How is Financial Aid Calculated?
Financial aid can substantially reduce college costs, if you apply and qualify. The first step in getting financial assistance is to fill out the Free Application for Federal Student Aid (FAFSA). The federal college aid formula requires 35 percent of the assets in your child's name to be used for college costs. But it only expects about 5.6 percent of the money in the parent's name to be spent. So, you may be better off keeping accounts in your own name, especially during the last two years of high school, which is generally when you'll be asked to start providing tax returns.
Note: Depending on the school, a different methodology or combination of formulas may be used to calculate financial aid awards. Parents must fill out the FAFSA and then fill out another form that asks for additional information.
Many private colleges and universities use the Institutional Methodology, which penalizes families with a great deal of home equity but permits more generous treatment of items such as medical expenses, elementary and secondary school tuition and child support. It also assumes the student will spend some time each year working to earn money.
A third methodology, called the Consensus Approach, is now used by approximately 30 colleges and universities including Yale, Cornell, Stanford, MIT, Columbia, Wellesley and Duke. Among its principles: Students' assets and parents' assets are treated the same to discourage families from moving assets between generations.
To make matters more confusing, even if a college uses one of the formulas described above, it can still be flexible when awarding its own money. In other words, when awarding federal grants, loans and most state aid, the federal formula is used, but when awarding a school's own awards, each school a student applies to may make calculations differently.
The average tuition at a four-year public university has tripled over the last three decades, but the average family's income has remained fairly consistent. Often, college savings accounts don't cover four years of tuition, fees, room and board.
So, who's making up the difference?
Student Loans and Income-Based Repayment Plans
Increasingly, students are applying for loans to fund college expenses. More than two-thirds of bachelor-degree recipients graduate with student loans, averaging about $30,000, according to a White House fact sheet.
Unfortunately, many new graduates are having trouble finding jobs in today's job market, making it difficult to repay student loans. Even those who find employment feel pinched to repay student loans as they pay daily living expenses, start families, buy houses, and save for retirement. College graduates who default on student loan payments may damage their credit scores, lose tax refunds and have their wages garnished.
The Health Care and Education Reconciliation Act of 2010 helped ease the burden of mounting college debt. Under the law, more than 1.2 million borrowers qualify for an expanded income-based repayment plan that allows students enrolling after 2014 to:
Limit payments to 10 percent of income (previously the cap was 15 percent).
Forgive any remaining debt after 20 years, or after 10 years for those in public service, such as teachers, nurses and those in military service. (The previous time frame was 25 years.)
On June 10, President Obama signed an executive order that extends the income-based repayment plan to $5 million additional borrowers with older loans -- those who borrowed before October 2007 or who have not borrowed since October 2011. For example, a single social worker who graduated in 2009, earns $39,000 a year, and owes $26,500 in college loans would be eligible to reduce student loan payments by more than $126 per month under the new law. These extensions will be available to borrowers by December, 2015.
The President also encouraged Congress to continue its ongoing discussion of legislation that would allow millions of Americans to refinance existing debt at today's lower interest rates. And he charged the U.S. Secretary of Education with improving efforts to educate students and their families about the availability of financial aid and scholarships, student loan programs, repayment plans and tax savings opportunities for higher education costs.
Grandparents and Section 529 Plans
Instead of applying for student loans, some college students turn to generous grandparents -- many of whom have higher net worth than their children (who are today's parents). Increasingly, grandparents contribute to their grandchildren's college funds, rather than giving Treasury bonds on birthdays and other special occasions.
Note: Be aware of the precedent you set with the first grandchild. Others are likely to follow. Budget according to your maximum number of grandchildren -- you don't want saving for your grandkids' college to compromise your retirement plans.
Section 529 plans are a popular vehicle for college savings accounts. These qualified tuition plans are operated by many states, as well as some educational institutions, and may be set up by anyone (not just parents) as prepaid tuition plans or college savings plans.
Prepaid tuition plans generally allow you to pay for tuition (and sometimes, room and board) at today's rates for a student who will attend college in the future. However, many prepaid plans are state-sponsored and only available to state residents. Alternatively, college savings plans are investment accounts that donors contribute to over time.
Distributions from a Section 529 plan aren't subject to federal tax -- and sometimes, state tax -- as long as they're used to pay for qualifying higher education costs at an eligible institution. This includes tuition, room and board, books and even computers.
Other Ways to Lower College Costs
Hundreds of millions of dollars of scholarships and grants, as well as tax credits and benefits, go unclaimed every year. Taking advantage of these funds can be complicated -- but the payoff can be significant over the course of your student's college career:
Scholarships and Fellowships. If you or your child is fortunate enough to receive a scholarship or fellowship for higher education (undergraduate and graduate), there may be tax issues to consider. According to the IRS, scholarship and fellowship money is tax-free if you are a degree candidate at an eligible educational institution and the money is used for qualified education expenses. Qualified expenses are tuition and fees, books, supplies and equipment required for a class (but not include room and board).
Education Tax Credits. The IRS allows for credits on your income tax through the American Opportunity Tax Credit or Lifetime Learning Tax Credit, which are based on income levels. Once you determine whether or not you qualify, then you can determine which one would be better to take. The credits can be taken for yourself, your spouse or your dependent. But, be warned -- you can't claim this deduction or credit if your filing status is married filing separately or if another person can claim an exemption for you as a dependent on his or her tax return.
Student Loan Interest Deduction. The IRS allows a deduction for interest on student loans, but there are income caps and other stipulations on this deduction.
These are just a handful of some of the ways to defray the costs of higher education. Contact with your tax adviser for more detailed information on tax breaks and tax implications related to college savings and expenses for you, your spouse or child.