By: Investor Solutions
Ah, the beginning of a new school year is upon us. Unfortunately, so is the dreaded reality that you’ll have to write a sizeable check to cover your child’s college expenses! Paying for college can be a serious financial burden for families and many fear they won’t be able to afford sending one, never mind, two or three children to college. There are ways, though, to make the financial burden of college funding easier to bear.
More and more families are looking for ways help subsidize their children’s college expenses. Some methods used to accomplish this include financial aid, scholarships, tax deferred investment vehicles and tax credits. In order to make the best decision regarding which investment vehicles to utilize, the first thing we must understand is how financial aid is calculated and how much, if any, your child is eligible to receive. In the first of a two part series, we will focus on the components of the financial aid formula. We will finish our discussion in the second part of the series by exploring strategies to help us minimize out of pocket expenses to pay for a higher education. Although this will seem overwhelming and unworthy of the time it will take to read, I will do my best to make it all come together in my subsequent article. Bear with me, it will be worth it.
There are basically three formulas used to compute the amount of aid a student will receive: federal, institutional and the consensus approach. Where the federal formula is used by all schools, the institutional formula is used by more than 300, mostly private, colleges and the consensus approach is being used by approximately 28 leading institutions for the first time this year. The federal formula calculates how much financial aid a student will receive from the U.S. government. The institutional and consensus approach quantify how much aid you will receive from the college or university itself. The college will advise you of the formula that they use to award aid which will help you plan your funding strategy.
The Federal Financial Aid Formula
The Expected Family Contribution (EFC) is the amount that a family, based on their income and assets, is expected to be able to contribute towards a student’s college expenses. A great website to learn more about college funding is http://www.savingforcollege.com. There you will learn that the following resources are included in the federal formula:
- 35% of student’s assets including money, investments, business interests and real estate
- 50% of student’s income
- 2.6%-5.6% of a parent’s assets including money, investments, business interests and real estate
- 22%-47% of a parent’s income
Sources of income included in the formula:
- Withdrawals, including both principal and interest, from traditional or Roth IRAs
- Interest, dividends and capital gains from a UGMA/UTMA account are included to the extent they are reported on a student’s Form 1040
- Withdrawals from a grandparent owned 529 account may be reported as student income (50%)
- Assets that are excluded from the formula include:
- Individual Retirement Accounts (IRA)
- 401(k) or 403(b)
- Equity in primary residence
- Insurance policies
- 529 account assets if owned by student’s grandparent
The Institutional Formula
The Institutional Methodology (IM) was developed by financial aid professionals and economists to measure a family’s ability to pay for college. The institutional formula takes a deeper look into the family’s finances and their ability to contribute more towards funding a college education. This formula looks at:
- Adjusted gross income from Form 1040 as its basis and adds back untaxed social security and child support
- Allowances from income include taxes, medical allowance, employment expense, annual education savings allowance, income protection allowance and elementary/secondary tuition allowance
- For parents that are divorced or separated, the information from the custodial parent as well as his or her spouse, if remarried, is used in calculating the family’s contribution
In this case, students are expected to contribute 25% of assets while their parents are expected to contribute between 3% and 5%. Assets included in this formula include:
- Savings and investments including parent’s assets in another child’s name
- Home equity
- Other real estate
- Business assets
Excluded assets are:
- Emergency Reserve Allowance which represents six months of the families average expenses that would be used by the family for unanticipated expenses related to illness or unemployment
- Cumulative Education Savings Protection Allowance which is the amount the family would have accumulated if they had saved a specific percentage per year per child to finance that child’s college education
The Consensus Approach to Need Analysis
The presidents of 28 of the nation’s leading colleges and universities have adopted principles that will guide them in allocating their financial aid dollars to students and families based on their ability to pay for part of the cost of a college education. This group, led by Hunter B. Rawlings, III, president of Cornell University, includes other elite colleges such as Boston College, Duke University, Emory University and Georgetown University, among others, and is known as the 568 Presidents’ Group. The consensus approach:
- Looks at the family’s assets (parent’s and children’s assets aggregately) and expects the family contribution to be equal to approximately 5% of these assets
- Protects moderate income families whose homes have appreciated in value significantly by excluding home equity greater than 2.4 times the family income
- Considers the financial status of one set of parents (be it birth parents or step parents) rather than the status of, potentially, four parents (birth parents and step parents)
Depending on the college your child will attend, be it Harvard or your local community college, and your family’s particular financial status, eligibility for aid will be calculated using one of these methods. Students may also qualify for other sources of aid from the government and institutions by way of grants or scholarships which are awarded based on merit rather than need.
Stay tuned to next month’s newsletter where we will take a look at other forms of educational funding including tax deferred accounts and tax credits. We will also see how to put it all together so that you get the most bang for your college buck.