are not worth their face value until they mature. Until that time, they are worth only what someone is willing to pay for them at a given moment.
In the aid formulas, debts against these assets reduce your net assets. However, the only real debt you can have against these types of assets is a margin debt.
Many parents shudder when they hear the word margin. “Oh, that’s just for people who really play the market,” they say. In fact, this is not true at all, and margin debt may be one of the more sensible approaches to paying for college if you run out of liquid assets. Here’s how it works:
In most cases, you set up a margin account with a brokerage firm. Using stock that you own as collateral, they will lend you a certain amount of money. Traditionally, you would then use this money to buy more stock. However, there are no rules that say you have to buy stock—these days, the brokerage firms are just as happy to cut you a check for the full amount of the loan.
Because this is a secured loan based on the value of your stock portfolio, the interest rates are far superior to unsecured personal loans. You still own the stock, and it continues to do whatever it was going to do. (Out of all the long-term investment possibilities, the stock market has been the single best way to build principal over the past 50 years.) In most cases, you get to deduct the interest expense against your income on your tax return. And—here’s the beauty part—you get to deduct the entire loan from your assets on the need analysis forms.
Margin Can Pay for College
If you own stocks or bonds and you need the money to pay for college, it may make sense to borrow against these assets rather than to sell them. If you sell the investment and write the college a check, the money is gone forever. By borrowing on margin, you can avoid capital gains (which will raise your AGI) and still retain your assets.
A margin loan is a bet that the value of your stock will increase faster than the interest you are paying on the loan (and based on long-term past performance, this is a reasonable bet). Even if you don’t make money on the deal, it will cost far less than an unsecured personal loan, and your assets will still be there when your child walks back from the podium with his diploma and tells you he wants to go to graduate school.
Margin allows you to avoid paying taxes on capital gains, keep your investment working for you, and reduce your assets in the eyes of the FAOs.
Tip # 20: Use a margin loan to pay for college and reduce the appearance of your assets.
A major drawback to this type of loan is that if the stock market declines drastically, you may be asked to put up additional stock as collateral, or even (it would have to be a very drastic decline) pay back part of the money you borrowed. If you were unable to put up additional stock or money—or if you couldn’t make the loan payments—you could lose the stock you put up as collateral. This is the kind of calculated risk you should discuss with your broker or accountant before you jump in.
Doesn’t This Margin Strategy Conflict with What You Said Earlier?
In the “Income” section of this chapter we suggested that you avoid margin debt as an investment strategy. How then can we turn around now and say it’s a good strategy for paying for college? Whether margin makes sense for you depends on what you’re using it for. If you are using it to purchase more stock, this should be avoided as it will overstate your investment income and therefore your AGI.
On the other hand, if you do not have sufficient income or liquid assets (such as savings, checking, or money market accounts) to pay the college bills, margin debt is infinitely preferable to:
(a)borrowing at high rates from loan sources that are not considered debts under the aid formulas and/or
(b)selling off assets that will generate capital gains during a base income year.
This category has nothing to do with the mortgage you have on your house. It refers to a situation in which you are acting as a bank and someone else is making monthly payments to you. This situation might have come up if you sold your house to a person who could not get a mortgage from a bank. If you were anxious to make the sale, you might agree to act as the banker. You receive an initial down payment, and then monthly installments until the buyer has paid off the agreed price of the house plus interest. The exact terminology for this is an installment or land sale contract.
If you are the holder of a mortgage, the amount owed to you is considered a part of your assets. However, you should not write down the entire amount that is owed to you. A mortgage, installment contract, or land sale contract is worth only what the market will pay for it at any particular moment. If you had to sell that mortgage right now, it might not be worth its face value. You should consult a real estate professional or a banker who is familiar with second mortgage markets (yes, there actually is a market in second mortgages) to find out the current market value of your investment.
529 Plans (Prepaid Tuition Programs & Tuition Savings Accounts) and Coverdell ESAs
The recent CCRAA legislation has changed some of the ways these three types of educational funding vehicles will be treated under the aid formulas, beginning with the 2009-2010 academic year. Since these are generally long-term planning options, see this page for more details on how these plans are treated under the federal and institutional methodologies.
As with the prepaid plans, the tax-free earnings portion of any withdrawal from a 529 savings plan or a Coverdell ESA for the student will not be considered income to the student for the purposes of the 2017-2018 aid forms.
What About Contributions from Grandma or Uncle Joe?
If someone other than a custodial parent or student is the owner of a 529 plan or Coverdell, then it appears that the account would be completely sheltered as an asset from the federal formula for the 2017-2018 academic year. However, don’t jump for joy just yet. For while the assets may be sheltered, the dollar value of the funds withdrawn or tuition credits redeemed may well be considered untaxed income that will eventually need to be reported on a subsequent year’s aid form—thereby raising the base year income for the year when that transaction occurred. If the student is beneficiary of such an account, there may be strategies you can follow to minimize the impact of such transactions. Yet, because this situation is too complicated for us to give general advice, we recommend you consult with a competent financial advisor who is thoroughly familiar with financial aid regulations as well as such accounts. For the institutional methodology, these accounts owned by others will be treated the same way as they are in the federal formula. However, colleges will have the option of asking additional questions regarding 529 plans or Coverdells that were funded by individuals other than the student or the parents. These optional questions will appear in the Supplemental Questions section of the PROFILE. As we went to press, it was impossible to determine how many colleges would be exercising this option.
Warning: with each successive year, more and more colleges are asking questions about these plans. Who set them up? Who owns them? How much will be withdrawn or redeemed in a given year? What’s the total value? Because of this increased scrutiny…because the colleges know these funds are specifically set up for the student beneficiary’s education…and because the FAOs can choose to ignore the federal and institutional formulas when awarding the school’s own money, placing funds in these accounts is increasingly risky if the student is otherwise eligible for aid—especially for grants awarded by the colleges themselves. Well-intentioned relatives should be alerted to the possible problems with these programs as well. Our website (www.princetonreview.com/financialaidupdate) will cover any late-breaking developments regarding these plans, should they occur before the 2018 edition of this book is published in the fall of 2017.
Ownership of a Business
If you own and control a business with fewer than 101 full-time (or full-time equivalent) employees, prepare yourself for one of the most amazing new loopholes we have ever seen—courtesy of the HERA legislation.
Previously, any business equity—that is, the value of the business assets minus the liabilities—needed to be reported on the FAFSA. However, starting with the 2006-2007 academic year, the net worth of these small businesses (which the US Department of Education classifies as “family businesses”) need no longer be reported as part of business/farm assets on the FAFSA.
However, if your business falls outside this definition (for example if you have more than 100 full-time employees) you will still need to include the net worth of the business as part of your assets on the FAFSA, which may very well increase your federal EFC.
And either way, you will still be required to list ALL of your business assets and business debts on the PROFILE form—whether yours is a “family business” or not. This could have a chilling effect on your eligibility for aid from the schools themselves.
Remember, though, if you need to report the equity of your business on any aid form, net worth is NOT the same thing as what you would get if you sold the business. It does not include goodwill; it has nothing to do with gross receipts.
The net worth of a business consists of the cash on hand, receivables, machinery and equipment, property, and inventory held, minus accounts payable, debts, and mortgages. In most cases you can find the figures you will need from the company’s year-end balance sheet, or a partnership or corporate income tax return (IRS forms 1065, 1120, or 1120S).
The main thing to realize here is that just like when you are assessing the value of your real estate, there is no point getting carried away with your valuation of your company. Business owners are rightfully proud of what they have accomplished, but this is not the time to brag. The higher your net assets, the worse your chances of receiving aid. The FAOs are interested in only selected portions of your balance sheet. Don’t look any further than they do.
For example, if your company is part of the service industry, it may have a very small net worth, even if it is extremely successful. Let’s assume for a moment that you own a small advertising agency. Like most service industry companies, you would have no real inventory to speak of, little in the way of property, and, because you’re putting your profits back into the company, not much money in the bank. The net worth of this company—even if you were required to report its equity on an aid form—would be almost nil. This would be true even if it were one of the most well-respected agencies on Madison Avenue.
The government has further clarified the definition of a family business. Specifically, more than 50 percent of the value of the business must be owned by the family, which can include relatives by blood (including cousins, nieces, nephews) or by marriage.
Obviously these rules may well be changed if and when Congress determines that this new law is being exploited. For example, if too many people start placing their investments into family partnerships or corporations established solely to qualify as “family businesses” for aid purposes, Congress may quickly close this loophole.
Business Assets Are Much Better Than Personal Assets
Because the FAOs acknowledge that a parent’s business needs working capital to operate, the net worth of the entity reported on the FAFSA or PROFILE is assessed much less harshly than the parent’s personal assets. For example, of the first $130,000 in net worth, the colleges count only 40 cents on the dollar.
So even if you do not “own and control” a business and must report the value of the business on the FAFSA, all is not lost. As long as you own at least 5% of the stock in a small corporation, it may be possible to call yourself a part-owner and list the value of your stock as a business asset on the aid form instead of as a personal investment. How much difference would this make? If you had $40,000 in stock in a small, privately held corporation, you could find yourself eligible for up to $1,300 per year in increased aid simply by listing this stock as a business asset rather than as a personal asset.
Real Estate as Business
Can you turn your various real estate properties into a business? It depends. If you own several properties, receive a significant portion of your income from your properties, and spend a significant proportion of your time managing the real estate, then you probably can.
If you own your own business and the building in which you conduct business, then you certainly can. If you rent out one or more properties and file business tax returns, then you perhaps can. Some schools will want to see extensive documentation before they will buy this strategy. The benefits, of course, are enormous. Business assets are assessed much less severely by the formula. Listing your real estate holdings as a business could reduce your expected family contribution by thousands of dollars—if the FAOs buy it.
Ownership of a Farm
If you live on your farm and can claim on schedule F of your IRS 1040 that you “materially participated in the farm’s operation,” the equity in the farm will be protected under the federal methodology. While the federal FAFSA form still includes a question regarding the net worth of farms, the instructions to the form tell you not to include “a family farm that you live on and operate.”
Unfortunately, the institutional methodology used by many private colleges and some state schools will assess your farm equity, regardless of where you live.
If you are filling out the PROFILE form, be sure not to count the value of your farmhouse twice. If you list it under “home,” then there is no need to count it again as part of your farm property.
All of our other strategies for ownership of a business apply to ownership of a farm as well. And similar to a parent-owned business, a parent’s farm equity report on the FAFSA or PROFILE will be assesed much less heavily than the parent’s personal assets.
Under the aid formulas, limited partnerships are also considered assets. Determining a value for limited partnerships can be difficult. If you can’t sell your interest in the partnership, and the other general partners are unable to buy back your shares, then it isn’t worth anything at the moment, and you should list this worth as “zero.” Again, the FAOs may not buy this strategy, but let them tell you that you can’t do it.
The Business/Farm Supplement
Some schools ask the owners of businesses and farms to fill out a standardized form that asks about your business or farm net worth and income in greater detail. We will discuss this, as well as some more complicated strategies in the “Special Topics” chapter of this book.
Asset Protection Allowance
After the FAFSA processor has determined your net assets, there is one final subtraction, called the Asset Protection Allowance.
This number, based on the age of the older custodial parent (or custodial stepparent), is how much of your net assets can be exempted from the federal financial aid assessment. The older you are, the more assets are sheltered. Below is a chart that will give you a rough idea of the asset protection allowance permitted at various ages under the federal methodology. According to the Department of Education, this allowance is calculated to yield the same amount of money as “the present cost of an annuity which, when combined with social security benefits, would provide at age 65 a moderate level of living for a retired couple or single person.” Of course, their idea of “a moderate level of living” probably means a more spartan existence than you had in mind.
ASSET PROTECTION ALLOWANCE (APPROXIMATE)
34 or less
65 or more
After subtracting the asset protection allowance, the remaining assets are assessed on a sliding scale (depending on income). The maximum assessment on parents’ assets is 5.65%. In other words, the most you will have to contribute is slightly more than five and a half cents for each additional dollar of assets.
Parents with few assets worry that the colleges will take what little they have. In fact, a family with low income and, say, $5,000 in assets would almost certainly not have to make any contribution from assets at all. If your total net assets are less than your protection allowance, then your assets will not be touched by the FAOs. In the federal methodology, the assessment of assets is related to the parents’ available income. After the asset protection allowance is subtracted, any remaining assets are then assessed at 12%. The result is then added to the available income to come up with what is called the adjusted available income (AAI). Since the maximum assessment rate on the AAI is 47%, the maximum contribution from assets is therefore approximately 5.65%
(.12 × .47 ≈ .0565 or 5.65%).
College Board Asset Allowances
Starting with the 2000-2001 academic year, the institutional methodology will no longer contain an asset protection allowance similar to the federal formula. Since the aid formulas do not assess assets in retirement accounts, the College Board feels that it is redundant to also protect some non-sheltered assets for retirement. Instead, the institutional formula has contained three other asset allowances: The Emergency Reserve Allowance, The Cumulative Education Savings Allowance, and The Low Income Asset Allowance.
The first allowance recognizes the fact that every family should have some assets available to handle emergencies, such as illness or unemployment. The emergency reserve allowance for the 2010-2011 award year was as follows: $20,330 for a family of two; $24,560 for three; $28,230 for four; $31,620 for five; $34,450 for six. Above six family members, $2,830 will be granted for each additional person. (Data for 2016-2017 will not be published by the College Board. However given low inflation, we expect the numbers will not be significantly higher.)
The cumulative education savings allowance is granted to shelter those assets that the family has presumably set aside each year to meet their annual goal for the educational savings allowance (see this page). For the student applicant and any other siblings also enrolled in college during the same academic year, the institutional formula assumes that the savings goal was met for each child for 18 years and that the accumulated savings are then used up during the student’s college career. For younger siblings, the allowance will be based on the number of children and their ages. All families received a minimum allowance of $23,130 in the 2010-2011 version of the institutional formula. Because this allowance protects assets for each dependent child in the household, any parental assets held in the names of the student’s siblings will be considered as part of the parents’ assets.
Lower income families who have negative available income in the institutional formula will be given a third asset allowance equal to the amount of the negative available income. This low income asset allowance is granted because such families generally need to use up some of their assets to cover those basic expenses in excess of their income.
The emergency reserve allowance, the cumulative education savings allowance, and the low income asset allowance (if applicable) will automatically be calculated by the PROFILE processor. These allowances are then subtracted from the parents’ net assets (the value of the assets less any debts secured by those assets) to determine the parents’ discretionary net worth. This net worth is then assessed to calculate the parents’ contribution from assets. Previously the asset assessment rate was based in part upon the family’s available income, with higher income families having their assets assessed at a higher rate. Under the new institutional formula, there is no longer any linkage between income and the rate of asset assessment. For the 2010-2011 academic year, the first $34,450 of the parents’ discretionary net assets was assessed at 3%. The next $34,450 was assessed at 4%. Any assets in excess of $68,900 were assessed at the rate of 5%. We expect these brackets to widen only marginally in future years. In addition, families with negative discretionary net worth will not have their available income reduced in the institutional methodology.
Multiple College Students
After the parents contribution is calculated, it is then adjusted based on the number of family members in college on at least a half-time basis. Beginning with the 2000-2001 academic year, the federal formula will no longer recognize a parent as a family member in college for the purposes of this adjustment—even if mom is pursuing a Ph.D. The institutional methodology will continue to only view dependent children as household members in college, so the two formulas are now alike in this respect. If a parent plans to attend graduate school during the same academic year as the student seeking aid, it would be a good idea to explain this situation to the FAO directly, since some may take the parent’s educational expenses into account on a case-by-case basis.
While the federal formula simply divides the parents’ contribution by the number in college to arrive at the parents’ contribution per student, the College Board has used a different formula for multiple students. If there are two in college, the parents’ contribution for each student has been 60% of the total parents’ contribution. If there are three in college, 45% will likely be the applicable rate. If there are four or more in college, 35% of the total parents’ contribution will likely apply to each student in the institutional formula.
Assets and Liabilities: How the Methodologies Differ
THE FEDERAL METHODOLOGY
✵Does not assess home value
✵Does not assess farm value provided the family lives on the farm and can claim on Schedule F of the IRS 1040 that they “materially participated in the farm’s operation”
✵Does not assess business net worth for a “family business” provided your “family” owns and controls more than 50% of the business and it has 100 or fewer full-time (or full-time equivalent) employees
✵Asset protection table based on present cost of an annuity
✵Provides for exclusion of all assets if you meet the Simplified Needs Test
✵Asset assessment on a sliding scale based in part on income
THE INSTITUTIONAL METHODOLOGY
✵Assesses home value, but some colleges will choose to ignore home equity (though sometimes only if family income is below a certain threshold) or cap home value at 2.4 times income or cap home equity at 2 times income
✵Assesses all farm equity and all business equity
✵All assets are assessed, regardless of whether or not you meet the simplified needs test
✵Asset assessment is unrelated to income, except for those with negative available income
✵Assets held in names of siblings considered as parental assets
✵Asset allowances based on emergency reserves, educational savings, and low-income supplements
Need analysis companies ask precisely the same questions about students’ income and assets that they do about the parents’ income and assets, but there is one major difference in the way students’ money is treated.
Colleges take a much larger cut of students’ money. In the federal formula (FM), a student’s assets are assessed at a whopping rate of 20% each year (versus a ceiling of 5.65% on parents’ assets). In the institutional formula (IM) for the past few years, the assessment rate has been 25%. A student’s income under the FM is assessed at up to 50% (versus a ceiling of 47% on parents’ income). For the IM we’ll soon discuss how student income is assessed.
Under the federal formula, there is no minimum contribution from student income, and the first $6,420 (after tax) dollars earned by a dependent student are excluded.
Thus an incoming freshman can earn about $7,000 before he will be assessed one penny. Once he crosses the $7,000 threshold, his additional income will most likely be assessed at a rate of 50%. If he then saves his money, it will also be assessed as an asset at a rate of 20%. Thus, if he banks his 7,001st dollar, 50 cents of it will be assessed as income and 20 cents of it will be assessed as an asset. The extra dollar he earned could cost him 70 cents in reduced aid. While this is much better than the old ridiculous rule under which the same child would have been assessed $1.05 for each dollar earned over a certain amount, most students will still be better off devoting their extra time to their studies once they have hit the $7,000 mark.
And that’s only if the college is using the federal formula. If your child attends a private college that uses the institutional methodology, she may be responsible for a minimum freshman year contribution as high as $2,000 ($2,650 as an upperclassman) and there is no $6,420 income protection allowance. A student at a private college will owe no more than the minimum contribution as long as she keeps her income below $4,708 as a freshman and $6,238 as an upperclassman. Over $4,708, she may be losing 71 cents in aid eligibility on each additional dollar she earns and saves. Recognizing that a student from a lower income family may be using their earnings to supplement the parent’s income, the institutional methodology beginning with the 2008-2009 academic year will be using a complicated formula for calculating a student’s contribution from income.
Tip #21a: For a student who hopes to receive aid from a school using only the federal methodology, it doesn’t make sense to have income higher than $7,000.
Tip #21b: For a student who hopes to receive aid from a school using the institutional methodology, it doesn’t make sense to have income higher than $4,708 as an incoming freshman, or $6,238 as an upperclassman.
The current assessment rates have set up a bizarre situation, in which the best way a student receiving financial aid can help his parents pay for college is by not working very much. If your family has no chance of receiving aid, then by all means encourage your child to make as much money as possible. However, any student who might qualify for aid will find that most of the money he earns will just be canceled out by the money he loses from his aid package.
Under current rules, it makes more sense for students receiving financial aid to earn the minimum amount of money the college will allow, and concentrate on doing as well as possible in school. Most aid is dependent at least in part on the student’s grades. A high GPA ensures that the same or better aid package will be available next year; a good GPA also helps students to find better-paying jobs when they graduate so they can pay back their student loans.
There is only one type of job that really benefits a student who receives financial aid:
The Federal Work-Study Program (FWS)/Co-op Programs
The Federal Work-Study program, funded by Uncle Sam, pays students to work, perhaps in the college library, the dining hall, even sometimes in nearby off-campus businesses. Work-study earnings, while subject to income tax, are excluded from the financial aid formulas and will not decrease your aid. The money a student earns through work-study goes either toward tuition or toward the student’s living and travel expenses. It does not count as part of the minimum contribution from income in the institutional formula that each student is expected to earn during the summer.
Because they are excluded from the financial aid formula, work-study wages are in effect worth much more than wages from a regular job. For an upperclassman receiving aid who has already earned $7,000 from non-FWS jobs, a work-study job paying minimum wage makes more sense than a $10.00 per hour regular job off-campus. Note: Beginning with the 2010-2011 FAFSA, earnings from a co-op program will also be excluded.
It’s Too Late. My Daughter Already Earned $8,000 Last Year!
Earning extra money is not the end of the world. Just remind her that as much as $412 of that $8,000 will have to go to the college. If she buys a car with it, she—or you—will have to come up with the money from some other source. You might also want to remind the colleges that while your daughter managed to earn $8,000 as a senior in high school, she is unlikely to earn that much again now that she is in college and has a tough work load. They might bear this in mind when they are allocating aid for the coming year. Some schools (Cornell is one) specifically ask you if your child will be earning less money in future years.
Student Income and Taxes: Not Necessarily Joined at the Hip
When does a student have to file a tax return? Generally, an individual who is being claimed as an exemption on his parents’ tax return has to file if he has gross income of over $1,050 and at least $350 of that income is unearned income (i.e., interest or dividends). If the student has NO unearned income at all, he can earn up to $6,300 in wages reported on a W-2 form before he is required to file a federal return. If the student is working as an independent contractor (with earnings reported to the IRS on a 1099), there are special rules to follow. Ask your accountant if the student has to file.
The rules used to be more lenient. The IRS is cracking down on parents who are sheltering assets by putting them in the child’s name. If your child has any investment income at all, his standard deduction can drop from $6,300 to as low as $1,050.
A student who cannot be claimed as a dependent on her parents’ taxes can have income up to $10,300 without needing to file a federal tax return, provided that she gets no more than $400 net earnings from self-employment.
As long as your children are under 24 years old, and are full-time students, they can be claimed as dependents on the parents’ tax return, whether they filed income taxes or not, and regardless of how much money they earned.
You should also realize that the colleges’ criteria for who can be considered an independent student are much tougher than the IRS’s. A student could have been filing a separate return for years, taking her own exemption, and paying taxes like anyone else, but that does not necessarily mean that she will qualify as an independent under the financial aid formula.
Can My Child Go the Independent Route?
If the colleges decide that a student is no longer a dependent of his parents, then the colleges won’t assess the parents’ income and assets at all. Since independent students are often young and don’t earn much money, they get large amounts of financial aid. The key point to grasp here is that it is the federal government and the colleges themselves who get to decide who is dependent and who is independent, and it is obviously in their best interest to decide that the student is still dependent.
We will discuss the criteria for becoming an independent student in Part Three, “Filling Out the Standardized Forms,” and in Chapter Nine, “Special Topics,” but don’t get your hopes up. The rules are tough, and getting tougher all the time.
Accountants and other financial counselors love to advise parents to “put some of their assets in the kid’s name.”
As a tax reduction strategy, this may be pretty good advice, since some of the earned income from the money in your child’s name will almost certainly be taxed in a lower bracket than yours. Unfortunately, as many parents learn the hard way, following this advice during college years is virtually economic suicide.
Parental assets are assessed by the colleges at a top rate of 5.65% each year, after subtracting your protection allowance. Your child’s assets, on the other hand, will be hit up for 20% in the federal formula (25% in the institutional formula) each year, and your child has no protection allowance at all. Any potential tax benefits of putting assets in the child’s name can be completely wiped out by the huge reduction you will see in your aid package.
Tip #22: If you think you will qualify for financial aid, do not put assets in the child’s name.
Even worse, some of the assets in the child’s name can be hit twice each year: first, colleges take 20% off the top of the entire amount of the asset; second, the colleges take up to 50 cents out of every dollar in income generated by the asset.
Let’s say a parent puts $10,000 in the child’s name and invests it in a bond fund that pays 6%. When he fills out the FAFSA form, he enters the $600 interest the fund earned that year as part of the student’s income; because the $600 was reinvested in the bond fund, the fund now has $10,600 in it, so he enters $10,600 under the student’s assets. The need analysis company assesses the $10,600 asset at 20% (in this case $2,120). The need analysis company also assesses the $600 income at a rate of up to 50% (in this case, $300). Note that the $600 income got assessed twice—20% as an asset, and 50% as income, for a total of 70%. That $600 in income may have cost the family $420 in lost aid.
It’s Too Late. I Put Assets in My Son’s Name!
If you have already transferred assets to your child in the form of a custodial account (such as an UGMA or UTMA) or a trust, you should pause and consider three things before you strangle your accountant.
1.You may not have been eligible for need-based aid in the first place. If you weren’t going to qualify for aid anyway, those assets may be in just the right place, and your accountant is a genius. However, you should probably contact her to discuss the “kiddie tax” provisions (See this page).
2.You may have been offered only a subsidized Stafford loan. If you were going to qualify only for minimal need-based aid in the form of student loans, the tax benefits of keeping assets in the child’s name may well exceed the aid benefits, and you did just the right thing.
3.Even if it turns out that putting assets in your child’s name was a bad mistake, you can’t simply undo the error by pulling the money out of your child’s account now. When you liquidate a custodial account, the IRS can disallow the gift, come after you for back taxes and back interest, and tax the money at the parents’ tax rate from the time the funds were first transferred to the child.
Is There Anything We Can Do to Get Assets Back in Our Name?
There may be, but this situation is much too complicated for us to give general advice. You should consult with a competent financial advisor who has a sound understanding of both the tax code and the ins and outs of financial aid.
Student Income and Assets: How the Methodologies Differ
THE FEDERAL METHODOLOGY
✵First $6,420 in student’s after-tax income is sheltered for a dependent student
✵No minimum contribution from income
✵Asset assessment rate of 20%
THE INSTITUTIONAL METHODOLOGY
✵No income protection allowance
✵Minimum contribution from income as high as: $2,000 for incoming freshmen, $2,650 for upperclassmen
✵Asset assessment rate of 25%
PUTTING IT ALL TOGETHER
Making an Estimate of How Much You Will Be Expected to Pay
After receiving all your financial data, the need analysis service crunches the numbers to arrive at your family contribution:
If you have read this book carefully up to now, you know that behind the apparent simplicity of the chart above lies a wealth of hidden options that can save—or cost—you money.
By using the worksheet at the back of this book, you can get a rough approximation of what your Expected Family Contribution will be under both the federal and the institutional methodology. Bear in mind that it will be just that—an approximation. Our worksheet uses basically the same formula(s) used by the need analysis companies, but because you will be estimating many of the numbers there is little likelihood that it will be exact.
Parents always want the bottom line. “How much will I have to pay?” they ask, as if there were one number fixed in stone for their family. In fact, you will see as you begin to play with your numbers that there are numerous ways to present yourselves to the colleges. By using the strategies we have outlined in Part Two of this book, you can radically change the financial snapshot that will determine your Expected Family Contribution.
Your bottom line will also be determined in part by whether you choose schools that use the federal or the institutional methodology to award institutional aid. We’ll discuss this in more detail in our chapters on “How to Pick Colleges” and “The Offer.”
Filling out our worksheet will be a quite different experience from filling out the need analysis form. The need analysis form asks you for your raw data, but does not allow you to do the calculations to determine your family contribution.
The FAOs Tinker with the Numbers
You should also bear in mind that the college financial aid officers have a wide latitude to change the figures the need analysis companies send to them. If a school wants a particular student badly, the FAO can sweeten the pot. If a school has a strict policy on business losses, your Expected Family Contribution at that school may be higher than the Feds said it would be.
It’s as if you submitted your tax return to five different countries. Each of them will look at you a little differently. One country may allow you to have capital losses that exceed capital gains. Another country may disallow your losses.
We know of one parent with unusual circumstances whose need analysis form generated an Expected Family Contribution of $46,000 but who still ended up getting $7,000 in financial aid for his son’s freshman year at a $22,000-per-year school. We know of another couple whose family contribution was calculated to be $10,000, but who ended up having to pay $15,000 because there was not much aid money left.
Even if your numbers look high, you should not assume that you won’t qualify for aid.