Ask Liz Weston

Get smart with your money

College Savings

Q&A: How to get the maximum in financial aid

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Dear Liz: I’m having trouble finding information about how to structure my finances to get the maximum financial aid for my kids when they enter college. For example, will contributing to an IRA instead of a taxable investment account matter? Should I focus on paying off my mortgage or should I buy a bigger house and acquire debt in the process if I want my kids to qualify for more aid? There’s plenty of advice out there about how to minimize taxes — for example, by contributing to 401(k)s or selling losing stocks at year-end. But I’m interested in legally and ethically shielding my assets from the family contribution calculations used by the Free Application for Federal Student Aid. Any idea how I can learn more about the inner workings of the FASFA formula?

Answer: Before you rearrange your finances, you need to understand that most financial aid these days consists of loans, which have to be repaid, rather than scholarships and grants that don’t. Wanting your kids to qualify for more aid could just lead them to qualify for more debt.

Also, the FAFSA formula weighs income more heavily than assets. If you have a six-figure income and only one child in college at a time, you shouldn’t expect much need-based financial aid, regardless of what you do with your assets.

That said, there are some sensible ways to shield assets from the formula, and often they’re things you should be doing anyway: maxing out your retirement contributions, for example, and using any non-retirement savings to pay down credit cards, car loans and other consumer debt.

Using non-retirement savings to pay down mortgage debt helps with the federal formula, but may not help much with private schools that include home equity in their calculations. Either way, taking on a bigger mortgage with college looming is rarely a good idea.

You can get some idea of how much the federal formula expects you to pay for your children’s educations by using the “estimated family contribution” calculator at FinAid.org. Another great source of information is the book “Filing the FAFSA: The Edvisors Guide to Completing the Free Application for Federal Student Aid” by Mark Kantrowitz and David Levy.

Should you hide assets to get more financial aid?

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Dear Liz: We have a son who is a high school junior and who is planning on going to college. We met with a college financial planner who suggest we put money in a whole life insurance policy as a way to help get more financial aid. Is that a good idea?

Answer: Your “college financial planner” is actually an insurance salesperson who hopes to make a big commission by talking you into an expensive policy you probably don’t need.

The salesperson is correct that buying a cash-value life insurance policy is one way to hide assets from college financial planning formulas. Some would question the ethics of trying to look poorer to get more aid, but the bottom line is that for most families, there are better ways to get an affordable education.

First, you should understand that assets owned by parents get favorable treatment in financial aid formulas. Some assets, such as retirement accounts and home equity, aren’t counted at all by the Free Application for Federal Student Aid or FAFSA. Parents also get to exempt a certain amount of assets based on their age. The closer the parents are to retirement, the greater the amount of non-retirement assets they’re able to shield.

Consider using the “expected family contribution calculator” at FinAid.org and the net cost calculators posted on the Web sites of the colleges your son is considering. Do the calculations with and without the money you’re trying to hide to see what difference the money really makes.

Most families don’t have enough “countable” assets to worry about their effect on financial aid formulas, said college aid expert Lynn O’Shaughnessy, author of “The College Solution.” Those that do have substantial assets have several options to reduce their potential impact, including spending down any custodial accounts, paying off debt and maxing out retirement plan contributions in the years before applying for college.

Another thing to consider is that most financial aid these days comes as loans that need to be repaid, rather than as scholarships or grants that don’t. So boosting your financial aid eligibility could just mean getting into more debt.

Meanwhile, it’s generally not a good idea to buy life insurance if you don’t need life insurance. The policy could wind up costing you a lot more than you’d save on financial aid.

If you’re still considering this policy, run the scheme past a fee-only financial planner—one who doesn’t stand to benefit financially from the investment—for an objective second opinion.

Uncle Sam can help with education costs

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Dear Liz: I have rental property, own my home outright, am contributing to a 401(k) and have a pension, so finances are not a big issue. I do have an adult son in law school and would like to know the most fiscally prudent way to pay for it. Are there limits on gifts, and can the money be tax deductible since it is an investment to increase his future earnings?

Answer: Interest on student loans is generally tax deductible for the person who takes out the loan if his or her income is below certain limits (the deduction begins to phase out at $50,000 adjusted gross income for single filers and $100,000 for joint filers), said Mark Luscombe, principal analyst for CCH Tax & Accounting North America.

Education tax credits also can help offset college costs. The American Opportunity Credit is limited to the first four years of college, but law school expenses could qualify for the Lifetime Learning Credit, Luscombe said. The credit starts to phase out at $53,000 of adjusted gross income for single filers and $107,000 for joint filers, he said.

If you don’t qualify for other credits and your son is under age 24, you may be able to deduct up to $4,000 in qualified education expenses if your income is below certain limits (modified adjusted gross income of $160,000 if married filing jointly or $80,000 if single), Luscombe said. You can find out the details in IRS Publication 970, Tax Benefits for Education.

Another potential tax benefit has to do with the gift tax. You can avoid the hassle of filing a gift tax return, or using up any portion of your gift tax exclusion, if you pay tuition or medical bills for someone else. You have to pay the provider directly — you can’t cut a check to the person receiving the services.

Normally, you’d have to file a gift tax return if you gave any recipient more than the gift tax exclusion limit, which is $14,000 in 2013. You wouldn’t be subject to an actual gift tax, however, until the sum of the contributions over that $14,000 limit exceeded your lifetime gift exemption. The gift exemption is currently $5.25 million, so the gift tax is an issue that few people face.

If you are that rich and generous, then you’ll probably want to discuss your situation with a qualified estate planning attorney to find the best ways to give.

Student loans may be better than home equity borrowing

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Dear Liz: I am almost finished with my associate degree at my local community college and will be starting my undergraduate degree in January. I have been lucky enough to accrue no college debt so far but know I will when I start my bachelor’s degree. I am considering taking out a home equity loan to cover this cost, borrowing around $10,000. I got a great deal on my house and it continues to grow in value even with this economy. Your thoughts on this?

Answer: Home equity loans are actually more expensive than most federal student loans. Home equity loan rates for people with good credit range from 7% to 9% in many areas, while the current rate for direct, unsubsidized federal student loans is 5.41%. Furthermore, home equity loans aren’t as flexible and have fewer consumer protections than federal student loans.

You may initially get a lower rate on a home equity line of credit, but these variable-rate loans easily could get more expensive as interest rates rise.

Not only do federal student loans offer fixed rates, but they provide many affordable repayment options plus deferrals or forbearance if you should lose your job or run into other economic setbacks. You don’t have to demonstrate financial need to get federal student loans, although people with such needs can get subsidized loans with a lower interest rate. Your college’s financial aid office can help you apply.

How much college savings is enough?

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Dear Liz: My husband and I have three children, two in elementary school and one in middle school. Through saving and investing, we have amassed enough money to pay for each of them to go to a four-year college. In addition, we have invested 15% of our income every year toward retirement, have six months’ worth of emergency funds and have no debt aside from our mortgage and one car loan that will be paid off in a year. Considering that we have all the money we will need for college, should we move this money out of an investment fund and into something very low risk or continue to invest it, since we still have five years to go until our oldest goes to college and we can potentially make more money off of it?

Answer: Any time you’re within five years of a goal, you’d be smart to start taking money off the table — in other words, investing it more conservatively so you don’t risk a market downturn wiping you out just when you need the cash. The same is true when you have all the money you need for a goal. Why continue to shoulder risk if it’s not necessary?

You should question, though, whether you actually do have all the money your kids will need for college. College expenses can vary widely, from an average estimated student budget of $22,261 for an in-state, four-year public college to $43,289 for a private four-year institution, according to the College Board. Elite schools can cost even more, with a sticker price of $60,000 a year or more.

Another factor to consider is that it may take your children more than four years to complete their educations, particularly if they attend public schools where cutbacks have made it harder for students to get required courses in less than five years, and sometimes six.

So while you might want to start moving the oldest child’s college money into safer territory and dial back on the risks you’re taking with the younger children’s funds, you probably don’t want to exit the stock market entirely. A 50-50 mix of stocks and short-term bonds or cash could allow the younger children’s money some growth while offering a cushion against stock market swings.

A session with a fee-only financial planner could give you personalized advice for how to deploy this money.

Using a Roth for college: hazards and benefits

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Dear Liz: My husband and I have been putting 5% and 6%, respectively, into our 401(k) accounts to get our full company matches. We’re also maxing out our Roth IRAs.

The CPA who does our taxes recommended that we put more money into our 401(k)s even if that would mean putting less into our Roth IRAs. We’re also expecting our first child, and our CPA said he doesn’t like 529 plans.

What’s your opinion on us increasing our 401(k)s by the amount we’d intended to put into a 529, while still maxing out our Roths, and then using our Roth contributions (not earnings) to pay for our child’s college (assuming he goes on to higher education)?

Our CPA liked that idea, but I can’t find anything online that says anyone else is doing things this way. I can’t help but wonder if there’s a catch.

Answer: Other people are indeed doing this, and there’s a big catch: You’d be using money for college that may do you a lot more good in retirement.

Contributions to Roth IRAs are, as you know, not tax deductible, but you can withdraw your contributions at any time without paying taxes or penalties. In retirement, your gains can be withdrawn tax free. Having money in tax-free as well as taxable and tax-deferred accounts gives you greater ability to control your tax bill in retirement.

Also, unlike other retirement accounts, you’re not required to start distributions after age 70 1/2. If you don’t need the money, you can continue to let it grow tax free and leave the whole thing to your heirs, if you want.

That’s a lot of flexibility to give up, and sucking out your contributions early will stunt how much more the accounts can grow.

You’d also miss out on the chance to let future returns help increase your college fund.

Let’s say you contribute $11,000 a year to your Roths ($5,500 each, the current limit). If you withdraw all your contributions after 18 years, you’d have $198,000 (any investment gains would stay in the account to avoid early-withdrawal fees).

Impressive, yes, but if you’d invested that money instead in a 529 and got 6% average annual returns, you could have $339,000. At 8%, the total is $411,000. That may be far more than you need — or it may not be, if you have more than one child or want to help with graduate school. With elite colleges costing $60,000 a year now and likely much more in the future, you may want all the growth you can get.

You didn’t say why your CPA doesn’t like 529s, but they’re a pretty good way for most families to save for college. Withdrawals are tax free when used for higher education and there is a huge array of plans to choose from, since every state except Wyoming offers at least one of these programs and most have multiple investment options.

Clearly, this is complicated, and you probably should run it past a certified financial planner or a CPA who has the personal financial specialist designation. Your CPA may be a great guy, but unless he’s had training in financial planning, he may not be a great choice for comprehensive financial advice.