Twenty Questions About Paying for College
Demystifying Financial Aid and the Related Tax Benefits

By Peter A. Karl III, Edward Petronio, and Kenneth Wallis

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DECEMBER 2006 - 1. When is a student considered independent for federal financial aid purposes?

A student is not regarded as independent (thus requiring parental financial information) unless he is—

  • an orphan or ward of the court,
  • age 24,
  • married,
  • enrolled in a graduate or professional program,
  • supporting one or more children, or
  • a member or veteran of the U.S. armed forces.

2. How does the divorce or separation of a student’s parents affect financial aid?

For 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.

A number of colleges are taking a facts- and-circumstances approach in evaluating this blended family issue.

3. What expenses are eligible for financial aid?

Financial 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.

It 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.

4. How is financial need determined?

All applicants for need-based aid must annually file the Free Application for Federal Student Aid (FAFSA), which can be completed online at 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 ( 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.

5. How is EFC calculated under the more common FM?

Under the FM calculation, the income and assets of both student and parents are considered in different percentages for the EFC, as detailed in Exhibit 1.

The 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.

6. What federal loan programs are available?

Federal loan programs for students enrolled at least halftime include the following:

  • 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 $40,000 total.
  • 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.

There 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 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 (; 888-272-5543).
  • Health profession loans. This program is available to both undergraduate and graduate students pursuing health studies.

7. What federal grant programs exist for college education?

Federal 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.

8. What tax benefits are available for education-related expenditures?

As 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.
  • The 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 QHEE.
  • 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.
  • New 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.

It 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

9. How can a 529 plan be beneficial for the financing of college expenses?

There 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 (

For 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.

Families 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 participate ( The website 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.

10. What is a Coverdell Education Savings Account?

The 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 level).
  • 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.
  • Anyone 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 following year.

Some 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 under 30.
  • 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).

11. What are the advantages and disadvantages in using U.S. savings bonds?

The 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 eligibility:

  • MAGI phaseouts apply as reflected in Exhibit 3.
  • The bond owner must be at least 24 years old at the time of purchase.
  • 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 in bonds.
  • Parents must keep detailed records of the QHEE from the bond proceeds.

Some 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.

12. Can an IRA be used?

Distributions 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.

13. What role do custodial accounts have in establishing funds for a child’s education?

The 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).

Some 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 and UTMA.
  • There are no tax penalties if the funds are not used for college expenses.

There 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 future distributions.

14. How are trusts factored into financial aid calculations?

While 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 education)?
  • Are income and principal distributions discretionary or mandatory by the trustee?

Consequently, 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.)

15. What are CollegeSure CDs?

The CollegeSure CD is an investment product that can be used to fund higher education offered by the College Savings Bank (800-888-2723;

The 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%.

CollegeSure 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.

Some of the advantages of a CollegeSure CD are as follows:

  • Anyone can contribute for a beneficiary.
  • The risk of rising college costs is eliminated.
  • They are insured by the FDIC up to $100,000.
  • There 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.

Some of the disadvantages of a CollegeSure CD are as follows:

  • They lack investment flexibility.
  • There are high surrender fees for early withdrawal.
  • The 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.
  • The owner or beneficiary has the freedom to spend funds as desired.

16. Why should parents consider investing in real estate located in a college town?

Besides 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).

Alternatively, 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.

17. What bias exists against Schedule C filers when applying for a child’s financial aid?

Because 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.

18. What strategies are available for financial aid planning?

First, 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 appreciation.
  • Use cash-value life insurance, retirement plans, and annuities as investment vehicles, because they are generally exempt from the asset calculations.
  • Consider 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.

19. What kind of investment returns can participants expect from their college savings options?

Savings 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.

Surprisingly, the returns for investments under 529 CSPs have been largely disappointing. A review of the website, 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.

This 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.

20. What are some of the top websites for financial aid information?

Peter 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 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).

The 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.





















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