Hidden Costs of Estate Planning on Student Financial Aid

By Thomas Zupanc, Wayne Wells, and Joleen R. Sytsma

In Brief

Unintended Consequences Lie Within the Details

There are many tools used to accomplish the income and estate tax planning goals of income shifting and reducing the taxable estate while passing on as much income or property to the intended donee as possible. High-net-worth individuals often make annual gifts of $11,000 and pay a beneficiary’s tuition directly as a means of transferring property tax free. Because these strategies run counter to asset and income planning strategies used to maximize student financial aid, they have hidden consequences for the donee. The authors explain the financial aid system, specifically the asset and income tests, and how it punishes those who use common estate tax planning tools and techniques. It is important to ascertain if student financial aid may be a factor and consider the overall effect of both estate planning and student financial aid on both the donors and the student donee.

The financial aid regulations (Title IV) are no less complicated than the IRS regulations. There are complex formulas, unfamiliar terms, esoteric definitions, and difficult calculations, many of which can become moving targets because financial aid officers (FAO) at both public and private education institutions can exercise professional judgment, which gives them broad authority to interpret the financial aid laws and regulations and distribute financial aid funds as they deem appropriate.

To complicate the college financial aid process, some private colleges use different rules than most public colleges. Individuals applying to both must consider two different sets of complicated, fluid rules to determine their eligibility for financial aid funds.

Financial Aid

There are two types of financial aid: self-help aid (loans and work-study) and gift aid (grants and scholarships). The type and amount of aid is based on two factors: merit and need. For the sake of simplicity, this article will only address need-based aid.

The process for determining a student’s need is called a needs analysis. It takes into account the cost of attending the school, the income and assets to be contributed by the student’s family, and the income and assets to be contributed by the student. For example:

As a student’s adjusted financial need rises, so does financial aid eligibility. If the student’s resources or the expected family contribution (EFC), increases, the adjusted financial need (AFN) decreases and the student receives less financial aid.

The cost of attendance (COA) is calculated by the school, and will vary. The EFC is the sum of a portion of the parents’ income and assets added to a portion of the student’s income and assets. Student resources include such things as scholarships and grants, cash gifts of tuition payment paid directly to the school, and prepaid tuition plans.

The EFC is calculated in two different ways: using the federal methodology (FM) or the institutional methodology (IM). Most state or public schools use FM, while most private schools use IM. Both measures have two components: income and assets. The income and assets of the student receive a higher factor of contribution than the income and assets of the parents.

The FM method for measuring EFC is the sum of the parents’ contribution from income and assets, plus the student’s contribution from income and assets. Both the IM and FM vary annually. The IM includes more assets than the FM, but also takes into account extraordinary medical expenses and private elementary, middle, and high school tuition costs. The IM typically produces a higher EFC than does the FM.

Under the 2002/03 EFC formula, the parents’ available income is calculated by adding the parents’ adjusted gross income (AGI) to their untaxed income and benefits, less taxes (federal, state, and FICA), employment expenses (up to $3,000), and living allowances, which increases as the number of individuals in the household and in college increases (see Exhibit 1).

The parents’ contribution from assets is the fair market value of net assets, minus the fair market value of “protected assets,” and minus an “asset protection allowance,” which rises with the age of the older parent (see Exhibit 2). The net amount is multiplied by 12%.

The sum of the parents’ available income is added to the parents’ contribution from assets, and multiplied by a percentage determined by the Federal EFC formula (published in the Federal Register, May 31, 2001, for the 2002/03 award year). It is a sliding scale based on the parents’ adjusted available income (AAI). As seen in Exhibit 3, 22–47% of the parents’ AAI counts toward EFC, while 2.2–5.6% (12% of 22–47%) of the parents’ assets counts toward EFC.

The student’s contribution from income is equal to the student’s AGI and untaxed benefits minus taxes (federal, state, and FICA) and a flat $2,330 of living allowance, multiplied by 50%. The student’s contribution from assets is 35% of the fair market value of net assets.

Adding the parents’ contribution from income and assets to the student’s contribution from income and assets equals the EFC. It is important to note that the student’s assets and income are available at a higher percentage than those of the parents. Assets and income transferred to the child will reduce available aid more than the assets or income in the parents’ possession.

Example. Assume the parents of a family of five with one college student have a reported AGI of $100,000 in the base year tax return, no employment expenses, and state, federal, and FICA taxes amounting to $29,000. The employment allowance would equal $3,000, the living allowance would equal $24,000, and their available income would be approximately $44,000.

Assume the parents have available assets with a fair market value of $200,000. The savings and assets allowance is $42,900 (determined by the older parent’s age of 49). The discretionary net worth of approximately $157,000 is multiplied by 12%, making the parents’ contribution from assets approximately $19,000. Applying the parental contribution formula (Exhibit 3) to this AAI of $63,000 yields a total contribution of approximately $24,853.

Assume the student has AGI of $6,000 (of which $5,500 is earned), minus taxes of $900 and a flat $2,330 allowance. This leaves approximately $2,700, multiplied by 50% to arrive at the student’s income contribution of approximately $1,400. Also assume this student has $11,000 in available net assets, multiplied by 35% to arrive at the student’s asset contribution of approximately $4,000. The student’s contribution of $5,400 plus the parents’ contribution of $24,853 creates an EFC of just over $30,000.

If the parents made gifts to the student of assets worth $100,000, the parents’ net assets would be $100,000, not $200,000, and the student’s assets would be $111,000, not $11,000. Also assume that, because of this transfer, the parents have $5,000 less income and the student has $5,000 more. The EFC would then become slightly over $60,000 rather than $30,000.

Note that student resources, as used in the formula, are different from student assets and income, which are components of the EFC. Student resources include private scholarships or grants, Veterans’ Educational (VA) benefits, cash gifts paid directly to the college for tuition (from outside the immediate family), prepaid tuition plans, employer-provided education assistance programs, and other funds the college considers the student has available to pay.

Impact of Estate Planning

The following discussion of common estate planning tools is not aimed at taxpayers who, because of the size of the estate, are compelled to use discount valuation techniques such as family limited partnerships, GRITS, GRATS, and GRUTS, or who need to use charitable remainder trusts as their most effective strategies. Taxpayers with estates that are large are not concerned with obtaining financial aid. This article focuses on a significant number of taxpayers concerned with estate planning and financial aid. They tend to need less complicated estate planning tools because of their more modest estates. There are also nontax reasons for asset shifting that may override tax and student aid considerations, such as ensuring assets pass to the intended beneficiaries and the need to protect assets from creditors.

Gifts made for estate planning purposes may be counterproductive because the percentage used to calculate the parents’ contribution of assets and income is lower than the percentages used to calculate the student’s contribution of assets and income. Every dollar given by parents to the student increases the student’s contribution from assets by 35 cents and lowers the student’s Adjusted Financial Need.

For example, if the parents gift $11,000 to the child as part of their gifting plan, they have reduced their estate, benefited the student, and saved potentially $4,100 in estate tax. However, this increases the Student’s Contribution from Assets by $3,500, thereby reducing Adjusted Financial Need by $3,500. If the parents pay $11,000 directly to school for tuition for the student, the parents saved up to $4,100 in estate taxes, but the student’s Adjusted Financial Need decreased by $11,000. Careful analysis is required to determine if the adverse financial aid consequences overshadow the potential estate tax savings.

Non-Assessable Assets

Some assets, called non-assessable assets, are not counted when totaling the parents’ or student’s contribution from assets. The FM and IM regard retirement accounts, unexpended financial aid, personal items, and stock options as non-assessable assets. Therefore, a student’s investments in IRAs (other than Coverdell or Education IRAs), or in a motor vehicle, clothes, and household goods, can shelter money from the EFC. Retirement accounts include 401(k), 403(b), Roth IRA, regular IRA, SEP, and Keogh plans. A Roth IRA may be a good college investment option:

Additionally, under the FM (but not the IM), annuities, personal residences, family farms, life insurance, and siblings’ assets are non-assessable. If the college uses the FM, the student can benefit from an investment in annuities, and converting assessable assets (CDs, savings accounts, stock) to annuities before applying for financial aid.

Crummey Trust, UTMA, and UGMA

Some estate plans call for gifting to a trust (e.g. a Crummey trust) or to accounts under the Uniform Transfer to Minors Act (UTMA) or Uniform Gift to Minors Act (UGMA). While the value of those gifts is not included in the estate of the donor if the trust is drafted correctly, the donor may still be able to exercise some control over the investment and distribution of the gift. The $11,000 per donee per year exemption remains available to the donor if the Crummey trust is drafted correctly. Unless unusual provisions restrict the use of the funds (such as a court order restricting use to medical reasons), the trust principal will be treated as a student asset and the income will be treated as student income, which will reduce the student’s financial aid.

Once established, it is too late for the trustee or custodian to undo these results by transferring assets back to the donor. However, the trustee or custodian can mitigate the problem by investing in non-assessable assets.

529 Plans

Many states have taken the opportunity to sponsor IRC section 529 plans (or Qualified State Tuition Plans, QSTP), which come in two varieties: prepaid tuition plans and college savings plans. Prepaid tuition plan contracts vary from state to state, but in essence they are contracts that guarantee a hedge against tuition inflation. The donor pays tuition for an enrollment date in the future at today’s prices. The tuition covers private or public schools in the state, and sometimes out-of-state schools, although generally, prepaid tuition plans work well only for students planning on attending in-state public schools. Prepaid tuition plan assets stay in the control of the donor, who decides when withdrawals are taken, and for what purpose. There is a penalty for withdrawals not made for qualified expenses. The donor can change the beneficiary at any time, provided the new beneficiary is a descendant of the donor. Because of these features, the prepaid tuition plan is a non-assessable asset for purposes of financial aid eligibility. Nevertheless, the distribution reduces the student’s COA, and therefore financial aid, dollar for dollar.

College savings plans are generally state-sponsored and state-managed mutual funds. There is a risk the investment may not keep pace with the rising cost of tuition, but college savings plans can offer advantages over other plans. The donor has some control over the types of investment and full control over distributions from the account. The donor can change the beneficiary to any qualifying family member. The donor can retrieve the money, with a 10% penalty. Contributions are a taxable gift, and therefore excluded from the donor’s estate. The donor can elect to donate up to $50,000 now, which would remove future appreciation on those assets from the donor’s estate.

The investment grows tax deferred, and any amounts withdrawn for qualifying educational expenses are tax-free. Withdrawals from a 529 plan must be coordinated with Hope and Lifetime Learning Credits to ensure that the tax-free income and tax credits are not used simultaneously for the same expenses. The withdrawal of principal is not assessed. If owned by the parent or student, the value of the 529 plan is deemed by FM and IM to be the parent’s asset (assessed at the rate of 5.6%, not the student’s rate of 35%). The withdrawal of principal is not assessed.

©2002 CPA Journal. Legal Notices