After reaching all-time highs on January 26, 2018, the Dow Jones Industrial Average and the S&P 500 went into a two-week slide that saw both stock indexes drop by more than 10%, a decline that is typically considered a market correction.1
Analysts have been saying for several years that the long, booming bull market was overvalued and due for a correction, so the drop was not a surprise in the big picture.2 And even after the 10% plunge, the Dow was up 19% over the previous 12 months, and the S&P 500 was up 12.5%.3
It’s natural to be concerned about this kind of shift, but more important to maintain perspective and focus on your long-term goals. It may be helpful to consider some of the reasons behind the surge of market volatility.
Too Much of a Good Thing?
The initial trigger for the downturn was a better-than-expected jobs report on February 2, that helped drive the Dow down more than 2.5%, a significant decline considering the unusually low volatility in 2017 and the beginning of 2018. The economy added 200,000 jobs in January, marking the 88th straight month of job creation, the longest such run in U.S. history. Wages rose by 2.9% over the previous January, the highest year-over-year increase since the end of the recession in June 2009. And the unemployment rate held steady at 4.1% for the fourth straight month, the lowest level in 17 years.4
Although the report was great news for U.S. workers, on Wall Street the rosy jobs picture generated fears of higher inflation that might drive the Federal Reserve to raise interest rates more quickly than anticipated. At its December 2017 meeting, the Federal Open Market Committee signaled its intention to raise the benchmark federal funds rate three times in 2018, bringing it up to a range of 2.0% to 2.25%. Theoretically, these changes have been priced into the market, but the strong jobs report made it more likely that the Fed will follow through on its projection and possibly execute further increases if inflation heats up.5
Stocks, Bonds, and U.S. Debt
Higher interest rates rattle the stock market because investors are more likely to move assets out of risky stocks and into more stable bonds as fixed-income yields become more attractive. Higher rates not only mean increased yields on new bonds but also on existing bonds, as prices are pushed downward to make yields competitive. In addition, the prospect of inflation tends to push bond prices lower and yields higher, because inflation erodes the purchasing power of fixed-income payments.
One reason for the initial reaction to the January jobs report expanding into a full-blown correction is that bond yields were already rising due to other factors. The yield on the 10-year Treasury note — a bedrock of global financial markets — has been rising since tax legislation was proposed in the fall of 2017, and the yield reached a four-year high of 2.85% the day the jobs report was released.6-7 Although the Tax Cuts and Jobs Act was generally welcomed on Wall Street, bond traders have been concerned that increased Treasury sales to pay for the $1.5 trillion tax cuts will erode bond prices. This concern was exacerbated by the bipartisan budget deal that further increased deficit spending.8
The Treasury is working to finance higher debt at the same time the Federal Reserve is unwinding its recession-era bond-buying program. With the Fed reducing its bond portfolio, the Treasury must sell more bonds to the public to cover growing deficits. The Treasury recently announced the first increase in bond sales since 2009.9
The question is who will buy these bonds and what are they willing to pay for them? A weak dollar has made Treasuries less appealing to foreign governments, which hold more than 44% of U.S. government debt. With the Treasury market depending more on U.S. investors, supply may be outpacing demand — illustrated by a tepid Treasury auction on February 7.10
The Long View
Although mounting government debt is a serious concern, the stock and bond markets are both driven in the long term by the economy, and the United States looks to be hitting its stride after a long, slow recovery. The global economy, which has been even slower to recover, is coming back as well.
A correction may be disturbing, but it can strengthen the market in the long term by returning equity values to levels that are more in line with corporate earnings and less dependent on investor exuberance. A corrected market may also be less vulnerable to overreaction. On February 14, the Dow and the S&P 500 closed up more than 1.2%, despite a consumer report that showed higher-than-expected inflation. Even with higher prices in January, core inflation (which excludes food and energy prices) is running at only 1.8%, still below the Fed’s 2% target rate.11
Of course, no one can predict the future, and you might see volatility for some time. The wisest course may be to remain patient and avoid making portfolio decisions based on emotion.
The return and principal value of stocks and bonds fluctuate with changes in market conditions. Shares, when sold, and bonds redeemed prior to maturity may be worth more or less than their original cost. U.S. Treasury securities are guaranteed by the federal government as to the timely payment of principal and interest.
The S&P 500 is an unmanaged group of securities that is considered representative of the U.S. stock market in general. The performance of an unmanaged index is not indicative of the performance of any specific investment. Individuals cannot invest directly in an index. Past performance is no guarantee of future results. Actual results will vary.
What is financial aid?
Financial aid is money distributed primarily by the federal government and colleges in the form of loans, grants, scholarships, or work-study jobs. A student can receive both federal and college aid. An ideal financial aid package will contain more grants and scholarships (which don’t need to be repaid) and fewer loans.
Financial aid can be further broken down into two categories: need-based aid, which is based on a student’s financial need, and merit aid, which is based on a student’s academic, athletic, musical, or artistic talent. Both the federal government and colleges provide need-based aid in the form of loans and grants. For merit aid, colleges are the main source, and they often use favorable merit aid packages to attract the best and brightest students to their campuses.
It’s worth noting that colleges can vary significantly in their generosity when it comes to merit aid; merit awards are typically related to the size of a college’s endowment and its unique objectives. College guidebooks and marketing materials generally provide statistics on the size of a college’s average aid award (both in dollar amounts and as a percentage of the typical aid package) and the family income thresholds necessary for different aid amounts. If you’re a family researching college choices, you can help your bottom line by targeting colleges that offer significant merit aid packages. For example, some colleges have made it a policy to replace loans with grants in their financial aid packages.
In addition to colleges, many businesses, foundations, and associations offer smaller merit scholarships with specific eligibility criteria and deadlines. Various scholarship websites allow your child to input his or her background, abilities, and interests and receive (free of charge) a matching list of potential scholarships.
How is my child’s financial need determined?
Financial need is generally determined by looking at a family’s income, assets, and household information. The federal government uses the FAFSA, which stands for Free Application for Federal Student Aid; colleges generally use the PROFILE form, or their own institutional form. The FAFSA uses a formula known as the federal methodology; the PROFILE uses a formula known as the institutional methodology. The general process of aid assessment is called needs analysis.
Under the FAFSA, your current income and assets and your child’s current income and assets are run through a formula. You are allowed certain deductions and allowances against your income, and you’re able to exclude certain assets from consideration. The result is a figure known as the expected family contribution, or EFC. It’s the amount of money that you’ll be expected to contribute to college costs before you are eligible for aid.
A detailed analysis of the formula is beyond the scope of this article, but generally here’s how it works: (1) parent income is counted up to 47% (income equals adjusted gross income or AGI plus untaxed income/benefits minus certain deductions); (2) student income is counted at 50% over a certain amount ($6,400 for the 2016/2017 school year); (3) parent assets are counted at 5.6% (home equity, retirement assets, cash value life insurance, and annuities are excluded); and (4) student assets are counted at 20%.
Your EFC remains constant, no matter which college your child applies to. An important point: Your EFC is not the same as your child’s financial need. To calculate your child’s financial need, subtract your EFC from the cost of attendance at your child’s college. Because colleges aren’t all the same price, your child’s financial need will fluctuate with the cost of a particular college.
For example, you fill out the FAFSA, and your EFC is calculated to be $25,000. Assuming that the cost of attendance at College A is $65,000 per year and the cost at College B is $35,000, your child’s financial need is $40,000 at College A and $10,000 at College B.
The PROFILE application basically works the same way. However, the PROFILE generally takes a more thorough look at your income and assets to determine what you can really afford to pay (for example, the PROFILE looks at your home equity and money you may have contributed to medical and dependent care flexible spending accounts).
What factors count the most in needs analysis? Your current income is the most important factor, but other criteria play a role, such as your total assets, the number of children you’ll have in college at the same time, and how close you are to retirement age.
Estimating aid eligibility ahead of time
Getting a ballpark estimate of financial aid ahead of time can be very helpful for planning purposes. There are two ways you can do this.
First, the federal government offers an online tool called the “FAFSA4caster” that you can complete to get an estimate of your EFC. Second, every college offers a tool called a “net price calculator” on its website that you can complete to get an estimate of how much financial aid your child might be eligible for at that particular college based on your family’s financial and personal profile.
Submitting financial aid applications
The best way to complete the FAFSA is to fill it out and submit it online (it can also be completed manually and mailed to the address listed on the form). The online route is more efficient because mistakes are flagged immediately and electronic FAFSAs take only one week to process (compared to two to four weeks for paper FAFSAs). In order to complete the FAFSA online, you and your child will first need to obtain an FSA ID, which you can also do online.
Starting with the 2017/2018 school year, families are able to file the FAFSA as early as October 1, 2016, using their 2015 tax return. Going forward, the FAFSA will rely on tax information from two years prior. The FAFSA has the ability to directly import your tax information using the IRS Retrieval Tool, which is built into the form. However, you will also have to answer additional questions.
The PROFILE (or individual college application) is usually submitted in late fall or winter but is typically required earlier if your child is applying to college early decision or early action. The specific deadline is left up to the individual college, so make sure to keep track of all college deadlines. In addition to the form itself, the CSS Profile will typically require you to submit tax returns, and possibly other financial documents, at a later date. If so, you’ll receive instructions on how to do this.
After your FAFSA is processed, your child will receive a Student Aid Report highlighting your EFC; the colleges that you list on the FAFSA will also get a copy of the report. When your child is accepted at a college, the college’s financial aid administrator will attempt to craft an aid package to help meet your child’s financial need. This is done using a combination of the following (typically in this order):
- Federal Pell Grant (for students with exceptional financial need)
- Federal Direct Stafford Loan (subsidized for students with financial need)
- Federal Direct Stafford Loan (unsubsidized for all other students)
- Federal Perkins Loan, Supplemental Educational Opportunity Grant (SEOG), and work-study (funds for these programs are allocated to colleges by the federal government for distribution to students; whether a student receives any of these funds depends on timing of application, financial need, and availability of funds)
- College grant, scholarship, or tuition discount (at the college’s discretion)
Keep in mind that colleges aren’t obligated to meet all of your child’s financial need. In fact, it’s not uncommon for colleges to meet only a portion of a student’s need, a phenomenon known as getting “gapped.” If this happens to you, you’ll have to make up the shortfall, in addition to paying your EFC. On the flip side, if a college says it is meeting “100% of your demonstrated need” keep in mind that the college is the one who determines your need, not you, and that you’ll still have to pay your EFC.
Comparing aid awards
In late winter or early spring, your child will receive financial aid award letters that detail the specific amount and type of financial aid that each college is offering. When comparing aid awards, read each award letter carefully and make sure you understand exactly what the college is offering. The goal is to compare your out-of-pocket cost at each college. To do this, look at the total cost of attendance for each college and subtract any grant or scholarship aid the college is offering. If the grant or scholarship is merit-based, find out if it’s guaranteed for each year your child is in college and what requirements must be met in order to qualify for it annually. If the grant or scholarship is need-based, find out whether you can expect a similar amount each year as long as your income and assets stay roughly the same (and you have the same number of children in college), and ask the aid office whether it increases to keep up with annual increases in tuition, fees, and room and board.
The difference between the total cost and any grant or scholarship aid is your out-of-pocket cost or “net price.” Compare this figure across all colleges. Once you determine your out-of-pocket cost at each college, determine how much, if anything, you or your child will need to borrow. Then multiply this figure by four to get an idea of what your total borrowing costs might be. Armed with this information, you’ll be in a position to make the best financial decision for your family.
If you’d like to lobby a particular school for more aid, tread carefully. A polite letter to the financial aid administrator followed up by a telephone call is appropriate. Your chances of getting more aid are best if you can document a change in circumstances that affects your ability to pay, such as a recent job loss, unusually high medical bills, or some other event that impacts your finances. Your chances of getting more aid by asking one college if they’ll match a favorable aid offer from another college is a less reliable strategy, but may be worth a shot if the colleges are direct competitors.
How much should our family rely on financial aid?
With all this talk of financial aid, it’s easy to assume that it will do most of the heavy lifting when it comes time to pay the college bills. But the reality is you shouldn’t rely too heavily on financial aid. Although aid can certainly help cover your child’s college costs, student loans often make up the largest percentage of the typical aid package, not grants and scholarships. Remember, parents and students who rely mainly on loans to finance college can end up with a considerable debt burden that can have negative financial implications for years after graduation.
For all of our articles about college planning, please click here.
A Coverdell education savings account is a tax-advantaged educational savings account that you can establish for a child under the age of 18 (this limit does not apply to beneficiaries with special needs). The child does not need to be your dependent. Contributions to a Coverdell ESA can total up to $2,000 each year. While contributions are made with after-tax dollars, distributions used to pay qualifying education expenses are not included in income.
- If you meet specified income limits, you can contribute up to $2,000 per child per year to a Coverdell ESA
- Contributions must be in cash
- Contributions can be made by April 15 of the year following the tax year for which the contribution is being made
- The beneficiary must be under age 18 at the time you open the Coverdell ESA, unless the beneficiary is an individual with special needs
- You don’t get a deduction for contributions that you make to a Coverdell ESA; the dollars that you contribute are after-tax dollars
- Earnings in the Coverdell ESA grow tax deferred, and the earnings portion of any distributions are income tax free as long as they are used to pay qualifying education expenses (the contribution portion is also tax free because they are made with after-tax dollars)
Qualifying Education Expenses
For purposes of a Coverdell ESA, qualifying education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an accredited post-secondary school (college) that is eligible to participate in the federal student aid program. For students enrolled at least half time, qualifying education expenses also include room and board.
Qualifying education expenses also include elementary and secondary education expenses. In addition to tuition, fees, books, supplies, equipment, and room and board, qualifying elementary and secondary education expenses may include tutoring, computer equipment, Internet access, and software that is primarily educational in nature.
For purposes of taking distributions from a Coverdell ESA, qualified education expenses must be reduced by any scholarships or other financial aid received.
You must meet income limits
If your modified adjusted gross income (MAGI) is less than $95,000 for single filers or less than $190,000 for joint filers, you can make a full $2,000 contribution to a Coverdell ESA. A partial contribution is allowed for single filers with a MAGI between $95,000 and $110,000 and joint filers with a MAGI between $190,000 and $220,000.
Contributions in the maximum amount have not already been made this year to a Coverdell ESA with the same beneficiary
You can establish and contribute to more than one Coverdell ESA (assuming you meet the income limits), but no more than $2,000 can be contributed in any calendar year on behalf of any one beneficiary.
You set up a Coverdell ESA for your five-year-old son. You also set up a Coverdell ESA for your three-year-old daughter. You can contribute the maximum amount to your daughter’s Coverdell ESA each year and the same amount to your son’s Coverdell ESA each year.
You establish a Coverdell ESA for your nephew Joe. Joe’s father also establishes a Coverdell ESA for Joe. Joe’s father contributes $1,900 to the Coverdell ESA that he established. You can contribute only $100 for that year to the Coverdell ESA that you established.
Beneficiary of Coverdell ESA has not yet reached age 18
When the beneficiary of a Coverdell ESA reaches age 18, no further contributions can be made. The exception is if the beneficiary is an individual with special needs, in which case there is no age limit.
Distributions used for the beneficiary’s qualified education expenses are income tax free
For distributions (withdrawals) used to pay qualified education expenses, the earnings portion of the distribution is tax exempt (contributions are also tax exempt because they’re made with after-tax dollars).
Funds can be rolled over to another Coverdell ESA for a family member of the current beneficiary
A Coverdell ESA can be rolled over without tax or penalty consequences to another Coverdell ESA established for the same beneficiary, or for a family member of the original beneficiary.
Contributions are discretionary
You do not have to make a contribution to a Coverdell ESA in any given year or years. Except for limits on the maximum amount that you can contribute in a year, you can exercise complete discretion in determining how much and when to contribute.
You have control over investments
With a Coverdell ESA, you can control the underlying investments. This is usually not the case with a 529 college savings plan or prepaid tuition plan.
Distributions from a Coverdell ESA can be tax exempt in same year an education tax credit is taken
A beneficiary can take a tax-free distribution from a Coverdell ESA in the same year that he or she takes the American Opportunity credit or Lifetime Learning credit. (The result is the same if the beneficiary’s parent takes the credit.) However, the catch is that the same qualified education expenses can’t be used to qualify for the tax-free distribution and the credit.
Coverdell ESA considered parental asset for federal financial aid purposes
The federal financial aid formula counts a Coverdell ESA as a parent’s asset. This means that 5.6 percent of the funds must be applied to college costs each year before a student is eligible for federal financial aid. Also, distributions that are used to pay qualified education expenses aren’t counted as either parent or student income for federal financial aid purposes.
After-tax dollars are contributed
You receive no deduction for amounts contributed to a Coverdell ESA. Your contribution comes from after-tax dollars.
Ability to contribute depends on income
If your MAGI is $110,000 or more for single filers or $220,000 or more for joint filers, you can’t contribute to a Coverdell ESA. A partial contribution is allowed for single filers with a MAGI between $95,000 and $110,000 and joint filers with a MAGI between $190,000 and $220,000. If your MAGI is less than $95,000 for single filers or less than $190,000 for joint filers, you can make a full $2,000 contribution to a Coverdell ESA.
Distributions not used to pay qualified education expenses partly subject to tax and penalty
Distributions that are not used to pay qualifying education expenses are included in the beneficiary’s income to the degree that the distribution consists of earnings. All distributions are considered made partly from contributions and partly from earnings. Also, any portion of a distribution that is included in a beneficiary’s income is subject to an additional 10 percent penalty tax.
Any remaining funds in a Coverdell ESA must be distributed when the beneficiary reaches age 30
Any funds remaining in a Coverdell ESA when the beneficiary reaches age 30 must be distributed (except for beneficiaries with special needs). Funds distributed from a Coverdell ESA at such time are considered taxable income to the beneficiary to the extent of earnings.
Fees and expenses
There are commission costs and other fees generally associated with opening a Coverdell ESA account.
How to do it
Establish Coverdell ESA at a bank or other financial institution
Coverdell ESAs can be established at a bank or other financial institution approved by the IRS.
Contributions to a Coverdell ESA must be made by April 15 of the year following the year for which the contribution is made.
Contributions to a Coverdell ESA are made with after-tax dollars
You receive no deduction for amounts contributed to a Coverdell ESA. Your contribution comes from after-tax dollars.
Qualifying distributions are tax free
If distributions are used to pay qualifying education expenses, the earnings portion of the distribution is tax exempt (the contribution portion is also tax free because they are made with after-tax dollars).
Portion of nonqualifying distribution is included in income and subject to 10 percent penalty tax
When a beneficiary takes a distribution from a Coverdell ESA but does not have qualifying education expenses in that tax year, the portion of the distribution that represents earnings is included in the beneficiary’s income. This portion of the distribution is generally also subject to an additional 10 percent penalty tax. However, this 10 percent penalty tax will not apply if the distribution is:
- Made after the death of the beneficiary to his or her beneficiary or estate
- Attributable to the beneficiary’s disability, or
- Made on account of a scholarship, an educational assistance allowance, or a payment of the designated beneficiary’s educational expenses that is excludable from gross income
Coverdell ESA may result in taxable income upon death of beneficiary
If a Coverdell ESA is transferred upon the death of the beneficiary to anyone other than a surviving spouse or family member, the Coverdell ESA ceases to be a Coverdell ESA, and whatever portion of the account represents earnings is income to the recipient.
A contribution to a Coverdell ESA is considered a completed gift
Contributions that you make to a Coverdell ESA are considered completed gifts. However, unless your Coverdell ESA contribution and other gifts you make to the same beneficiary (in the same year) total more than the annual gift tax exclusion, there is no federal gift and estate tax liability. And, gift tax due on gifts in excess of the annual gift tax exclusion may be offset by your applicable exclusion amount.
There may be state gift tax consequences as well.
Coverdell ESA is not included in calculating estate tax
Because money contributed to a Coverdell ESA is considered a completed gift to the beneficiary at the time of the contribution, such money is no longer part of the contributor’s assets once it has been contributed to the Coverdell ESA. Therefore, the money contributed would not be included in the contributor’s estate upon his or her death. However, if the beneficiary dies before using up all of his or her Coverdell ESA money, the remaining balance in the Coverdell ESA may be included in the beneficiary’s estate for estate tax purposes, depending on the value of the estate at the time of death and the year in which he or she dies.
A Coverdell ESA can be rolled over without tax or penalty consequences to another Coverdell ESA established for the same beneficiary, or for a family member of the original beneficiary. This can be done once every 12 months. Like IRAs, there is a 60-day window in which funds may be rolled over.
If the beneficiary dies while there is money in a Coverdell ESA, and the Coverdell ESA is transferred to a surviving spouse or other family member, there is no taxable transaction. Similarly, if a Coverdell ESA is transferred to a spouse or former spouse as the result of a divorce decree, there is no tax consequence. However, if upon the beneficiary’s death, the Coverdell ESA is transferred to anyone other than a surviving spouse or other family member, the Coverdell ESA stops being a Coverdell ESA, and the portion of the account that represents earnings is considered income to the person who receives the funds.
Questions & Answers
How much can you contribute if your income falls in the phaseout range?
The most you can ever contribute to a Coverdell ESA for a single beneficiary in a year is $2,000. If your MAGI is between $95,000 and $110,000 for single filers or $190,000 and $220,000 for joint filers, your ability to contribute to a Coverdell ESA is limited. This limitation is calculated as follows:
MAGI between $95,000 and $110,000:
- Subtract $95,000 from your MAGI (if your MAGI is less than $95,000, you can contribute the maximum). If the result is $15,000 or more, stop–you cannot contribute to a Coverdell ESA.
- Divide the result from line 1 by $15,000.
- Multiply the result from line 2 by $2,000.
- Subtract the result from $2,000.
This is the maximum amount you can contribute to a Coverdell ESA.
MAGI between $190,000 and $220,000:
- Subtract $190,000 from your MAGI (if your MAGI is less than $190,000, you can contribute up to $2,000). If the result is $30,000 or more, stop–you cannot contribute to a Coverdell ESA.
- Divide the result from line 1 by $30,000.
- Multiply the result from line 2 by $2,000.
- Subtract the result from $2,000.
This is the maximum amount you can contribute to a Coverdell ESA.
Are there restrictions on taking distributions from a Coverdell ESA?
Yes and no. Generally, contributions that you make to a Coverdell ESA are considered gifts. Once you contribute to a Coverdell ESA, distributions from the Coverdell ESA can only be made to the beneficiary (except for withdrawals of excess contributions). Distributions can be made from Coverdell ESAs at any time, but only qualifying distributions qualify for tax-free status.
Qualifying distributions are tax exempt if they are used for qualifying education expenses and if they do not exceed the expenses incurred by the beneficiary during the year.
Nonqualifying distributions are distributions made for noneducation expenses, and they are partially included in the beneficiary’s income and may be subject to a 10 percent penalty. Distributions are considered to consist partly of original contributions and partly of earnings. Only the portion of a distribution that represents earnings is included in the income of the beneficiary.
The part of the distribution that represents contributions (and is therefore not included in income) is calculated by multiplying the amount of the distribution by the ratio of contributions in the Coverdell ESA (prior to the distribution) to the total balance in the Coverdell ESA prior to the distribution. The remainder of the distribution represents earnings.
A Coverdell ESA has a total balance of $5,000. The $5,000 consists of $4,000 in contributions and $1,000 in earnings. A $1,000 distribution is made to the Coverdell ESA beneficiary, but none of the $1,000 is used for qualified education expenses. Because 80 percent of the entire value of the account at the time of the distribution consists of contributions, 80 percent of the distribution ($800) is considered to represent original contributions, and only 20 percent ($200) is considered to be earnings includable in income.
A special calculation is required when you have qualifying education expenses but the distribution exceeds these expenses.
What happens when a beneficiary has $5,000 in qualifying education expenses but receives $6,000 as a Coverdell ESA distribution?
Any time that a distribution from a Coverdell ESA totals more than the qualifying education expenses, a beneficiary must make a special calculation to determine how much of the distribution must be included in income:
1. Enter total qualifying higher education expenses.
2. Enter total amount of distribution.
3. Enter portion of distribution that represents earnings.
4. Divide line 1 by line 2.
5. Multiply line 4 by line 3. This amount must be excluded from income.
What happens if you contribute too much money to a Coverdell ESA in a given year?
If you contribute more to a Coverdell ESA than you are allowed in one year, you have until May 31 of the following tax year to withdraw the funds, along with any earnings attributable to the funds. Any over contributions remaining after this date are subject to a 6 percent excise tax.
The 6 percent excise tax is also assessed if total contributions to all Coverdell ESAs for any one beneficiary exceed the maximum $2,000 amount.
To read all of our articles about college planning, please click here.
When we talk to families about college planning, the topic that provokes the most conversation is always asset and income positioning. What does “asset positioning” mean? What assets do the FAFSA and CSS Profile look at? What options are out there? Will this effect my other savings goals? With February being Financial Aid Awareness Month, we wanted to address this complex and critical topic with a blog post.
What does it mean to use asset positioning enhance your financial aid eligibility?
If you qualify for federal financial aid, there are a number of strategies you can try to implement to enhance the amount of aid your child will receive when you apply for financial aid. The idea is to lower your expected family contribution (EFC), which in turn raises your child’s aid eligibility. Although some of these strategies can be employed as late as the base year–the tax year that your Free Application for Federal Student Aid form (FAFSA) will rely on–others can be implemented years before your child will be starting college.
NOTE: Beginning with the 2017/2018 school year, the base year will be two years prior. For example, financial aid for the 2017/2018 year will rely on 2015 tax information.
It is important to note that these strategies are perfectly legal and are not in any way meant to undermine the federal financial aid process. These strategies simply examine the federal methodology and take advantage of its rules regarding which family assets and income are included in determining a student’s financial aid eligibility.
You increase your child’s eligibility for federal financial aid
By implementing strategies that lower your assessable income and assets under the federal formula for financial aid, you decrease the amount of money your family is expected to contribute to college costs. A decrease in your EFC, in turn, means your child will be eligible for more financial aid. This translates into less current out-of-pocket costs for you.
You may reap incidental financial benefits that are important to you
By implementing certain strategies tailored to the federal methodology for financial aid, you not only increase your child’s aid eligibility but also may place yourself in a better financial position. For instance, by paying down your mortgage, you not only increase your child’s federal aid eligibility because home equity is not counted as an asset under the federal formula, but you also benefit by saving on mortgage interest and owning your home sooner.
Colleges don’t use the same formula as the federal government in determining aid eligibility
The primary drawback of implementing specific strategies to take full advantage of federal financial aid is that you increase your chances for aid under the federal system only. Colleges have their own formula for determining which students are most deserving of campus-based aid, and this formula may not recognize a strategy that is successful under the federal methodology. For instance, under the federal methodology, the federal government does not consider your home equity in calculating your total assets. However, some colleges do consider home equity in determining a family’s ability to contribute to college costs, and some may even expect parents to borrow against it.
The increased financial aid may consist entirely of loans
If you are successful at reducing your total income and assets under the federal methodology and thus increasing your child’s financial aid package, there is no guarantee that a portion of the increased aid package will consist of grants or scholarships (which do not have to be paid back). Instead, your child’s additional aid package could consist entirely of loans that will need to be paid back by you or your child.
You may not want to disrupt an otherwise sound investment program
It is generally not a good idea to drastically change your overall financial planning scheme for financial aid reasons only. Ideally, any changes you make should be in line with your overall financial planning picture.
Strategies to reduce available income
There are a number of steps you can take to reduce your adjusted gross income (AGI) under the federal methodology for determining financial aid. The lower your AGI, the less money you will be expected to contribute toward college costs and the higher your child’s aid eligibility.
TIP: Remember, you apply for financial aid each year. Thus you should consider the following strategies for each of the years you will be applying for aid, not just for the initial application.
Time the receipt of discretionary income to avoid the base year
Your income in the base year will directly affect your child’s financial aid eligibility in the corresponding academic year. Although it is highly unlikely that you will be able to defer your weekly (or monthly) paycheck, it may be possible to defer other types of discretionary income beyond the base year. For example, if possible, you should try to:
- Defer receiving employment bonuses until after December 31 of the base year.
- Avoid selling investments that will have taxable capital gains or interest, such as mutual funds, stocks, or savings bonds, until after December 31 of the base year. To avoid taking an untimely distribution from an investment that is earning a favorable rate of return, use the investment as collateral for a low-interest loan instead.
- Sell investments that can be taken at a loss during the base year, as long as the investments are not expected to recover.
- Avoid pension and IRA distributions in the base year.
- If you are on an expense account, ask your employer to reimburse you directly so that any reimbursement amounts do not artificially inflate your income.
Pay all federal and state income taxes due during the base year
Paying all federal and state income taxes due during the base year is advantageous for two reasons: it reduces the amount of available cash on hand, and you can deduct the total amount of federal and state taxes you pay during the base year on the FAFSA.
Leverage student income protection allowance
For the academic year 2017/2018, the first $6,420 of income a student earns is not considered in determining a child’s total income. This is known as the student’s income protection allowance. However, everything a student earns beyond the allowance is assessed at 50 percent for financial aid purposes. In other words, the federal government expects your child to contribute 50 percent of all income earned over the allowance (after taxes).
To avoid this result, parents may want to consider having their children perform volunteer work once their kids reach the allowance limit.
Strategies to reduce available assets
There are a number of steps you can take to reduce the amount of assets that will be included under the federal methodology. Under this formula, the federal government includes some assets and excludes others in arriving at your family’s total assets. The lower your assessable assets, the less money you will be expected to contribute toward college costs and the higher your child’s aid eligibility.
It is important to remember that the relevant date for determining whether you own a particular asset is the date that you submit the FAFSA. Consequently, the following strategies can be implemented up to the time you complete the FAFSA.
Use cash to pay down consumer debt
The federal methodology does not care about the amount of consumer debt you may have. So if you have $10,000 in assets and $10,000 worth of consumer debts, the federal government still lists your total assets as $10,000. When you use available cash to pay down consumer debt, you reduce the amount of your cash on hand.
Use cash to make large purchases
Another strategy to reduce cash on hand (an assessable asset) is to make large planned purchases in the base year. Such items may include a car, furniture, or the like for parents and a car (second-hand, of course), computer, or the like for students. Remember, the idea is not to go out and spend the money on anything; the purchase should have been previously planned.
Increase home equity
The federal methodology does not count home equity as an asset in determining your child’s financial aid eligibility. So using assessable assets to pay down the mortgage on your home is one way to reduce these assets and benefit yourself at the same time.
CAUTION: Although the federal government does not include home equity in determining a family’s total assets, some private colleges do include home equity in deciding which students are most deserving of campus-based aid. In addition, some colleges may expect parents to borrow against the equity in their homes to help finance their child’s college education.
Leverage parents’ asset protection allowance
Once the parents’ assessable assets are totaled, the federal methodology grants parents an asset protection allowance, which enables them to exclude a certain portion of their assets from consideration. The amount of the asset protection allowance varies depending on the age of the older parent at the time the child applies for aid (the idea being the closer the parents are to retirement age, the larger the asset protection allowance). For example, if parents are married and the older parent is 48 when the child applies for financial aid, the asset protection allowance is $20,200 for the 2017/2018 academic year.
Once parents determine what their asset protection allowance will be, one strategy is to consider saving an equal amount of money in assets that are counted under the federal methodology. Then, any savings above this amount can be shifted to assets that are excluded by the federal methodology, such as home equity, retirement plans, cash value life insurance, and annuities.
Use student’s assets for the first year
Under the federal methodology for financial aid, the federal government expects a child to contribute 20 percent of his or her assets each year to college costs, whereas parents are expected to contribute a maximum of 5.6 percent of their assets. If assets have been accumulated in a child’s name, parents may want to consider using these assets to pay for the first year of college. By reducing the child’s assets in the first year, the family will likely increase its chances to qualify for more financial aid in subsequent years.
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