If not careful, families helping a student pay for college may learn a new meaning behind the phrase “no good deed goes unpunished.” That’s because common college savings vehicles, from 529 accounts to trust funds, that are not set up properly can adversely impact the amount of financial aid a student receives.
It is not hard to see why mistakes are made. Planning for a child's college education is more challenging than ever. With college costs continually rising, parents and students are forced to put aside more money, over a longer period of time, to meet educational costs. From 2008 to 2018, the cost of college increased by more than 25%.
Many students will pay for college through a combination of savings and financial aid. Knowing how one affects the other will help your student effectively take advantage of both.
Here are some common college savings options and how they affect financial aid.
How financial aid is calculated
But first, it is helpful to understand how things add up.
The federal government expects parents and students to contribute a percentage of their income and assets toward the cost of college each year. This is known as the expected family contribution (EFC). The EFC is computed based on the income and assets of the parents and the income and assets of the child. A student’s financial need is calculated as the difference between the cost of attendance and the EFC.
The Free Application for Federal Student Aid (FAFSA) must be completed when applying for financial aid. This is where your family’s income and asset information is reported. For the most part, all assets count except for retirement assets and home equity.
The sum of the parents' adjusted income and assets is the amount that parents are expected to contribute towards paying college costs. Meanwhile, a student's contribution is 50% of income after subtracting an income protection allowance, plus 20% of assets. Income and assets are then added together to determine the student's expected contribution amount.
Basically, the financial aid works like this: The more countable assets owned, the higher the EFC will be. The higher the EFC, the less financial aid a student is eligible for.
Assets counted toward the EFC include:
- Cash, savings, checking accounts, money market funds and certificates of deposit
- Investments such as mutual funds, stocks, stock options, bonds, commodities and precious metals
- Real estate equity, businesses, investment farms and trust funds
- College savings plans, 529 and Coverdell savings accounts, if they are assets of the owner (the parents) not the beneficiary
The government excludes the following assets from consideration when determining the EFC:
- Home equity in a primary residence
- Retirement plans (401(k), IRA)
- Cash valued life insurance
- Value of a small business owned and controlled by the family
What does all that mean?
Generally, college savings accounts owned by the parents are more advantageous because the federal methodology formula expects a smaller contribution from parental assets than from assets owned by a student. Assets owned directly by students will result in a greater reduction of financial aid.
Meanwhile, accounts owned by grandparents are excluded from EFC. But, funds from those accounts will count as student income.
For a closer look, let’s look at the impact of each individual asset type and how to avoid any unnecessary financial aid reductions.
529 plans are state-sponsored tax-advantaged investment accounts designed for college and other higher-education expenses. They are counted as an asset in calculating your EFC.
Therefore, who owns the account matters for financial aid:
- If the parent owns the account and the child is the beneficiary, the asset is counted as the parent’s asset.
- If the student owns the account, the value of the account is included when determining the student's expected contribution amount.
- When a grandparent owns the account, none of the assets are considered in the expected family contribution portion of the financial aid calculation.
529 account withdrawals are treated differently for financial aid calculations. They are treated as student income for financial aid purposes.
Therefore, grandparents should consider changing ownership of the account to the parent or student, otherwise a withdrawal used to pay for college expenses is reported as untaxed student income on the FAFSA form. Because income is assessed by the federal government at a much higher rate than assets, it is best to avoid this situation.
Another strategy for a grandparent-owned 529 account is for grandparents to wait until the grandchild enters their junior year of college to withdraw any funds. By then, the student will be through college before the withdrawals count against his or her financial aid amount.
Coverdell Education Savings Accounts (ESAs) are tax-deferred savings accounts that can be opened for any child before the child reaches age 18.
The owner of a Coverdell ESA is usually the person who establishes the account. Ownership has important implications that affect financial aid.
- If a dependent child is the owner and the beneficiary of the account, the assets are not counted against financial aid.
- If an independent child is both the owner and beneficiary of the account, 20% of the assets will count against financial aid.
- If the owner of the account is a parent, then 5.64% of the assets are counted against financial aid.
- If the owner is a grandparent, extended family member, or is unrelated to the beneficiary, then the assets may not count against financial aid because there is no place to report assets owned by people other than a parent or student on the FAFSA form.
U.S. Series EE bonds offer interest that grows tax-deferred until the bonds mature or are redeemed and is not subject to state income taxes. Both the interest and principal on Series EE bonds may be exempt from federal income taxes if used to pay for qualified higher education expenses for the owner, spouse or dependents.
Bonds used for educational purposes must be purchased in a parent's name, and the parent must be at least age 24 before the bond's issue date. The child should be listed as the beneficiary of the bond but not as a co-owner. The bonds will be counted as the parents' assets for financial aid.
Custodial accounts are typically established at a financial institution for the benefit of a minor and managed by a designated custodian such as the child's parent. Upon reaching the age of majority (age 18 or 21, depending on the state), the child assumes control of the account.
Custodial accounts are counted as the student's asset for financial aid, and may increase student income if any interest, dividends or capital gains are reported on the student's personal income tax return.
Parents may want to give money or property to their children in a trust, so that the children will not have control over the assets. A trust is a legal entity that holds assets for beneficiaries and is administered by a trustee according to the terms of the trust document.
Distributions made from trusts to beneficiaries who use the funds to pay for education expenses are counted as the child's income for financial aid purposes. Therefore, trusts are not the most efficient college savings vehicle to pay for college if financial aid is needed.
Saving money for a student’s college expenses is a good move. But there are various implications in how you do it. Therefore, it is worthwhile to plan carefully so that your good deed means your student is ultimately rewarded.