Five Mistakes to Avoid When Maximizing Financial Aid
Many parents assume that clever ways exist to maximize financial aid awards.
It is possible to increase eligibility for financial aid, although it’s usually just around the edges. You need to be careful because pursuing some strategies to maximize financial aid can backfire and cost you.
Here are five mistakes to be aware of:
1. Failing to understand when increasing financial aid is possible.
If you have less money in the bank, your child should qualify for more financial aid. That is an easy assumption to make, but sometimes having fewer assets will be irrelevant.
In a recent email, a dad told me that he had been urged to limit his assets to qualify for financial aid.
“I’ve been advised to do everything from spending down my investments to putting them in the hands of relatives in order to minimize their impact,” he wrote in an email.
To his credit, the dad didn’t feel right hiding his assets and he questioned the wisdom of spending down his cash since he needed it to pay for college.
I told the father that using either of these dubious strategies wouldn’t work because North Carolina State University, which is where his daughter attends, wouldn’t have awarded his family need-based financial aid anyway.
Why? Because his daughter, who is a freshman, is an out-of-state student and public universities routinely reserve their institutional grants for state residents.
With rare exceptions, students are only eligible for institutional aid at public universities in their own state. Nonresidents at state universities can only hope for merit scholarships from their institutions.
2. Contributing more to retirement accounts.
It makes financial sense for parents to contribute to Individual Retirement Accounts, 401(k)s and other workplace retirement plans for their own future financial security, but doing so simply to increase financial aid is unlikely to help.
Many parents think that stuffing more money into their retirement accounts is a wise idea because the financial aid formulas only assess nonretirement assets when determining if a student is eligible for need-based aid.
For instance, the FAFSA doesn’t even ask if you have any money in qualified retirement accounts. So you could have $1 million sitting in your IRA and 401(k) and it will never show up on the financial aid form.
There is a major problem with this strategy, however, which can turn it into a fruitless exercise. Starting two years before a child begins college, retirement contributions that parents make will be added back into their income.
Let’s assume, for example, that a parent contributed $10,000 into a 401(k). Once that money is inside the IRA that $10,000 would no longer be considered an asset for financial aid purposes. However, that $10,000 contribution will still be counted as income on the financial aid forms.
Here’s why: When you file the FAFSA and CSS/Financial PROFILE, you must use two-year-old tax returns. On your tax return you must declare certain types of untaxed income, such as retirement plan contributions.
Thus, contributions to a qualified retirement plan will shelter the contributions as assets, but will not shelter them as income.
If the parents add to retirement accounts three years prior to a child heading off to college then they could avoid declaring these contributions on the aid forms. Parents, however, are rarely exploring financial aid strategies three years in advance.
The only exception to this rule is contributions to a Roth IRA. Unlike other popular retirement accounts, contributions to a Roth don’t provide an upfront tax break so they don’t generate untaxed income.
3. Voluntarily reducing your salary.
Some parents assume that a ticket to qualify for more aid is to voluntarily reduce their income.
In hopes of eventually qualifying for more aid, I heard this month from a 65-year-old dad, who is considering trying this strategy. The wife is already retired and he will join her by the time their daughter is in college.
Here is what he proposed:
“My plan is to reduce my taxable income by going part time in my engineering job on January 1 and maintain most of our spending level by refinancing our home and pulling out home equity. If necessary, additional funds can be pulled out of a Roth IRA income free.”
Many reasons exist for why this would likely be a major mistake.
No. 1. The dad would be reducing income at the very time when he should be contributing more money for his future retirement.
No. 2. The couple would be making their retirement more precarious by pulling equity out of their home. Most families should try to pay off their mortgages in full by the time they retire.
No. 3. It’s typically best to delay making withdrawals from a retirement account for as long as possible. What’s more, money pulled from a retirement account will be added back as income on financial aid application forms.
No. 4. Just because the household income drops doesn’t mean the student will get more financial aid. The dad said his daughter was a “B” student with some learning disabilities. Without a sterling academic record, she wouldn’t have any chance of getting into the elite colleges that are essentially the only ones that meet 100% of its students’ financial aid.
4. Buying insurance to hide assets.
Beware of insurance agents who promise fatter aid packages if you divert your assets into life insurance or annuities.
Here’s an example of how this questionable strategy can backfire from Stephanie Hancock, a Certified Financial Planner in Los Angeles, who advised a father who got snookered.
Hancock said an agent had advised the man, who had $500,000 in taxable assets, to move it into a life insurance policy so the money could be hidden from the financial aid formulas. The FAFSA doesn’t ask about the cash value of life insurance, but some PROFILE colleges do assess the value.
The policy, with a $2.2 million death benefit, was going to cost $18,000 a year. The award the student ultimately received was $8,000 and only a portion of that was need-based. So the family was in the hole for hiding money in the insurance policy.
The real beneficiary in this example was the insurance agent, who received a commission. These insurance peddlers often have little understanding of the financial aid rules and they count on parents not even knowing when they have been ripped off.
5. Selling investments to pay down debt.
Using money in the bank to pay down consumer debt – such as credit card debt, auto loans and, in some cases, mortgages can increase eligibility for need-based financial aid. In effect, this makes a reportable asset, the money in the bank, disappear because most forms of debt are ignored on financial aid forms.
It also makes good financial sense to pay down debt, because the interest rate on the savings is usually less than the interest rate on the debt. Of course, one should maintain half a year’s salary in a savings account as an emergency fund.
However, paying down debt can backfire if you sell appreciated assets as part of this strategy. Selling stocks, bonds and mutual funds can yield capital gains, which count as income on the FAFSA and PROFILE forms. The increase in income will reduce eligibility for need-based aid, potentially wiping out any increases in aid eligibility from reducing reportable assets.
If you can’t offset the capital gains with capital losses, plan on using this strategy at least three years before you apply for financial aid, so that the capital gains won’t hurt eligibility for need-based financial aid.
Lynn O’Shaughnessy is a best-selling author, speaker and journalist. Her book, The College Solution: A Guide for Everyone Looking for the Right School at the Right Price, is available on Amazon.com.