Questions About Paying for College
Demystifying Financial Aid and the Related
Peter A. Karl III, Edward Petronio, and Kenneth Wallis
2006 - 1. When is a student considered independent
for federal financial aid purposes?
student is not regarded as independent (thus requiring parental
financial information) unless he is—
an orphan or ward of the court,
enrolled in a graduate or professional program,
supporting one or more children, or
member or veteran of the U.S. armed forces.
How does the divorce or separation of a student’s
parents affect financial aid?
a dependent student whose parents are divorced or separated,
financial aid is granted based on the financial information
for the parent who lived with the child for the greater
amount of time during the 12 months preceding the date of
application. If the dependent lived with neither parent,
or if the dependent lived with each parent equally, financial
aid is granted based on the financial information for the
parent who provided the greater amount of financial support
during the 12 months preceding the date of application.
If the student received no parental financial support during
that time, he or she must submit information about the parent
who most recently provided the greater amount of financial
support. If the parent who provided financial support was
single, divorced, or widowed but has since remarried, the
student must submit the stepparent’s financial information.
The stepparent’s income and assets will be considered,
but this does not legally obligate the stepparent to provide
financial assistance to the student.
of colleges are taking a facts- and-circumstances approach
in evaluating this blended family issue.
What expenses are eligible for financial aid?
aid can be obtained for costs of attendance (COA), which
encompasses (in addition to tuition and fees) reasonable
educationally related allowances for room and board, a personal
computer, study abroad, transportation, supplies and books,
and extraordinary expenses due to disability.
should be noted that while the aforementioned COA items
qualify for financial aid consideration, not all of these
expenses are eligible for the various tax benefits discussed
below in question 8.
How is financial need determined?
applicants for need-based aid must annually file the Free
Application for Federal Student Aid (FAFSA), which can be
completed online at www.fafsa.edu.gov.
The information on the FAFSA is used to determine an Expected
Family Contribution (EFC). While a federal methodology (FM)
is used by all educational institutions for determining
eligibility for federal student aid, an institutional methodology
(IM) through the College Board’s Profile application
is used by some private colleges (www.collegeboard.com).
There are distinctions between the two methodologies; for
example, the FM (in contrast to IM) neither counts home
equity as an asset nor allows deductions from family income
for medical expenses or private school tuition. In addition,
tax losses emanating from Schedules C, D, E, and F are not
allowed under the IM while assets of siblings are included
as family assets.
How is EFC calculated under the more common FM?
the FM calculation, the income and assets of both student
and parents are considered in different percentages for
the EFC, as detailed in Exhibit
EFC is then subtracted from the COA (net of any third-party
education benefits, such as scholarships) to determine an
individual’s financial need (FN), which will vary
by institution because of differences in the COA.
What federal loan programs are available?
loan programs for students enrolled at least halftime include
Stafford loans. There are two versions of these
programs, subsidized and unsubsidized. For the former,
the 6.8% fixed interest is waived while the student is
in school and the first six months after leaving school
as well as any period of deferment granted. For dependent
students, the amount that can be borrowed ranges from
$3,500 for the first year of undergraduate study to $5,500
for juniors and seniors; graduate/professional students
may annually borrow $20,500 with no more than $8,500 being
a subsidized loan.
Perkins loans. Like the subsidized Stafford loans,
Perkins loans are based on the EFC and financial need,
although qualification is further restricted to students
with exceptional need. Unlike Stafford loans, the interest
rate is fixed at 5%. An undergraduate student can borrow
a maximum of $4,000 per year and $20,000 total; a graduate
or professional student can borrow $6,000 per year and
Plus loans. In contrast to the Stafford and Perkins
loans, no FAFSA is required for a Plus loan and the entire
COA can be borrowed each year (Plus loans are available
to graduate students as of July 1, 2006). The qualification
process is based solely upon a credit check. Unlike the
Stafford and Perkins loans, which allow repayment to be
delayed until six months after the student leaves school,
Plus loans require repayment starting within 60 days of
the first disbursement. It should be noted that Stafford
and Plus loans may have upfront fees of up to 4%. A student
should consult with the financial aid office for a set
of “preferred lenders” with whom the school
has negotiated favorable terms.
are two Plus programs: the Direct and the FFEL. In a Direct
Plus, the U.S. Department of Education acts as the lender
with the school acting as the administrator. FFEL involves
the borrower finding a participating private lender such
as www.myrichuncle.com. However, the Direct Plus is usually
preferable because the interest rate of private Plus is
usually variable and higher.
Sallie Mae offers signature student loans which a parent
must usually co-sign. An undergraduate may borrow (including
all other student loans) up to $100,000; graduate students,
$150,000. The interest, based on prime rate, is variable
with terms up to 30 years (www.salliemae.com;
Health profession loans. This program is available to
both undergraduate and graduate students pursuing health
What federal grant programs exist for college education?
education grants include the following:
Pell Grants—awards of up to $4,050 for the neediest
of applicants (an EFC below $3,850; those qualifying for
Pell Grants are also eligible for the new Academic Competitiveness
and National Smart Grants),
Supplemental Educational Opportunity Grants—awards
of up to $4,000, most often given to students who have
qualified for a Pell grant,
Byrd Grants—awards of $1,500, funded by the U.S.
government and administered by the states, and
AmeriCorps—awards of $4,725 in return for service
during or after postsecondary education.
What tax benefits are available for education-related expenditures?
outlined in Exhibit
2, the definition of qualifying higher education expenses
(QHEE) will vary among the following tax benefits:
The Hope Scholarship Credit (HSC) permits a maximum tax
credit of $1,650 (100% of the first $1,100 of QHEE and
50% of the second $1,100 incurred) in each of the first
two years of postsecondary education, provided the student
is enrolled at least half time. The credit can be taken
for each eligible student in the family, defined as the
taxpayer, spouse, or dependent.
Lifetime Learning Credit (LLC) permits a credit of up
to $2,000 per tax return, calculated as 20% of the QHEE
of the eligible student (using the same definition as
the HSC). While the actual payor of the QHEE could be
a third party such as a grandparent, the deemed payor
for purposes of taking the LLC (or HSC) can be the parent
(or student). Consequently, if a divorced noncustodial
parent is the payor, either parent is eligible for the
LLC (or HSC), provided the taxpayer claiming the benefit
has the dependency exemption. In certain situations, the
parents may choose not to take a dependency exemption
so that the LLC (or HSC) credit can be used by the student.
This may be appropriate if the parents are ineligible
because of their earnings and the student has sufficient
taxable income. Unlike the HSC, the LLC is not limited
to the first two years of college education and does not
require the student’s half-time enrollment; the
LLC is available for the taxpayer, spouse, and dependents
for any coursework (including graduate or professional)
to acquire or improve job skills. Generally, if a taxpayer
is incurring more than $8,250 in QHEE for a student, the
LLC will be more advantageous. The number of eligible
students in the family and the college costs will dictate
whether the HSC or LLC should be claimed for a particular
individual in order to optimize the credits for the family’s
benefit. It should be noted that QHEE prepayments in one
tax year for study beginning within the first three months
of the following year qualify for the HSC and LLC credits
in the year of payment.
An annual $2,500 tax deduction is available as an adjustment
to gross income for interest related to QHEE incurred
for a student who is enrolled at least half time. This
deduction cannot be taken by a student while he is claimed
as a dependent on another person’s tax return. Likewise,
the deduction cannot be taken by a parent who is merely
the loan guarantor (i.e., the parent must be at least
a cosignor), and the loan must not be from a related party.
In order for the debt to qualify, it must be used solely
for QHEE. The deduction precludes interest generated from
a credit card unless it is being used solely for incurring
IRC section 2503(e) permits unlimited transfers by, for
example, grandparents without using the gift tax annual
exclusion when paid directly to the institution for a
student’s tuition. IRS Private Letter Ruling 2006-2000
even allows several years to be paid in advance, provided
the payments are nonrefundable and nontransferable.
York State tax credit (tuition): $200-$400.
See questions 9–12 for discussion of 529 plans,
Coverdell ESAs, the U.S. savings bond interest exclusion,
and IRA distributions for QHEE.
should be noted that taxpayers are prohibited from receiving
a double tax benefit associated with QHEE, and phaseouts
apply when a taxpayer’s Modified Adjusted Gross Income
(MAGI) exceeds certain levels, as reflected in Exhibit 3.
For further information regarding the HSC and LLC, refer
to “Planning for College Tuition Tax Benefits,”
by Mark E. Riley, Cindy L. Seipel, and P. Larry Tunnell
(which also covered the Qualified Tuition Deduction/Higher
Education Expense Deduction), published in the January 2006
CPA Journal and available online at www.cpaj.com.
How can a 529 plan be beneficial for the financing of college
are two kinds of IRC section 529 plans: a prepaid tuition
plan (PTP) and a college savings plan (CSP). A PTP allows
parents to pay for college tuition presently and guarantees
the purchase of up to four years of future tuition at current
market prices. In contrast, a CSP provides participants
the option to contribute to a portfolio of funds in order
to use this investment to defray qualified college expenses.
The earnings of the CSP are exempt from federal income tax
when used to pay for QHEE, and any taxpayer can contribute—regardless
of income level or relationship to the student. Contributions
made to New York’s only 529 plan, a CSP, are allowed
up to a maximum aggregate balance of $235,000 (www.nysaves.com).
gift tax purposes, an accelerated giving option allows for
the funding of CSP plans in one year up to five times the
2006 annual exclusion of $12,000. Negative aspects of certain
CSPs include high plan fees, which can result in this being
a poor choice for short-term planning, and a 10% penalty
(in addition to income taxes), which is assessed if funds
are not used for QHEE. However, there is no time limit for
withdrawals and the CSP can be rolled over tax free to a
member of the prior beneficiary’s family.
interested in private higher education should consider the
independent 529 plan, a PTP that provides for enrollment
in the more than 250 institutions nationwide which currently
The website www.upromise.com
provides a list of vendors that will contribute a percentage
of purchases to 529 plans. The account balance of a CSP
is an asset of the contributor, whereas a PTP is an asset
of neither the parent nor the student.
What is a Coverdell Education Savings Account?
Coverdell Education Savings Account (ESA) is an account
owned by a custodian until the beneficiary attains the age
of majority at eighteen. Some of the benefits of the ESA
are as follows:
Withdrawals are tax-free if utilized for QHEE (the definition
of educational institution includes public, private, and
religious schools from kindergarten to the postdoctoral
Investment options are unlimited
Assets can be transferred to an ESA or 529 plan for another
eligible family member. (even if enrolled less than halftime).
Tax is deferred on earnings.
can contribute for the benefit of a beneficiary, provided
the contributions (eligible for the gift tax annual exclusion)
for a given year are made no later than April 15 of the
of the negative aspects of the Coverdell ESA are as follows:
As noted in Exhibit
3, income restrictions may preclude certain contributors
(though, for example, a child can establish an ESA after
receiving a cash gift from an ineligible parent).
A $2,000 per child annual limit applies to the contributions,
which are nondeductible.
Generally, plan assets must be used before the beneficiary
attains age 30 unless they are rolled over (within 60
days of the beneficiary’s 30th birthday) to another
ESA or a 529 plan for the benefit of another beneficiary
A tax penalty applies if not used for QHEE.
Contributions must cease after the beneficiary attains
age 18 (except under special circumstances, such as physical
or mental disability).
The account is treated as the parent’s asset for
financial aid purposes (but not for estate taxes).
What are the advantages and disadvantages in using U.S.
interest earned on Series EE bonds issued from December
31, 1989, and all Series I bonds is tax exempt if the bonds
are redeemed to pay QHEE. The following rules determine
MAGI phaseouts apply as reflected in Exhibit
The bond owner must be at least 24 years old at the time
Parents must register bonds in their name.
A child cannot be a co-owner, only a named beneficiary.
A husband and wife have an annual purchase limit of $60,000
Parents must keep detailed records of the QHEE from the
of the benefits of U.S. savings bonds are that there are
no costs to purchase them and no tax penalties if the proceeds
are not used for QHEE. In addition, anyone can purchase
bonds for a beneficiary and the beneficiary can be changed
at any time.
Can an IRA be used?
from a traditional IRA will avoid the 10% penalty for a
premature withdrawal prior to age 59 Qs if the funds are
used to pay QHEE. Tax-free withdrawals can be taken from
a Roth IRA (contributions made from after-tax earnings)
if they are used for QHEE.
What role do custodial accounts have in establishing funds
for a child’s education?
Uniform Gifts to Minors Act (UGMA) and Uniform Transfers
to Minors Act (UTMA) both allow assets to be titled in the
name of a custodian for the benefit of a minor, who will
have full control of the property upon reaching age 21 (unless
an age 18 election is made initially).
of the advantages of such accounts are as follows:
If the child is age 18 or older, earnings are taxed at
the child’s lower income tax rate (including the
5% capital gain rate by gifting prior to executing a contract
for an asset sale).
There are no restrictions for high-bracket taxpayers.
Stocks, bonds, bank accounts, assets, and tenant-in-common
interests in real estate can be retitled under the UGMA
are no tax penalties if the funds are not used for college
are some disadvantages associated with custodial accounts.
Although the expectation is that the custodial assets will
be used to pay college expenses, the beneficiary has the
freedom to spend it as desired upon reaching the designated
age. This concern will sometimes necessitate the consideration,
for example, of drafting a Crummey trust, which would allow
transfers to qualify for the gift tax annual exclusion and
provide the ability to establish control with respect to
How are trusts factored into financial aid calculations?
a trust funded at death pursuant to the provisions of a
last will and testament or living trust (referred to as
a testamentary trust) is not considered for financial aid
purposes except to the extent that benefits are received
by the student, an irrevocable living trust can impact an
aid determination. The following questions should be asked:
Is it a self-settled trust (i.e., created by a parent
who has an obligation under state law to finance a college
Are income and principal distributions discretionary or
mandatory by the trustee?
a non–self-settled living trust (created by a relative
such as a grandparent) with provisions that do not mandate
distributions could preserve future benefits for the beneficiary.
However, it should be remembered that the tax rate structure
is compressed for a trust accumulating income, resulting
in higher taxes. (For additional information on trusts,
see “Answers to 20 Questions on the Use of Trusts,”
by Peter A. Karl III, in the September 1998 CPA Journal.)
What are CollegeSure CDs?
CollegeSure CD is an investment product that can be used
to fund higher education offered by the College Savings
Bank (800-888-2723; www.collegesavings.com).
CollegeSure CD is offered in maturity terms of 1–25
years. Its return is based on the growth rate of the Independent
College 500 Index. The College Savings Bank guarantees a
minimum interest, currently 2%, that depends upon that year’s
college inflation index. Since 1987, the CollegeSure CD
has yielded an average of 5%.
CDs are sold in whole or partial units. The unit at the
time of maturity is equal to the average cost of one year’s
tuition, fees, and room and board at a typical four-year
private college. The unit’s cost is established using
data developed by the College Board with a specific priced
index value assigned to each institution.
of the advantages of a CollegeSure CD are as follows:
Anyone can contribute for a beneficiary.
risk of rising college costs is eliminated.
are insured by the FDIC up to $100,000.
are no restrictions for taxpayers in a higher bracket.
Contributions can be made for a beneficiary of any age.
At the time of maturity, the funds can be used for any
purpose without penalty.
of the disadvantages of a CollegeSure CD are as follows:
They lack investment flexibility.
are high surrender fees for early withdrawal.
interest earned is taxable each year, although no money
is paid until the CD matures.
If the child is the owner, the CD cannot be transferred
to another beneficiary.
owner or beneficiary has the freedom to spend funds as
Why should parents consider investing in real estate located
in a college town?
the inherent tax advantages of real property ownership and
its related appreciation (unavailable when rent is paid
to an academic institution), the rental structure in many
college towns dictates strong consideration of purchasing
realty there while the child is a student. Higher rates
of return for residential realty investments can be found
in many college towns because the market usually allows
a landlord to charge rent on a per student or per room basis.
Thus, in a common scenario, a five-bedroom house could yield
the landlord $2,500 in gross monthly rent. Upon the child’s
graduation, the portion of realty rented to others could
be replaced tax-free with business or other investment realty
using an IRC section 1031 exchange (see “20 Questions
About Deferred Realty Exchanges Under IRC Section 1031,”
by Peter A. Karl III, in the May 2003 CPA Journal).
if the real property is titled in the child’s name
while also being rented to others, the IRC section 121 gain
exclusion of $250,000 could be applied to shelter gain both
from that allocated to the personal residence (after a two-year
holding period) along with the rental portion except to
the extent of depreciation since May 6, 1997, pursuant to
Revenue Procedure 2005-14. It should be noted that while
this IRS pronouncement implies a two-party exchange, the
transaction should be structured with the use of a qualified
intermediary for any proceeds not being excluded under IRC
section 121. As a further benefit, the basis of the replacement
investment/business realty will be stepped up by the amount
of any gain excluded under IRC section 121.
What bias exists against Schedule C filers when applying
for a child’s financial aid?
college financial aid departments may be uncertain about
the actual impact of a proprietor’s Schedule C, their
calculations may include adjustments to income. Business
owners are advised to include a balance sheet for the business
to support the fact that gross revenue does not reflect
a commensurate level of net worth. With enough lead time,
a sole proprietor could consider forming an operating entity
in order to generate a W-2 instead.
What strategies are available for financial aid planning?
determine whether the student and parents could qualify
for need-based financial aid. If they do not, consider the
unsubsidized Stafford loan and the Plus loan discussed in
question 6. If financial aid is a possibility, then the
following options should be considered in order to maximize
the available financial aid:
Determine which methodology (as discussed in question
4) will be applicable. For example, under the FM a personal
residence is excluded, under the IM it is not.
Because income typically has more impact than assets in
the EFC calculation, consider postponing income, where
possible, by investing in assets that will yield future
Use cash-value life insurance, retirement plans, and annuities
as investment vehicles, because they are generally exempt
from the asset calculations.
disbursements from assets that are not exempt under the
EFC computation to pay debt that, as a general rule, cannot
be used as an offset.
Consider transferring assets to a family member whose
financial situation is not factored into the family’s
MAGI (or EFC).
Because parental assets are not as detrimental to the
EFC calculation as those held by the student, it should
be noted that a section 529 plan established by a parent
is considered an asset of the parent, whereas Coverdell,
UGMA/UMTA accounts, and Crummey trusts are considered
an asset of the child.
If a tax benefit would be denied to the parents because
of excess MAGI, determine whether the student would qualify.
What kind of investment returns can participants expect
from their college savings options?
bonds are an excellent low-risk investment vehicle for parents
to consider when investing for a child’s college education.
The interest for Series E bonds (which are issued at a discount)
is calculated every six months at 90% of the five-year Treasury
rate. The interest is compounded every six months, with
a minimum guaranteed rate of 4.16% if held for 17 years.
the returns for investments under 529 CSPs have been largely
disappointing. A review of the website www.savingforcollege.com,
which is devoted to rating and analyzing CSPs, reveals a
marked difference between investment strategies, styles,
and performance among plans. In terms of their investment
performance, the worst plan and the best plan returned,
on average, 4.1% and 10.8% annually over the last three
years. As a comparison, the S&P 500 index returned an
average of 12.02% over the same time period.
investment performance can be viewed as a downside for 529
plans, especially considering that there are tax penalties
if CSP assets are not used for higher education. In addition,
CSP options are often limited, and plan expenses can substantially
reduce the tax-deferred earnings. The result can be considerably
less beneficial than simply investing in a no-load mutual
fund. As a result of recent scrutiny by the SEC and various
consumer groups, along with the growing competition, CSP
investment performance is likely to improve in the future.
What are some of the top websites for financial aid information?
A. Karl III, JD, CPA, is a partner with the law firm
of Paravati, Karl, Green & DeBella in Utica, N.Y., and
a professor of law and taxation at the State University of
New York–Institute of Technology (Utica–Rome).
He is also the author of www.1031exchangetax.com
and a member of the CPA Journal Editorial Board.
Edward Petronio, PhD, is the owner of E.A.
Petronio and Associates, an investment advising firm in Skaneateles,
N.Y., and an associate professor at the State University of
New York–Institute of Technology (Utica–Rome).
Kenneth Wallis, CPA, was the founding owner
of the accounting firm of Wallis, Loiacono & Cook, P.C.
in Rome, N.Y., and an associate professor at the State University
of New York–Institute of Technology (Utica–Rome).
authors wish to acknowledge the input of Joseph A. Russo,
director of student financial strategies and financial aid
at the University of Notre Dame and co-author of How to
Save for College from Day One, published by The Princeton
Review and Random House.