Financial Aid and Personal Assets: Is There an Optimal Strategy?
January 29, 2009
What is the impact of a parent's 401(k) savings on a college-aged child applying for financial aid? And, in general, what asset allocations are the most advantageous to receiving a maximum financial aid award? In other words, if I want my kid to get financial aid, am I better off having my money in a 401(k), in a taxable investment account, in my house (used to pay off my mortgage), or in cash?
Thanks for the question. And because I’m quite sure that this is a topic that will be of interest to many readers, I’d like to broaden my answer to include some other things to consider when you’re planning how best to pay for college.
How Financial Aid Works
First, just a little background. Financial aid is designed to bridge the gap between what a family can
pay and what the college actually charges (and that’s where aid differs from scholarships, which are generally awarded without regard to need, usually for distinguished prowess in something like athletics or academics). Financial aid in the form of grants, work-study programs, and loans is a huge component of the academic “industry.” Federal Student Aid, an office of the U.S. Department of Education, provided about $83 billion
of aid to nearly 10 million postsecondary students and their families in the 2007-2008 academic year.1
Plus, colleges have their own aid programs depending on their financial resources.
How do you access financial aid? You have to apply for it, generally using one of two standard forms: the Free Application for Federal Student Aid (FAFSA
), which uses what’s called the “Federal Methodology,” or a form using the “Institutional Methodology.” They differ slightly, but both use a formulaic approach to determine what’s called the “Effective Family Contribution” (EFC).
In broad terms, the EFC is what you’re expected to contribute to your child’s educational costs, but it isn’t a mandate. Different colleges have different admission and aid policies, though they may use the FAFSA and the EFC in their decision making. Some schools have more aid available than others, and your situation may be unusual. Still, the EFC is a reasonable estimate of what most schools are going to expect from you. I advise to start by taking a look at the FAFSA itself. You’ll see for yourself what counts and what doesn’t when it comes to determining your family’s EFC.
Retirements Assets Don’t Count
As you’ll see from the FAFSA, the short answer to your question is good news: Retirement assets (investments in 401(k) plans or IRAs) are not
considered a resource for parents to tap for college. Naturally, I think this is very wise policy, since those resources are earmarked for retirement and vital to your own long-term future. The finance folks in our nation’s postsecondary schools don’t want you to bankrupt your retirement account in order to put your children through school.
What Does Count?
As you walk through the FAFSA form, you’ll see the main considerations that financial aid officials are looking at are exactly what you’d expect: adjusted gross income, which is your gross income minus certain adjustments, such as for IRA contributions, self-employment tax, alimony payments, etc., along with assets including taxable brokerage accounts and mutual funds, real estate (not your home), and business assets. The FAFSA does not include home equity in its calculations (probably a good thing, especially in this era), but some colleges do. There are other factors—like how many kids you have in college at once—but essentially, your current income and non-retirement assets are used to determine your Expected Family Contribution.
And remember: Colleges are not expecting you to go broke to put your kids through college! For example, they don’t expect you to use all your assets or all
your disposable income. That’s what the formula is designed to do: calculate a reasonable Expected Family Contribution.
If your child has assets and/or income of his or her own, they’ll be reported on the FAFSA and the prospective student will be expected to pick up part of the tab, generally at a much higher rate than their parents. Here’s where 529 plans prove better than custodial accounts; 529 assets are considered assets of the parents (typically assessed at less than 6% for financial aid purposes), while custodial accounts are assets of the student (and assessed at 20% in most cases). One worthwhile exception here: 529 plans established by a grandparent for a grandchild don’t factor into the college financial aid question at all. (This is a great idea for grandparents, especially if your grandchildren are young: Give them an investment that could really pay off big when they head off to college.)
Increasing Your Potential for Aid
No doubt the aid process is arcane (though the FAFSA form makes it relatively easy), but the idea is simple: to figure out a reasonable way for people to handle the substantial cost of higher education. The professionals at different schools know what college costs and, after you’ve done the paperwork (the FAFSA or its equivalent), they’re going to have a reasonable idea of what your family is able to pay.
Can you increase your odds? It’s not easy, unless you’ve already planned ahead with things like 529 plans (instead of custodial accounts). You mention paying off your mortgage. Since home equity is not a factor for many colleges, it is possible that this could have a minor impact, but unless the numbers are really big, you’re probably not talking about too much of a difference.
Finally—and this may be the most important point of this column—I urge you not to choose paying for college for your kids over saving for your own retirement. For example, I would advise you not to withdraw money from your IRA to pay that first tuition bill. That distribution will increase your taxable income that year, potentially limiting your ability to get financial aid in the future. (Withdrawals for qualified higher education expenses are generally not subject to the 10% penalty from IRAs or Roth IRAs, but consult your tax advisor before doing so.) And, most troubling of all, raiding your retirement account will put a dent into your retirement preparation. There are all kinds of ways to get kids through college, from seeking out scholarships and grants to choosing less expensive educational options to borrowing more. But there is no other way of financing a secure, comfortable retirement than saving and investing during your peak working years. Good luck on both fronts!
For more information, here are some additional resources:
“The Free Application for Federal Student Aid
“An Overview of Paying for College
“Maximizing Aid Eligibility
1. “Funding Education Beyond High School: The Guide to Federal Student Aid” from the Federal Student Aid Information Center.
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