I occasionally get an email or see a comment from a reader about how to properly plan for financial aid for their children's college. Most high-income professional readers of this site shouldn't bother, since their children aren't going to qualify for need-based aid anyway, and what aid they will qualify for is mostly loans, which in my view aren't real aid anyway since these folks generally have tons of opportunities to borrow on better terms already. That said, the financial aid system, including the Free Application for Federal Student Aid (FAFSA) and the CSS is pretty complex and it is possible you have some kind of unique situation where this matters to you. At any rate, I thought this would be a great opportunity to do a big long post about how the need-based financial aid system, particularly with regards to the FAFSA, works.
What Is The FAFSA Used For?
Most people going to college should fill out a FAFSA, even if there is little chance of the child of a high-income professional getting any meaningful need-based aid. It isn't that hard and can be done online or with paper. The FAFSA is used by the federal government to determine your Expected Family Contribution (EFC), or the amount that you and your family “should” be able to pay toward your education. The gap between the Cost of Attendance (COA), which is determined by the school by adding tuition and fees to room and board, and the EFC is your financial need. That is the maximum amount of financial aid (grants and loans) you can get. The FAFSA must be filled out if you wish to qualify for federal aid including
- Pell Grants (up to $5,185 per year for up to six years)
- Federal Supplemental Educational Opportunity Grants for undergrads only
- TEACH grants (for teachers only, but turns into a loan if service obligation isn't met)
- Iraq and Afghanistan Service Grants (if your parent died serving in the Middle East while you were in college)
- Work-Study Program (a job for those who apparently can't get one the regular way)
- Perkins Loans for undergrads and graduate students
- William D. Ford Federal Direct Loan Program (including subsidized Stafford loans for undergrads, unsubsidized Stafford loans for undergrads and grad students, and Direct PLUS loans for the parents of dependent students
In addition to these federal programs, many states, colleges, and private organizations require the FAFSA be filled out in order for you to be considered for grants, scholarships, and loans, even merit-based ones. The WSJ even argues that well-to-do families should fill out the FAFSA to give their kid an admissions edge by demonstrating they have the ability to pay the tuition themselves. They also note that you could lose your job this year, allowing your child to qualify. So consider filling out the FAFSA despite what I write here.
Dependent or Not?
The first issue to determine when filling out a FAFSA is whether the student is a dependent or not. Ideally, they are not, because then you do not have to take the parent's assets into consideration. Here are the ways the student can become independent:
- Be 24 or older (for 2016-2017, that means born before Jan 1, 1993.)
- Be married (on the date of application)
- Enroll in a masters or doctorate program
- Be on active duty
- Be a veteran
- Have and support a child or other dependent
- Lose both parents
- Be declared an emancipated minor
- Be homeless
There is also a third FAFSA formula for an independent student with a dependent other than a spouse, which gives you a little smaller expected family (personal really) contribution.
What Goes On The FAFSA?
Just to keep things simple, we're going to concentrate on the FAFSA for a dependent student. Here is the application, and here is the formula. Let's concentrate on the formula for now. Here's page 1.
As you can see, page 1 includes the parent's income, a section for allowances (think deductions) to parent's income, and the parent's assets. There are a few interesting things to note. First, it starts with AGI, line 38 on your 1040. (Starting in 2017-2018, it's not last year's AGI, it's the year before.) So anything that decreases your AGI (like putting money into retirement accounts like 401(k)s, individual 401(k)s, SEP-IRA, contributing to HSAs, or business expenses) reduces this number. However, you also have to add in “untaxed income and benefits” on line 4. What is that, exactly? Well, it includes
- Workers Comp
- Black Lung Benefits
- Untaxed portions of Railroad Retirement Benefits
- Disability Benefits
- HSA Contributions (yup, that's right, they got you.)
- Foster Care Benefits
- Student Aid
- Earned Income Credit
- Child Tax Credit
- Welfare Payments
- Untaxed Social Security Benefits
- Supplemental Security Income
- Workforce Innovation and Opportunity Act Benefits
- On-base Housing
- Military Allowances (BAH, BAS)
- Combat Pay
- FSA Benefits
- Foreign Income Exclusion
- Credit For Federal Tax on Special Fuels
Guess what else counts? Distributions from Roth accounts. Bummer eh? However, there is a special provision for the taxable income that results from a Roth conversion. That doesn't count toward your income.
Now, check out the allowance section. The allowances include taxes (Federal, State and Social Security), an “income protection” allowance, (which varies from $15-38K depending on how many people in the household and how many are in college,) and what amounts to a $4K “employment expense” allowance if you don't have a stay at home parent. Yes, that's right, the formula discriminates against stay at home parents.
You subtract the allowances from the income, and that leaves you with Line 15, “Available Income.” Now, for a doc with an AGI of $200K, that available income number is likely to be a six figure amount.
Now, we move on to the part you've all been waiting for. This is where you see how your assets count against you in this formula. The following are included:
- Cash (green stuff, checking, and savings)
- Taxable Investments
- Real Estate except the primary residence
- Trusts
- 529s and ESAs owned by the parent or the student
The following is NOT included:
- Retirement Accounts and Pensions
- HSAs
- Cash Value Life Insurance
- Annuities
The value of these is determined by the value on the day you submit the application. There is some potential for market timing there, of course. The moral of the story, like the stories of early retirement, tax reduction, asset protection, and estate planning, is max out your retirement accounts. If you REALLY want to try to lower your assets, you could move all your taxable stuff into an annuity or life insurance policy just before applying, but that seems pretty silly given the likely tax cost, the downsides of annuities and life insurance as investments, and the fact that if you have all this income and assets your kid isn't getting anything good anyway.
After including the value of your investments, you move on to the value of any small businesses you may own. This section is pretty cool, since it basically allows you to minimize the value of the business. As little as 40% of the value of the business might be included, although for businesses worth millions there isn't going to be much of a discount there.
You also get another allowance, the education saving and asset protection allowance, which ranges from $0 to $30,000. It won't have much of an effect for most long-time readers of this site. Then you multiply the assets that count by 12%. Add this amount to the “available income” number to get an “adjusted available income.” Now, you have to run it through another chart, which for high earners basically boils down to multiplying the adjusted available income by 47% and calling it the Total Parent's Contribution from Adjusted Available Income. You divide this number by the number of kids in college, and you get the parent's contribution for this child.
Whew! You survived page 1 of the FAFSA calculation, which is the parent's page. What did we learn? Several things.
- Income matters more than five times as much as assets for most high-income professionals.
- Only taxable and education-directed investments count, and they don't even count that much.
- The number of kids in college matters a lot.
Let's move on to page 2, the student's page.
You basically repeat the income exercise that you did for the parent, but for the student's income. If the student is like most, this isn't going to be a big contribution. That $6,400 income protection allowance plus the tax allowances will probably wipe out most or all of the student's earnings.
Moving on to the assets, everything is the same as the parent's page except that the student's multiplier is 20% instead of 12%. The student also doesn't get that sweet 47% multiplier, which effectively reduces the parent's asset rate from 12% to 5.6% and cuts their contribute from income in half. Add it all up and you get the EFC. Subtract that from the school's Cost of Attendance to get your financial need, if any. Even if, by some miracle or because you have multiple kids attending expensive schools at the same time, you actually have a financial need, that doesn't mean there will be a financial aid package available to fill it. And that financial aid package is still likely to be mostly loans and a job, rather than any type of need-based grant or scholarship.
An Example
Let's run the numbers for a typical physician family. Let's say the married 50 year old doc has an AGI of $200,000, no untaxed income, $60K worth of tax allowances, cash and taxable assets of $500,000, two kids but only one in college, $100,000 saved for college in 529s ($50K for each kid), and the kid is attending a school with a COA of $30,000 per year.
- Parent's Available Income: $200,000 – $60,000 – $27,440 (income protection allowance) = $112,560
- Parent's Contribution from Assets ($600,000 -asset protection allowance of $19,700)* 12% = $69,636
- Parent's Adjustable Available Income = $112,560 + $69,636 = $182,196
- Total Parent's Contribution = $8,706 + 47% * ( $182,196 – $32,200) = $79,204
I think we can stop there. It doesn't really matter what the kid's income and assets are. The total parent's contribution is almost three times the cost of attendance.
The College Scholarship Service (CSS)
To make matters worse, some schools have opted to use the CSS instead of the FAFSA in determining who gets aid, especially aid from the school. There are some minor differences between the two, which could possibly matter to you, but probably not if you're a typical reader of this blog. These guys give a good summary of the differences.
Bottom line, everything works out a little worse for you with CSS than with FAFSA. Your home counts, your business counts more, even the sibling's assets are counted. (WTH?)
Lessons Learned
Unless sending more than one kid at a time to expensive schools, the typical high income professional reader of this site and her children are going to be on their own as far as paying for school. The upside of this is that you can skip all this crazy planning people do to try to get their EFC down. You know, stuff like buying annuities and insurance they don't need, avoiding Roth IRA withdrawals etc. What you do need to do, however, is have a plan to pay for school without any help. That means choosing a school you can afford, saving money for college in advance using some combination of 529s, ESAs, and a taxable account, cash flowing some of the expense with current earnings, and expecting the child to generate some kind of income during school and in the summers. Having your child get typical student loans, however, may not be an option since the EFC will probably be higher than the COA.
Possible exceptions to the above advice include:
- A really expensive school (Columbia Medical School for instance)
- A really poorly-paid doctor with few assets and a large family (although note you don't get to subtract YOUR student loans from your investments)
- Many kids in school at once
- Kids in college AFTER you retire on a fraction of your prior income
Twelve Potential Techniques For Exceptions and Lower Earners
As you can see, your high income dramatically simplifies this process (by allowing you to mostly ignore it.) But I thought it might be fun to illustrate some of the techniques that lower earners can use to maximize the potential for creating a large gap between the COA and the EFC.
Moraine Lake, Banff. Photo not retouched, the water really is that color due to glacial sediment
# 1 Max Out Retirement Accounts
This one helps you in two ways on the FAFSA- it lowers your AGI and the assets don't count against you.
# 2 Max out the HSA
While this still counts as income, once it is in there it doesn't count as an asset
# 3 Grandparent 529s
The parent's assets and the child's assets count against you, but the grandparent's don't. Distributions from the grandparent's 529 does count as income the next year, however. The workaround? Have the grandparent 529 pay for the last year of college. (Actually, with recent changes, the grandparent's 529 can be used for both Junior and Senior years.)
# 4 Bunching
If retired, you can take a double distribution from a Roth IRA (or any retirement account really) one year and then take none the next year, which could potentially make the COA-EFC gap larger. Just like with your taxes, you can bunch income or deductions in unique ways to try to minimize your tax burden and EFC.
# 5 Move Cash and Taxable Assets into Annuities and Life Insurance
I see more downsides than upsides to this one, but it is a potential technique. Perhaps if you were going to buy a 5 year deferred income annuity anyway similar to how many use a SPIA.
# 6 Pay for college with loans against your assets
You can borrow against your house, your life insurance, or your investments and none of it counts as income.
# 7 Get More Kids Into College At Once
One child could delay his enrollment by a year, or another could take summer classes, or graduate from high school early etc.
# 8 Get Kids Independent
Military service, early marriage, having a child, grad school- it all makes the student independent and parental assets no longer count.
# 9 Have Your Child Save In A 529 Instead of an UGMA
529s count as parental assets, but an UGMA is the kid's, and subject to the higher percentage multiple (~4 times higher).
# 10 Get Rid of Your Cash
Buy stuff, pay down the mortgage, pay off your student loans, make your retirement contributions early, whatever. The less you have, the less that goes into the calculation.
# 11 Hold Earnings in a C Corp
C corporations can retain earnings. I don't generally recommend docs use these, since it causes double taxation, but it does allow you to delay income until after the kids finish college.
# 12 Make the Custodial Parent the Poor One
After divorce, only the custodial parent's assets are taken into account. So have the custodial parent take the house and larger retirement account, while the non-custodial parent gets the larger taxable account.
This post is getting long enough. Time to cut it off. What do you think? Do you expect to see a gap between your EFC and COA? Why or why not? Did your kids receive any aid? How are you saving for college? Are you doing any financial aid planning whatsoever? What financial aid hacks did I miss? Comment below!
Just a reminder for military docs out there – transfer at least one month of your post-9/11 GI Bill to each child and your spouse right now (okay, so check first to see if this makes sense for you – but for 99% of you it does) – that starts the 4 year obligation clock. You can shuffle the months around later so that one dependent gets the whole 4 years or divide the months evenly or whatever. But start that clock that runs concurrent with your current obligation(s).
Unless you did a civilian residency, and less than 4-yr HPSP, you will be paying back 4 years anyway. May as well get another $160K+ non-taxed for college. You would have to earn an extra $240K pre-tax later to reach that same goal.
Although to be clear – if you use this benefit for a cheaper school, the overall benefit is lower!
Keep in mind that you have to meet these criteria (from http://www.benefits.va.gov/gibill/post911_transfer.asp):
The option to transfer is open to any member of the armed forces active duty or Selected Reserve, officer or enlisted who is eligible for the Post-9/11 GI Bill, and meets the following criteria:
-Has at least six years of service in the armed forces (active duty and/or Selected Reserve) on the date of approval and agrees to serve four additional years in the armed forces from the date of election.
-Has at least 10 years of service in the armed forces (active duty and/or Selected Reserve) on the date of approval, is precluded by either standard policy (by Service Branch or DoD) or statute from committing to four additional years, and agrees to serve for the maximum amount of time allowed by such policy or statute.
-Transfer requests are submitted and approved while the member is in the armed forces.
A lot of these strategies really seem like letting the tail wag the dog. Probably not a good idea to spend all your money just to not declare it. I’ll just bite the bullet and budget for college especially since I may have 3 in college at once. Who knows what this thing will look like in 15 years when I need it.
+1, that’s how it feels to me too. Even if you’re not a doc, you have to be in a real small window of income/asset range plus situation of kid going to expensive college for moves like this to really help.
Re: Work-Study. When I was in school lo these many years past, many on-campus jobs held spots reserved for Work-Study participants only, and Work-Study generally paid more than minimum wage, especially to juniors and seniors. However, I went to a small school, and larger schools may have proportionally less WS money to grant than ours did.
Another benefit to Work-Study over a non-WS job for lower-income families is that WS earnings do not count as income for the following year’s FAFSA.
I agree – work study can be valuable for those who qualify. At minimum, this is books and spending money that parents can avoid paying – and to further incentivize kids to start working / building in the resume for internships that hopefully lead to jobs.
At my college, most on-campus jobs were also held for work study. Paid better than minimum wage AND had the shortest commute time AND also shared the rest of the school’s calendar, e.g. flexible during exams and vacations. If your kid is there for study first, making them hold a job (e.g. most non-work study jobs) that competes for school’s attention may not be optimal – depends on your kid’s ability to multitask and orient to college life. Or you can call it training for the real world – but the point is, work study has its place.
I filled out the FAFSA because someone told me everyone needed to fill it out. That was not true, everyone doesn’t need to fill it out. After I was done, I swear the computer was laughing at me for expecting any financial aid. I was a multimillionaire with a high income so who would ever give me any aid. I was expected to take care of the cost myself since I had plenty of money. You will likely be in the same boat. I didn’t waste my time filling it out with the second child. I learned my lesson. If you make an average physician’s income, $200,000 and have some money saved, don’t waste your time filling out this form. Your time will be better spent playing catch with your kid in the front yard.
A couple of things:
1. When I applied to medical school at age 27, I was explicitly told by them all that they would not consider me to be independent. That was despite having fully supported myself for 5 years by then. They required financial data on my parents before completing any aid offer.
2. The $4,000 allowance off income for 2 working-parent households isn’t a penalty for stay-at-home parents. It’s a recognition that if both parents work outside the home, then they need to pay for child care. How else would you allocate the scarce resource of financial aid?
1. Was it a school requirement?
2. As a member of a family with a stay at home parent? I’d allocate it equally to families with a stay at home parent! I mean, we don’t give extra financial aid to those with boats, but they’ve got to gas, maintain, and winterize the boat every year. It’s just the government subsidizing one lifestyle over another. The tax code is full of stuff like that- mortgage interest deduction hurts renters, marriage penalties and benefits hurt/help married folks, child tax credits hurt non-parents etc.
It doesn’t matter to me either way, of course. Even if my spouse was working we wouldn’t be getting any financial aid. Actually, now that I think about it, my spouse is working. 🙂
1. If it was a school requirement, it was a school requirement at many schools. Their answer when I pressed was that they consider medical school to be a family responsibility. I ended up saying no to the Ivy League school and going to the school that gave me a scholarship instead.
2. I too am in a family with a stay at home parent, but that is a family choice. We should recognize that the first $x of a second parent’s income essentially pays to replace the care that parent provides at home. The $4000 in FAFSA partially accounts for that (not that you could ever get child care for $4000/yr).
3. Not all school use the CSS formula as they provide it. Many (including the one where I went for my undergraduate degree) use it to provide more granular data than FAFSA, enabling the school to use their own aid formula. For example, I just tried the online estimator at my alma mater. Despite earning an attending emergency physician income, owning our home, and maximizing retirement accounts for years, we still would qualify for about 10% of the cost of attendance in aid (without loans).
Interesting. Kudos to your school for making a confusing process even more confusing!
Sometimes I wish the bottom line was just the bottom line. Would save a lot of hassle.
Agreed. I think the lesson here, much as in medicine, is there’s no one-size fits-all answer. If you’re on top of your finances, then filling out the forms isn’t too time-consuming, and some schools may surprise you.
I had the same issue with my medical school. I was married, had 2 kids and still had to get info from my dad every year to be considered for aid (not that my parents contributed a single dollar to my medical education!). School told me it was required to even be considered.
School aid is different from federal aid (Federal Student Aid is the FSA part of FAFSA). The school can ask for anything they want with regard to the money they are willing to give you.
My wife had to file as dependent as well for her medical school even though we were married at the time. It ended up being a double penalty because they counted both of our incomes and her parent’s income.
That’s ridiculous. I’d be calling my state senator over that policy (if it’s a state school.)
We delayed getting married for 2 years in large part for that reason. Counting my income along with her parent’s income would have eliminated about $40K in aid.
We just refused to give that info. We weren’t on friendly terms w/hubby’s family at the time, so no way we were asking for financial info. We were told we were immediately disqualified for Perkins grant because of this. Everything ended up being Stafford and then private loans. All of which we are still paying back (he graduated in ’96). The house will be paid off before the student loans are.
I was working as a nurse and we bought our first home during those years. If I had read POF and WCI at the time, I might have done a few things differently, but hindsight is 20/20.
Me too. UMD-NJMS Newark NJ. Despite being 26, and a veteran, the financial aid person insisted I include parental financial data. Circa 1994.
Cannot complain too much- I was more or less paid to attend undergrad.
The 7-figure taxable account will likely be enough to keep us from qualifying for any financial aid. Each of our boys should have a 6-figure 529 to draw from, though.
Also, I never turn down free money. With a low enough AGI in early retirement, we should qualify for the American Opportunity Tax Credit. The first $2000 towards tuition is fully refunded as a tax credit, and 25% of the next $2000.
So the plan would be to pay the first $4000 out of pocket for a $2500 tax credit, and draw from the 529 accounts after that.
For married couples, this credit phases out at a MAGI of $160,000 to $180,000. It’s half that for singles.
Best,
-PoF
I saw this in Forbes:
“If you are not able to claim the AOTC because your income exceeds the $180,000 (MAGI) phase-out threshold, maybe your child can claim the credit on his or her tax return. If you cannot, or do not claim the AOTC (or any other tax credit or the tuition and fees deduction), and you also do not claim that child as a personal exemption on your tax return, your child can claim the American Opportunity Tax Credit on his or her tax return. ”
I have a college freshman at an expensive school with no school or federal support and have an appt to discuss this with my accountant. PoF or WCI, any thoughts?
I’m assuming you would have to stop claiming your child as a dependent, for reasons outlined by WCI in the intro. Is he or she homeless, by any chance? 😉
I’m guessing you’ll probably miss out on the AOTC, but it might be a good question for your CPA and for the WCI forum.
Best,
-PoF
Right. But if you make a bunch, you might not get any benefit from claiming them anyway. But they have to be independent.
Note that, if your income is high enough, you lose the benefit of your personal exemptions due to the phase-out rules. In this case, not claiming the exemption has no net cost to you. (But check with your tax professional for other possible impacts of foregoing the exemption.)
My partner has low income, with an EFC of zero. Since we are not married, only her income is considered. Some things we learned when her son applied to college a few years ago:
1. Each school has a “net price calculator” available on their Web site. This will give you a good idea of what the school is likely to offer in both merit and need-based aid. (Many of the top Ivy League schools offer only need-based aid; some excellent but less prestigious private schools offer significant merit aid, especially to students with top grades.)
2. For those few of you who may qualify for need based aid – many top Ivy’s meet the full demonstrated need. Many less prestigious private schools cannot afford to fully meet the need. In my partner’s case, her son did not have top grades; the gap between demonstrated need and actual aid was $20,000/year for two good but less prestigious private schools.
There are actually a lot of privates that meet full demonstrated need for U. S. students. Here’s a wikipedia article about need blind admissions but school down to the lists of schools that do or do not meet full demonstrated need and also do or do not consider need in admission decisions.
https://en.wikipedia.org/wiki/Need-blind_admission
I don’t think much has changed in the 24 years since I applied to colleges. I had some great options, but the Ivy league and similar caliber schools offered me no aid whatsoever. Vanderbilt (good, next tier private school) offered 75% of tuition as a merit scholarship.
I stayed at my home state University with a full tuition scholarship. In hindsight, it was the best choice.
Best,
-PoF
Maybe not much has changed on the merit side, but full demonstrated need is actually a big change for some schools. You mentioned Vanderbilt, that’s my alma mater. VU’s full demonstrated need initiative, Opportunity Vanderbilt, started in 2008 (awful timing but the school hung with it), if it had existed in the 80’s my undergrad loans would have all been grants.
No undergrad debt is a tremendous benefit for economically disadvantaged kids who can get in to VU and like minded schools.
A number of schools are doing something similar, including Stanford, Harvard, and Yale. The headlines make it sound like it’s income-based, but the fine print shows it’s means tested, also. Which is fine.
http://money.cnn.com/2015/04/01/pf/college/stanford-financial-aid/index.html
One thing to keep in mind when planning with 529s is how long the account needs to be open before it can be drawn from. I am in a different position than most in that my stepdaughter just got accepted into college when I’m not even 2.5 years out of fellowship and still have 80k left in student loans, myself. It was worth my time and effort to put down $50 into a 529 3-years before she started school, as I wouldn’t have been able to make withdrawals from the account unless I had done this, whether or not I had funds in it. She is thankfully going to our state school. We will get zero aid, but at ;east the 529 allows me to deduct tuition expenses from our state’s income tax. My plan is just to pull her tuition (about the annual max deductible contribution for a couple of $6,000) into the 529 from my bonus and immediately withdraw it to pay for school. I figure it saves us 7% off the top. Not a lot, but it’s something.
Is that minimum time to withdraw a state-specific requirement? I don’t see anything about that when I googled for it. (And in fact, I found the exact opposite stated as a general fact: that money can be withdrawn the day after it is contributed).
I’ve never heard of a minimum time in the account rule either, in any state. But there are a lot of states out there and I confess to not being an expert in every one of their laws.
Sometimes the Sec. 529 plans maybe don’t make as much sense as you hope.
You can actually save quite a bit of money for a kid in a uniform gift to minors act account and, if invested in a tax efficient way, the kids pay basically no tax.
And then the other advantage of kids having money in one of these accounts rather than in a Sec. 529 plan is that if they don’t need the money for college, they can use it easily for something else with basically no tax consequences.
How I know this… I saved money for my daughters before the Sec. 529 option was available and so used the approach described above to set aside money for four years at the University of Washington.
In end, neither daughter used the money. One because she went to school for free. One because basically she worked her way through the 3 years of college so she could keep her beloved horse. (Long story.)
BTW in end both kids used their college money to buy their first homes during the great recession after the real estate market cratered, picking up great bargains.
Excellent point with regards to the tax benefits of an UGMA often being similar to that of a 529, particularly when account values are relatively small and when the kid has little earned income. However, there are two major downsides to this approach. First, if your state offers a deduction or credit for contributions, you’re missing out on it. For us, that’s 5% of $16K a year, or about $800. Multiply that by 25 years and it becomes a significant sum- maybe 3 years of tuition at one of our state schools. Second, 529 money belongs to the parents but UGMA money belongs to the child. If the child wants to blow their UGMA on hookers and coke, you can’t stop them. With a 529, you can just change the beneficiary. That flexibility comes with a price.
WSJ article suggest that even HNW individuals might complete the FAFSA form to demonstrate that they don’t need the financial aid? Doesn’t not applying for aid in the first place demonstrate that?
Yes, but maybe not as strongly.