Financial aid can make the difference between attending college or not for hundreds of thousands of students. Given these high stakes, it’s no wonder that applying for aid is fraught with stress for many families, especially in these economic times. It doesn’t help that the paperwork can be daunting and the colleges’ aid decisions are often shrouded in mystery.
In this increasingly competitive—and confusing—landscape, families are flocking to seminars and consultants promising to maximize students’ eligibility for need-based aid. Too often, anxious parents are encouraged to buy investment products that would otherwise be inappropriate or to make planning decisions that would be unsound in any other context. As your client’s trusted advisor, you do have a responsibility to fulfill. In this month’s column we will look at a common scenario in the college financial aid area and suggest some options for you to consider.
Scenario One:Stuck in the MiddleYour client has come to you for a second opinion on recommendations from a so-called college planning consultant. The recent market meltdown, coupled with the high rate of college tuition inflation, has thrown a wrench into the family’s college savings plan. Fortunately, Grandma provided for Junior with a $100,000 bequest, in the form of a Uniform Transfers to Minors Act (UTMA) account. This inheritance will go a long way toward paying for Junior’s education, but with the average cost of a private college at nearly $40,000 a year, his top-choice school may still be out of reach. This isn’t a family with the ability to pay but not the willingness; it’s one that is stuck in the middle.
The First OpinionAccording to the college planner that your client consulted, if the family simply shifts Junior’s UTMA account to an annuity, the college will ignore the investment in its aid award calculation. The consultant also advised the family to reduce its home equity by taking out a loan and investing the proceeds in a single-premium life insurance policy on the parents’ lives. Because the policy promises a return of premium, they could surrender the policy after Junior’s graduation and repay the loan. The college planner demonstrated how these strategies would increase the family’s need in the eyes of colleges.
Yet your client is uncomfortable with the recommendations and wants confirmation that they are legal. And well they should. The Department of Education takes fraud very seriously. According to FinAid, an online financial aid resource, at least one third of financial aid applications are verified; in other words, your financial aid application is much more likely to be audited than is your tax return. To dissuade people from trying to game the system, paid aid consultants are required to sign the dreaded Free Application for Federal Student Aid (FAFSA) form—the lengthy form that all parents must fill out for their prospective and current college students—even if the consultants don’t actually fill out the form.
There are legitimate asset-positioning strategies that can help with aid eligibility, but it’s never wise to make moves that might sabotage other financial goals. How would you evaluate this case?
Second Opinion Step 1: Estimate the EFC and consider the factsThe first step is to estimate the student’s expected family contribution (EFC) using one of several free online calculators, such as those at www.finaid.org. Then, subtract the EFC from the cost of attendance to determine the student’s financial need. In this scenario, your client’s EFC prior to planning is $32,206 with $20,000 of the contribution coming from Junior’s inheritance. While Junior will not qualify for a federal Pell Grant, he may still qualify for loans, a Federal Work-Study award, and other grants. If the family acts on the college planner’s recommendations, the EFC drops substantially, to $12,206. As enticing as this strategy may appear, it’s less than desirable given some of the hard facts about college financial aid.
• For the middle class, financial aid equals loans and work study. "No strings attached" aid, called grants, may be offered in addition to loans, but it never replaces them. While student lenders offer a variety of repayment options, and repayment may be deferred for hardship reasons, student debt can’t be erased with bankruptcy. Burdening the student with debt may not be the best idea if the family can otherwise foot the bill.
• The EFC is simply a comparative number to help financial aid officers allocate aid. Just because a student demonstrates need doesn’t mean that the school will meet it fully. A recent U.S. News & World Report survey found that only 1% of American colleges promise to meet all of their students’ need. It probably won’t surprise you that these include Harvard and Princeton, schools that are extremely selective. Families should expect to come up with additional resources to pay college expenses over and above the EFC number.
• Strategies that work for public colleges may not apply to private school aid. And since private schools have different guidelines for awarding grants, strategies that work for one private college may not work at another. For instance, some schools include home equity or the cash value of life insurance and annuities in the calculation, and others do not.
• Current income, not assets, carries considerable weight in the financial aid calculation, and it’s a lot harder to shift income until the child graduates from college. Further, parents are only expected to contribute 5.6% of their non-retirement assets to their child’s education annually. The child is expected to contribute 20% of his assets annually.
Second Opinion Step 2: Offer a sound solutionIn your client’s situation, removing the UTMA account from the calculation makes a big impact. Keep in mind, however, that UTMAs and UGMAs (Uniform Gifts for Minors Act accounts) are the child’s assets and must be used for his or her benefit. They cannot be returned to the donor under the guise of increasing the child’s financial aid. Instead, consider drawing down the UTMA account first when paying the college bill so that it won’t factor again in the need-based formula. Financial aid is recalculated every year, so it’s worth reapplying annually, even if aid is not offered in the freshman year. Alternatively, the account might be used for other pre-college expenditures for the child’s benefit, like a computer, music lessons, or sports camp. Remember: for incomes under $50,000, UTMAs are taken off the table completely for FAFSA purposes.
The Solution You ProposeYou advise your client that a deferred annuity is rarely a suitable investment for a child because of early surrender charges and the 10% early withdrawal tax penalty. After considering various options, the parents choose to move Grandma’s bequest to a UTMA-registered 529 plan. While still legally Junior’s asset, the UTMA 529 plan is treated as a parental asset for financial aid purposes, with only 5.6% of the account going into the aid calculation annually. If used for qualified educational expenses, distributions from the UTMA 529 plan will be free of federal income tax. The move increases the family’s EFC to $17,846 but gives them more flexibility to dip into the account without penalty for Junior’s college expenses. A loophole? Maybe, but this loophole is just smart planning. (Note that contributions to 529 plans can only be made in cash. Liquidating the UTMA account may create immediate taxation.)
Using the EFC calculator, you find that adding back the family’s home equity has no effect on the FAFSA. After talking with the college financial aid office, your client is surprised to find that the college’s guideline only includes home equity in excess of three times parental income. Your client’s home equity is well within that range. While the family may choose to dip into its home equity in the future to help pay for Junior’s college, you warn the parents that it rarely makes sense to incur interest charges earlier than necessary.
Next, you evaluate the parents’ current need for life insurance and make adjustments as needed.
Second Opinion Step 3: Assign some homeworkFinally, you remind Junior’s parents that carefully researching colleges is possibly the best time they can spend in the financial aid planning process, and most of the information is free. Advise them to look for private schools with large endowments and state schools with merit aid for good students. They can also search for colleges where their son fits the target student profile, whether in terms of diversity, talent, or another characteristic.
An excellent resource for free scholarship information is FastWeb (www.fastweb.com). Based on information about the student, FastWeb searches a database of awards and identifies only the scholarships that match the student’s profile. Other helpful resources include www.finaid.org and www.usnews.com/fullneed. Finally, if your clients still seem stressed, have them check out the "Five-Minute FAFSA" video on YouTube, which takes a lighthearted approach to tackling financial aid paperwork.
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