How Financial Aid Works

The biggest problem people have with financial aid is understanding what is call your Expected Contribution. The Expected Contribution is a number which represents how much you are expected to contribute (pay) for your / your child's college education. The number comes from a pretty complex formula that is based in large part around your income. Since the financial aid system is primarily a federal government led system (they are the ones who invented the FAFSA) it is a pretty difficult job to lie about your income because they already have (and will want another copy) of your income taxes. Discrepancies here are a recipe for trouble. Still, there is one area that can make a big difference.

Parent Contribution smaller than Student Contribution

Ok, here is the huge thing that can litterally save or ruin your financial aid plans. The student is expected to contribute 20% of their assets to the cost of attending college while the parents are expected to contribute 5.64%. The difference is HUGE! And it is why some the strategies that used to be a good idea are terrible ideas now. With recent changes to UTMA/UGMA laws, these things are mostly worthless. The amount of money you will save on taxes will pale in comparison to the smack down you'll take by these being assessed at nearly 15% higher rate than if the money had been saved in the parent's name.

Even better is to use a 529 plan. The 529 plan allows the money to grow without being taxed. If the money is used for college, it will not be taxed on withdrawl either. Plus, many states give the parents some sort of state income tax break for contributing to the state's 529 plan. The 529 plan counts as parent's assets and therefore only counts against you at the 5.64% rate.

Forget what you have heard about these kinds of plans going bankrupt. Those were pre-paid tuition plans organized under the same tax advantages. The non-prepaid plans cannot go bankrupt just like your 401(k) can't go bankrupt, because it it your money. There is nothing to go bankrupt. Even if the 529 plan went under, the assets are still invested in something (usually mutual funds) and those investments are the ones that would have to go bankrupt.

Go one better, and have grandma and grandpa open a 529 plan for the grandkids. There is no restriction on who can open a 529 plan or how many 529 plans can be setup for a child's benefit. So, Mom and Dad open a 529 plan and put their money in there. Grandpa and Grandma open another 529 plan and put their money in there. Now it isn't even in the parent's name!

No Savings Unless You Have No Debt

Again, because the financial aid office is going to look at the money and assets you have, the time to pay off your credit cards and home equity lines is BEFORE you apply for financial aid.

Consider this: A family has $15,000 on a HELOC and $20,000 in the bank. They like it this way because they get to deduct the interest on the HELOC and they like the cushion of the $20,000 in the bank. Well, at financial aid time, they are going to lower the child's financial aid package by $1,120. But, if the family had paid off the $15,000 HELOC then the aid package would only be lowered by $280 because there would be just $5,000 in the bank. This is especially important for a HELOC because you can always get the money back later! A HELOC is an open line of credit, so if you pay it off it isn't like you have nowhere to go if you need money later. For the same reasons you want to pay off all of your credit cards and have nothing left in the bank. (Obivously if you have more assets than debts this isn't going to apply as much -- and kudos by the way -- but it can help some. Pay off those cards and equity lines in November (don't mess around with waiting until December) fill out your FAFSA right away in Janauary and then wait until AFTER you recieve AND accept your financial aid package before building up any more cash.

Spend Junior's Money First

Likewise, because the student's assets are assessed at a much higher rate than the parent's it is wise to spend whatever the student has first. In other words if for whatever reason little Johnny has $25,000 in the bank, then the first year should all come out of that until it is gone, even if Mom and Dad have $100,000 put aside (this assumes that you aren't trying to let Johnny keep the $25,000 without using it for college). By spending away the $25,000 that means that next year's financial aid package won't count that $25,000 at the much higher 20% and the $25,000 extra in the parent's names will only come off at 5.64%.

I Want Every Detail

If you want to know everything the professioanl finacial aid people know, then you can get the full guide. The Federal Government publishes a guide each year for financial aid professionals. I don't know how many of them actually read it, but it has every detail that is publicly availible. You can get it direct from the Department of Education under Information for Financial Aid Professionals (IFAP). It is 35 pages this year and it reads like the instructions for your Form 1040, but if you are willing to dig in, it is all in there.