Let's face it, there are countless reasons why families should save for college, yet some parents fear that having money set aside will hurt their child's chances of getting financial aid. But the reality is, you may still qualify for need-based financial aid even if your child has a college fund. And with four-year costs of attendance exceeding $100,000, most families will want as much help as they can get. What's more, most aid is given out in the form of loans that will eventually need to be paid back, so you're better off being able to pay as much as possible out of pocket.
There are three things that will determine how much aid a student will qualify for – the school's COA (cost of attendance), financial resources provided to the student from outside sources (think: scholarships) and the Expected Family Contribution (EFC).
What you'll want to pay close attention to is how your EFC is calculated. The formula uses information provided on your child's Free Application for Federal Student Aid (FAFSA) to determine the family's available funds to pay for college. But what's important to understand is that not all assets and income are given equal weighting. That means some of your savings may have a greater impact on the student's eligibility for financial aid than others.
Below are some things to consider when saving for college if your child will apply for financial aid. Keep in mind that these figures apply to federal need-based aid, and some colleges will use a different formula to determine the amount they offer in their own grants and tuition discounts.
Consider how your savings account will affect your EFC
- Roth IRA (parent-owned) - Money held in a qualified retirement account is not counted at all in determining EFC.
- Custodial account – 20% of a student's assets, such as an UTMA account, are counted as money available to pay for college.
- 529 plan – 529 plans receive special treatment on the FASFA, and will not be included with student-owned investments. The value of a 529 plan owned by a parent or dependent student is counted as a parental asset on the FAFSA. Up to 5.64% of the value of parental assets is included in a family's EFC.
- Grandparent-owned 529 plan – If the account owner is anyone other than a student or one of their parents, the assets will not have to be reported on the FASFA.
What's counted as income on the FAFSA?
- Roth IRA (parent-owned) – While you can take a withdrawal from a traditional or Roth IRA to pay for college, the entire amount of the withdrawal (including principal and earnings) will count as income on the FAFSA. This is true whether or not the withdrawal triggered taxable income.
- Custodial account – Any interest, dividends or capital gains that are reported on the student's income tax return will be counted as student income on the FAFSA.
- 529 plan – Withdrawals from a 529 plan or other Education Savings Account (ESA) are excluded from your federal income tax return and therefore not reported on the FAFSA. Grandparent-owned 529 plan – The amount of withdrawals from a 529 plan owned by anyone other than the student or one of their parents will have to be “added back” when reporting income on the FAFSA.
Income tax considerations
- Roth IRA (parent-owned) – If you're 59½ or older when you take money out of a Roth IRA your withdrawal will be tax-free and penalty-free. This is true whether you use the money to pay for college or anything else. If you're not 59 ½ yet, you can withdraw the amount of your contributions without having to pay taxes or penalty. There is also an exception to the penalty rule for early withdrawals when the funds are used to pay for higher education expenses.
- Custodial account – Any gains in the account will be subject to the kiddie tax. In 2018 that means the first $1,050 in income will be tax-free, covered by the child's standard deduction, the next $1,050 will be subject to the child's tax rate and any of the child's unearned income in excess of $2,100 will be taxed at the rates that apply to trusts and estates.
- 529 plan – Earnings in the account grow federal tax-free and are not taxed at withdrawal as long as the money is spent on higher education expenses, which now includes computers and other similar technology equipment. The majority of states also offer an income tax credit or deduction for 529 plan contributions. Grandparent owned 529 plan – Earnings in any 529 account will receive the same federal tax treatment, and depending on the plan, the account owner may be able to receive a state tax benefit for contributions.