FINANCE

Personal Financial Planning

College Aid and Tax Planning. Part 1 of 2

By Alan R. Sumutka

Increasing amounts of financial aid are available (even to some couples with $150,000 or more annual income) to offset soaring college costs, yet many remain unaware of aid provisions and the downside to widely accepted tax planning strategies (e.g., IRC section 529 plans). Good tax planning is often poor financial aid planning.

Financial Aid Formulas

Methodologies: The federal methodology (FM) and the institutional methodology (IM) are techniques commonly used to determine eligibility for aid, including grants (no repayment required), loans (repayment required), or work-study programs (required work for the school). Authorized by the Higher Education Act of 1965, the more liberal FM must be used by colleges to award federal aid, and many use it to award institutional aid as well.

To apply for aid under FM, a student must submit a Free Application for Federal Student Aid (FAFSA), which a third party may be asked to prepare or substantiate in the aid audit process known as “verification.” For example, a student who enters college in September 2005 must file a FAFSA no earlier than January 1, 2005. Deadlines vary by college. The FAFSA contains parent and student income data for 2004, which is base year 1 (BY1) and asset data as of the date the FAFSA is signed in 2005. The data is evaluated by financial aid officers to award aid for the freshman year in college (the first “award year”). The process is repeated annually. Therefore, planning strategies must be implemented two years before the expected college enrollment date in order to influence the evaluation of the initial FAFSA data.

The typical form of IM for nonfederal aid awards is administered by the College Board (www.collegeboard.com) for about 350 colleges. Other colleges do not rely on the College Board profile, but instead apply their own IM. Several elite institutions have recently banded together to create an even more restrictive aid delivery system.

Overview of the federal methodology. Section 471 of the Higher Education Act dictates that the “amount of need of any student for financial assistance” equals the “cost of attendance” (COA) minus the “expected family contribution” (EFC) and minus estimated financial assistance not received under this title (resources). For example, if the COA is $20,000, the EFC is $5,000, and resources (e.g., private scholarships) are $2,000, the student has financial need of $13,000, which the college can satisfy either fully or partially. If fully met, the family contribution is limited to the EFC. If partially met, say with $10,000, the family must contribute $8,000. Long-term, the actual family cost depends on the form of aid. If the $13,000 of need in the first example is satisfied with grants, the total family cost remains only $5,000. If satisfied with loans, however, the long-term cost is $18,000 (i.e., $5,000 EFC plus $13,000 of loans).

Cost of attendance. Each college computes its COA, which generally includes tuition and fees, books, supplies, transportation, miscellaneous personal expenses, and room and board.

EFC from income. The EFC from income is based on a family’s available income (AI), which approximates a family’s annual discretionary cash flow. It is the sum of adjusted gross income (AGI), or earned income if no tax return must be filed, and untaxed income and benefits, minus deductions, which equals total income, minus allowances. An assessment rate (22% to 47% for parents, 50% for students) is applied to AI to compute the EFC.

Untaxed income generally means any income excluded from federal taxation under the IRC, representing money not included in AGI but available for education expenses (e.g., welfare benefits, the untaxed part of Social Security benefits, child support, tax-exempt interest income, worker’s compensation, disability income, Roth IRA income, exclusion on the sale of a principal residence, and gifts received by the child). Several exceptions apply. The excluded income from a section 529 college savings plan distribution and from contributions to a flexible spending account are not considered untaxed income, and the excluded income from a Coverdell Education Savings Account (CESA) distribution is treated as student income. The “untaxed benefits” concept is pervasive. It includes the return of capital of aid-sheltered assets (e.g., the untaxed part of an IRA, pension, annuity, or life insurance withdrawals, except when rolled over), discretionary payments that could have been used to pay for education (e.g., employee elective deferrals to retirement plans and deductible contributions to IRA, SEP, Keogh, and other qualified plans), and specific refundable tax credits (e.g., earned income credit, additional child tax credit, and the credit for federal tax on special fuels).

Deductions generally represent specific amounts included in AGI that are unavailable to pay education expenses (e.g., taxable grants and scholarships, or earnings from a Federal work-study program), cash outflows not deducted for AGI (e.g., child support), and education tax credits (e.g., Hope and Lifetime Learning credits).

Most allowances are predetermined and published in government tables. (See the IFAP website at www.ifap.ed.gov.) Only two allowances represent actual cash outlays: the amount of federal income taxes paid, including the alternative minimum tax less nonrefundable credits; and Social Security taxes paid, including Medicare.

Parental AI is generally assessed at graduated rates. If AI is $3,410 or less, the parents’ minimum EFC is $750. Subsequent incremental brackets (approximately $3,000 each) are assessed at rates of 22%, 25%, 29%, 34%, 40%, and 47% (on AI over $24,300). Students are assessed at a flat rate of 50%.

EFC from assets. The EFC from assets is based on a family’s ability to fund education expenses from its current net worth. Discretionary net worth (DNW), which is valued as of the date the FAFSA is signed, is the sum of all assets owned by the family, minus certain debts, which equals net worth minus an education savings and asset protection allowance. For parents, 12% of DNW is considered to be the parents’ contribution from assets to which the same assessment rate as income is applied (22% to 47%), for an effective rate of between 2.64% (22% of 12%) and 5.64% (47% of 12%). Students are assessed at a flat rate of 35%.

Net worth is calculated as the sum of 1) cash, savings, and checking account balances (excluding aid money); 2) the adjusted tangible net worth of a business or farm (current value minus related debt, as adjusted per government tables to reflect a reduced forced sale value); and 3) the net worth of other investments (current value minus related investment debt), such as real estate (excluding a principal residence, but including a vacation home), trust funds, money market funds, mutual funds, stocks, and bonds. A CESA is considered a student asset; a college savings plan is considered an owner asset; and a section 529 prepaid tuition plan is not counted as an asset, but its distributions are considered resources.

Significantly, certain assets are noncountable (a personal residence, retirement plan assets, life insurance, annuities, personal items), and personal debt is ignored in the net worth calculation. For example, a family with $100,000 in cash and $100,000 in consumer debt has an aid net worth of $100,000. Therefore, asset planning favors the maximization of certain noncountable assets and favors business or investment debt over consumer debt.

Resources. Resources reduce financial need dollar for dollar, and may include payments received from education assistance plans, prepaid tuition plans, veterans’ education benefits, gifts paid directly to colleges, and private grants and scholarships.

Significant differences in IM. AI is usually higher under IM because it counts flexible spending account contributions, disallows losses in the AGI calculation, offers no student income protection allowance, and assesses an independent student’s income at 70%. DNW is usually higher too, because IM counts home equity and includes the assets of a student’s siblings as parental assets, but assesses student assets at only 25%.

Implications of Aid Methodology

Although it is difficult to generalize about aid eligibility, the following examples underscore its relevance to a wide range of individuals. In the Exhibit (cont), it is assumed that the parents’ 2002 BY AGI is $125,000 (each parent is 45 and earns $62,500) and that they have $142,200 in countable assets [excluding the value of their residence and the retirement assets in their 401(k) and IRAs]. They file jointly, use the standard deduction, and claim as an exemption their one, unmarried dependent child, who will attend college in 2003. The student earned $5,000 in wages and has $7,500 in countable assets. The EFC is $34,490. Because the COA is $33,000, the family has no need. But if the COA were to exceed the EFC (a possibility at many private institutions), the family would qualify for aid.

If the same couple had no countable assets and the student had no income or countable assets, the EFC would drop to $25,000 and the family would qualify for $8,000 in aid in BY1, or $32,000 over four years if the BY data remains constant. If this family had two children in college simultaneously, one at College A with a COA of $33,000 and another at College B with a COA of $18,000, the EFC to each college would drop to $12,500, resulting in need of $20,500 at College A and $5,500 at College B, or $26,000 of family need for one year.

Other variations provide further perspective. For example, a couple with only one working spouse and $75,000 of salary/AGI and one child in college has an EFC of $12,900. With two children in college, the EFC per college is $6,450. If two working spouses earned a total of $75,000 salary/AGI and had one child in college, the EFC is $11,500; with two children in college, the EFC per college is $5,750. Families with low AI and DNW are more apt to receive grants; others are more likely to receive loans and work-study aid.

Because aid eligibility drives the planning process, it is important to accurately, quickly, and cost-effectively project it under a host of variables. An excellent calculator is available at www.finaid.com.

Implications to the aid planning process. The traditional “pay-as-you-go” method is flawed. Typical savings (certificates of deposit, savings bonds, stocks, bonds, and mutual funds) are countable and may generate countable income (interest, capital gains) when redeemed to pay for education. Furthermore, financial aid officers argue that the proceeds are available for COA (regardless of the intended purpose) and often count the proceeds as untaxed benefits. Tax-advantaged educational savings plans are treated similarly, except that college savings plan income is not countable. Prepaid tuition plans are considered resources. Although aid-sheltered assets (retirement assets, insurance, annuities) are not countable, they are counted as taxed or untaxed benefits upon withdrawal. Therefore, the best strategy to maximize aid is to minimize countable assets and redemptions, borrow to pay for college expenses, and use cash (accumulated up to the asset protection allowance) and certain aid-sheltered assets to pay college expenses and loans.

Base Year Planning

Base year (BY) planning strategies encompass three different periods: pre-BY1, BY1–4, and post-BY4.

Pre-BY1 planning. Pre-BY1 is usually the most important period. Financial aid qualifiers attempt to posture their financial picture for BY1, and financial aid officers evaluate FAFSA data, develop an impression of the family’s need for the college years, and award aid with the understanding that their offer will probably affect the student’s enrollment decision.

Two favorable aid provisions should be carefully considered. If, in any BY, the parents’ AGI is less than $15,000 (the 2002 amount) and they are eligible to file a Form 1040A or EZ, the family EFC is deemed zero, regardless of the child’s assets or income. Also, under a simplified needs test, if the parents’ and student’s AGI are less than $50,000 (for 2002) and all are eligible to file a Form 1040A or EZ, family assets are deemed zero. When these thresholds are met, filing the appropriate form, not merely using a Form 1040, is important to capture the financial aid benefits.

Planning for students. A student’s countable assets (assessed at 35%) should be depleted before parents’ countable assets (assessed at 5.64%). The student, in high school sophomore or junior year, first should deplete the more restricted-use CESA assets to fund qualified high school expenses, and then custodial accounts (UGMA/UTMA). This will decrease BY1 countable assets and income.

Planning for parents. Parents can accelerate income into this year (to reduce BY1 47% countable income) by taking an early bonus or redeeming U.S. savings bonds, stocks, bonds, and mutual funds. The countable cash can then be reduced, preferably in the following order: maximize retirement plan contributions; extinguish probable high interest, aid-ignored debt; purchase necessary big-ticket items; accelerate itemized deductions (e.g., property and state taxes), to increase BY1 aid-deductible income taxes; and pay a mortgage or home equity loan, to increase the value of a noncountable residence and increase borrowing capacity.

If cash is lacking to make these payments, it can be obtained, first, via bank loan against bank assets or margin debt against corporate or nonmunicipal bonds and funds (because either action will reduce the respective countable asset) and, then, via home equity credit line (because the residence is noncountable, unless using IM).

If excess cash remains, the following actions can reduce it: Gift it to the student’s sibling (although these assets are countable under IM). Invest in a college savings plan (to shelter the income for aid and tax purposes). Acquire a permanent life insurance product, if cost effective (to shelter the asset and increase borrowing capacity), or acquire a low-cost, tax- and aid-sheltered annuity.

BY1–4 planning. If long-term savings and pre-BY1 planning are effective, the family should report few countable assets during BY1-4, or none at all.

Planning for students. Any remaining student assets should be depleted by using pre-BY1 strategies. Yet, because aid is rarely packaged solely as grants, most student planning centers on borrowing.

Subsidized federal loans are the best loans because interest does not accrue while the student is in school and usually repayment does not begin until nine months after the student graduates, and then can be spread over 10 years. Parents do not have to co-sign the loans, so repayment is the child’s legal responsibility. Perkins loans charge a fixed 5% interest rate; Stafford loans charge a variable annual adjustable rate (2.82% at July 1, 2003). Perkins loans, however, are usually superior.

Stafford loans assess a 3% origination fee; Perkins loans do not. Financial aid officers can award up to $20,000 of Perkins aid ($4,000 for five undergraduate years), but rarely do so because they spread these advantaged loans among students. The maximum subsidized Stafford aid is approximately $23,000 ($2,625 for the first year, $3,500 for the second year, and $5,500 for each of the last three years).

A dependent student who is ineligible for a subsidized Stafford loan can obtain an unsubsidized one, which is a reason to file a FAFSA even if the family has no need. The loan provisions are similar, except that the student is responsible for interest during school, although usually it can be capitalized and paid after graduation. In addition, if a parent is denied a federal Parent Loan for Undergraduate Student (PLUS), discussed below, the student can borrow another $23,000 ($4,000 for each of the first two years and $5,000 for each of the last three years).

Students can deduct up to $2,500 of interest for AGI on any of these loans, if their MAGI is below the threshold.

Planning for parents. Income planning focuses on deferring discretionary income into later years, possibly by deferring bonuses and asset sales, preferably to post-BY4, where they can be used to pay final-year college expenses or loans. Any targeted education savings (e.g., college savings plans and qualified U.S. savings bonds) should be depleted, to eliminate these countable assets. Borrowing against bank assets and corporate or nonmunicipal bonds or funds and then against a home equity credit line—all of which can yield itemized interest deductions—can further reduce countable assets.

If further borrowing is warranted, a parent of an undergraduate dependent student can obtain from the college a non-need-based PLUS in an amount equal to the COA less financial aid. The loan carries a variable annually adjustable interest rate (4.22% at July 1, 2003), and repayment must begin 60 days after the loan was made, over a maximum 10-year term. The government assesses a 3% origination fee and a 1% guarantee fee; if the parent dies, the loan is forgiven. Parents may consider alterative college-sponsored loans, permanent life insurance policy loans, or, as a last resort, 401(k) and 403(b) loans.

Parents that prefer to fund education as-you-go can use the cash flow from forgone mortgage payments from a properly structured refinancing, or can reduce retirement plan contributions. No immediate tax deductions are sacrificed by reducing Roth contributions. But decreasing traditional IRA contributions and other retirement plan elective deferrals leads to increased income taxes.

Post-BY4 planning. Financial aid forms are not filed during this phase, which includes the student’s junior or senior college year. Thus, planning focuses on financing or paying for the final year and developing loan repayment strategies.

Planning for students. This period is ideal for encouraging grandparent gifting, especially stock that the student can sell at a long-term capital gains rate as low as 5% (0% in 2008). If grandparents hold a college savings plan, this is the ideal time to use it to pay for college expenses.

Planning for parents. Parents can now generate discretionary cash flow from bonuses and other sources. The most tax-efficient order for redeeming assets is: qualified U.S. savings bonds (to obtain the interest tax-exemption if proceeds are used to pay for education); taxable bonds or funds (to generate possible long-term capital gains or losses and decrease future ordinary interest income); stocks or funds (to generate possible long-term capital gains or losses and decrease future 15% taxable dividends); and municipal bonds (to generate possible capital gains or losses and decrease future tax-free interest). The most tax-efficient order in which to withdraw assets from tax and aid-sheltered retirement accounts is: Roth IRA (tax-free withdrawal without penalty if used for education); traditional IRA (ordinary income tax upon withdrawal without penalty if used for education); and annuity (ordinary income tax upon withdrawal and 10% penalty if under age
59 !s). Last, if possible, parents might convert college loans to a home equity loan to be able to fully deduct the interest with no phase-out.