Saving For Your Children Part I: Organizing Your Child’s Savings to Maximize College Aid

“The truth is, most of us discover where we are going when we arrive."
― Calvin & Hobbes

“The secret of getting ahead is getting started." 
― Mark Twain

Ownership of Assets & College Aid

In the last article we discussed tax planning around providing care for your kids. The next question that often arises is how do I start saving for my children’s future? Education costs continue to significantly outpace inflation and the price of college seems to have doubled since I attended just over a decade ago. But college isn’t the only expense our kids will be facing. They’ll get married, they’ll buy homes, and they’ll need a first car. How do we plan for these things now so we can employ tax savings and maximize our money’s buying power?  Since where we invest our money affects how it is taxed, and the cost of our kid’s college to us, today in Part I we’ll discuss how the FAFSA measures financial aid eligibility. In Part II we’ll discuss three options for saving children’s money: your own brokerage accounts, custodial accounts, and Roth accounts. Finally, in Part III, we will dive into the types and characteristics of 529 plans.

Financial Aid Eligibility and the FAFSA

If you’re a decade or more away from sending a child to college, you may wonder why you should read about applying for financial aid. But the reality is that where your money is parked may significantly change your eligibility for aid. Next post we will talk about the variety and characteristics of specific types of accounts that you can use to save. Today, as a prequel, we’ll discuss how your ownership of assets affects your children’s college costs.

As you probably already know, one of the first steps to applying for aid for higher education is the completion of the FAFSA. Schools utilize the FAFSA to determine the Expected Family Contribution (EFC). Institutions, especially elite private schools, may also use additional standards such as the CSS Profile and other methods for calculating aid. While not comprehensive, this article should serve as a good starting place as you plan your savings for the upcoming years. So how will your assets location influence the calculation of your EFC?

Parent's Assets

By federal calculations, parents are expected to use up to 5.64% of their assets each year to pay for their children’s college funding, after roughly $50,000 of exempt savings allowance. So, if your net worth is $1,000,000 and higher education expenses are $60,000, you likely will pay almost exclusively out of pocket. In this case merit based scholarships would be a significant help in covering college expenses. Applying for merit based scholarships may actually become as important as applying to the school itself.

Happily, there are some exceptions for the calculation. Retirement accounts are exempt, and are not counted towards your expected family contribution. So if you have the same $1,000,000 in assets but 3/4ths of this is in you and your spouse’s retirement accounts the expected family contribution will be calculated quite differently. If both you and your partner save $18,000 per year for 18 years your contributions alone will amount to $648,000. This, along with the growth, would be protected from counting against you for federal aid considerations.

Your primary home equity is also not counted in the Expected Family Contribution, though vacation homes, second homes, and investment property are factored in. If much of your wealth is sheltered in your primary residence and retirement accounts you may still qualify for need based aid, even with a sizable net worth. Cash value life insurance, small business equity, and personal assets (such as vehicles) also do not figure into the FAFSA calculation.

Parent's Income

Income counts in much greater percentage than assets. The portion of parent's income available for college funding is calculated by the FAFSA between 22% and 47% each year. The final percentage partially depends on the number of people in the household. There is also an exemption amount. In school year 2017-2018 for a married couple with two children this is $24,480.

Households with multiple six figure incomes will have a hard time qualifying for need based aid. Employment income, dividends and capital gains, retirement fund withdrawals, and asset sales are all included. Untaxed retirement contributions (i.e. your 401k deductions) are also added back in to your income and considered.  The truth here is that if there are ever years you want to be making less than usual, they are the years that will be factored into your child's financial aid package. If you have a variable income (i.e. in sales, consulting, or small business), maybe those are the years to slow down a bit and enjoy your kids as they prep to head off to adulthood.

It is worth noting that the EFC is per family, not per student. Having multiple children attending higher education simultaneously may therefore prove to be a cost saver. Have you ever considered that having twins could save you on college expenses?

Beginning in 2017-18, the FAFSA has a two year look back.  Without gaps in schooling, the last two years of high school and the first two years of college are those used for all FAFSA calculations. For example, for the 2018/2019 school year the student and parent income used on the FAFSA will be calculated using the 2016 tax returns.

Children’s Income And Assets

Student income of less than $6,310 is exempted from the EFC calculation, but after that the government expects 50% of their income to be available for higher education expenses. While the summer job babysitting or helping out at the local pet shelter is probably a safe way to make pizza money, the summer internship at Facebook will have significant effect on overall aid. The 2-year look-back affects children who might take a gap year off to work between high school and college. While they may glean valuable life experience, 50% of what they make taking a year off may be counted as income available for tuition. That can be a tough pill to swallow, so it’s worth considering long before planning a gap year that will involve paid work.

The two year look-back opens up plenty of interesting possibilities. If that internship at Facebook comes during the summer of their junior year in college, they’ll have graduated by the time it would be used in FAFSA calculations.

Student assets are also more heavily factored into the expected contribution than parents’ assets. Institutions will expect up to 20% of assets owned by a dependent student to be available for their education each year. They also are not allocated an exemption allowance. Again, the working gap year may have a negative effect on aid eligibility if the student saved what they made.

Guardian accounts, such as UGMA’s and UTMA’s, which we will discuss next week, as well as Trust Fund accounts which name the student as beneficiary are considered student assets and the expected contribution is also calculated at the higher rate.

Fortunately, as far as the FAFSA is concerned, student owned 529 plans (which we will also cover in Part III) are factored as parents’ assets at the 5.64% rate, rather than the child’s rate.

Assets Owned By Others - Gifts

Grandparents, family friends, and aunts and uncles may also decide that they want to support your child in college, help with their first down payment, or give them the gift of travel for the summer. In general the giver is responsible for paying gift taxes, and the child does not have to account for the gift come tax time. Currently givers have a $14,000 gift exemption per beneficiary every year. Couples can give $28,000 per recipient. Anything above this amount should be tracked by their tax preparer, and subtracted from their lifetime gift tax exemption which is indexed for inflation - currently $5.45 million per individual.

But things become a little trickier when it gets to need based financial aid. While the child won’t owe taxes on the gifts, the gift will be considered income to the child when calculating their ability to pay for college. Again, this suggests some planning strategies. Gifts from family and friends should be given during the last two years of school, not when they’re headed off to college. Since moving forward the FAFSA uses the two year look-back, the last two years of college will be a good time for them to receive gifts. Alternatively, extended family and friends can pay off student debt, again keeping in mind the annual $14,000 gift exclusion.

Summary Take-Aways

Let’s close with some final overarching take-aways.

Income counts a lot more than assets. Minimizing both your income and your child’s income up to two years prior to their commencement of higher education could have financial benefits. Their junior year of high school would be a great year for you to take a gap year.

After the first $6,310, 50% of your child’s income is included in the Expected Family Contribution. As far as financial aid is concerned, well-paying jobs and internships during high school summers or gap years result in taking two steps forward and one step back.

Gifts, including 529’s owned by grandparents, should be given toward the tail end of their education.  They can also be given to pay off student debt after the child graduates rather than while she is attending college.

Saving money in qualified retirement accounts, a primary residence, and 529s are tax efficient ways of minimizing the way the FAFSA counts your assets.

Having multiple children in school at the same time will help limit the total expected family contribution.

All this being said, if your family income is in the multiple six figures, you’ll probably end up footing most of the bill regardless of where you save. In this case pursuing merit based scholarships, and focusing on disciplined savings, should likely be the focus of your education planning strategy.

Whose Timeline is Longer?

Finally, in my conversations with financial planners a common theme arises.  In parents’ zeal for saving for their children they are prone to neglecting their own future. Ultimately your children have a longer life runway than you do. One way or another they will navigate their educational path. Put on your own oxygen mask before helping your child. Otherwise they’ll live with the consequences of having to take care of you.

Next Up

In Part II we're going to discuss the variety of accounts available to you as you consider where to put the money you're saving for your kids.

If you would like to dive deeper into today's topic you might read Troy Onink's 2016 article on college planning (including a discussion of the CSS Profile) here, or dive into the government's informational site on the FAFSA here, including discussion and FAQ on the changes for 2017-18 here.