College Financial Aid Basics #3

By SavingForCollege.com

Financial Aid and Your Savings

In order to determine the investment mix that offers the most favorable impact on your child's federal financial aid eligibility, let's first look at how the formula for computing EFC works. The formula counts the following financial resources as being available to pay college expenses:

• 35% of a student's assets (money, investments, business interests, and real estate)
• 50% of a student's income (after certain allowances)
• 2.6%- 5.6% of a parent's assets (money, investments, business interests, and real estate, based on a sliding income scale and after certain allowances)
• 22%-47% of a parent's income (based on a sliding income scale and after certain allowances)

Now let's see how specific types of assets affect the aid formula:

The best type of asset to own when applying for financial aid is probably a retirement account such as an IRA or 401(k). These qualified retirement accounts, whether owned by you or by your child, are not counted at all in determining EFC for purposes of federal financial aid. Be careful, however, about taking money out of your IRA (or any retirement account) to pay for college. Though the tax law now permits penalty-free withdrawals from a traditional or Roth IRA to pay for qualified college costs, doing so could jeopardize financial aid in the following year. The entire withdrawal, principal and earnings, counts as income on the following year's aid application.

The equity in your primary home, insurance policies, and annuities are also excluded from your assets when determining EFC.

Assets that belong to the student result in a greater reduction in financial aid. UGMA/UTMA accounts are counted as the student's asset. In addition, they may increase the student's included income to the extent that interest, dividends, or capital gains are reported on the student's income tax return.

Often the income tax benefit of setting aside investment assets in a child's name is more or less offset by the reduction in the child's financial aid package.

529 plans and Coverdell ESAs may be two of the better options to save for college without jeopardizing financial aid. These are treated as assets of the account owner, not the beneficiary.
If a parent owns the 529 account or ESA, up to 5.6% of the value is included in EFC. If grandparents own the account, none of the value is included. A 529 account or ESA owned by the student, or by a trust or custodian for the student, will not be counted as the student's asset.
Withdrawals from parent- and student-owned 529 plans and ESAs are also treated advantageously. Such withdrawals when used for college are excluded from your federal income tax return, and according to the U.S. Department of Education are not required to be "added back" when reporting your family income on the student's federal financial aid application. Withdrawals from a grandparent-owned 529 account, however, may have to be reported as student income, reducing financial aid eligibility by as much as 50% of the amount of the withdrawal.

Section 529 prepaid tuition plans used to be a different story. Benefits from a prepaid tuition plan were considered a "resource," reducing aid eligibility on a dollar-for-dollar basis. However, legislation enacted in early 2006 has changed the treatment of prepaid tuition plans to make it consistent with 529 savings plans. Families with prepaid tuition plans will no longer face negative consequences.

Note that some colleges will calculate financial need using a different formula when offering their own grants and tuition discounts. The "institutional methodology" used by many of these colleges may count home equity, siblings assets, and certain investment accounts in a manner that differs from the federal methodology.