Our blog post today is from Ann Garcia, CFP®, of Independent Progressive Advisors, aka The College Financial Lady.
Many grandparents want to help pay for college. Unfortunately, this help often results in a student’s tuition bill going up because they lose financial aid. College is far more expensive for the current generation than for previous ones so helping is wonderful. But it’s best to take a version of the Hippocratic oath—do not harm—when trying to help with the cost of college.
How do you help and not harm? First, by understanding how college financial aid works. About 70% of college students receive some form of grant or scholarship aid. These scholarships and grants can be either need- or merit-based. There is a big difference between the two. Eligibility for need-based aid is determined by strict formulas that assign values to parents’ and students’ income and assets and “third-party” assistance. Merit aid is far more discretionary and is generally used to attract students that will benefit the school in some way. Most people think of sports scholarships when they think of merit aid but t’s far broader and the majority of merit aid goes to students with high GPAs and test scores. In fact, in the 2014-2015 school year, academic scholarships dwarfed athletic scholarships with about $8 billion more in academic than in athletic grants, according to scholarshipstats.com.
So, who gets which type of aid? Need-based aid depends on a family’s resources and the cost of attendance at a particular school. This means that a student may be a need-based aid candidate at one school and not another. The family’s Expected Family Contribution is calculated via the FAFSA or CSS PROFILE. If it’s less than the school’s cost of attendance, then the student is a need-based aid candidate. Families can estimate their EFC using the FAFSA4caster. (If you want to ballpark it, assume 25-30% of parents’ income, 5% of parent non-retirement assets, and 20% of student assets.) Grandparents wanting to help can assume that students attending private colleges are eligible for some form of need-based aid; for those attending public schools, need-based aid generally stops for families with household incomes above $120,000.
Merit aid, on the other hand, typically goes to students in the top quartile academically based on high school results. This can be either GPA, test scores, or both. Why high school results? Because merit aid is used to recruit students who will make the school look better to prospective students, typically by raising the average GPA or test scores of the student body.
If the student you intend to help is a need-based aid candidate, then you need to develop a strategy to help, not harm, their ability to pay for college. Here’s why: Any money given to the student by someone other than the custodial parent (grandparents and ex-spouses being the main givers in these cases) counts in the aid formulas as the student’s income. And the aid formulas consider 50% of the student’s income to be available to pay for college. So if you give a student $10,000, it could increase their EFC by $5,000 and the school would reduce their scholarship by that amount.
What’s a well-intentioned grandparent to do? There are several ways to help a student who is eligible for need-based aid. The right choice for you and for the student depends in large part on how much you plan to give and other goals you have in helping.
Starting your own 529 plan account. Opening your own 529 account is most helpful if you have very large sums available (the cost of several years’ attendance). That’s because there may be benefits to the grandparent in contributing to a 529 plan—including upfront tax breaks in some states and removing assets from the estate—but when the money comes out, it’s treated as income to the student. Student income increases the EFC (and therefore decreases the aid award) by up to 50% of the amount of income: a $10,000 distribution from a grandparent-owned 529 account might cost a student $5,000 in financial aid. 529s have several additional benefits for grandparents: If the student doesn’t use all the money, a new beneficiary can be named to use the remainder of the funds. And the funds in the account grow tax-free, and distributions are tax-free as long as they’re used to pay for qualified higher education expenses. To maximize the benefit of a grandparent-owned 529, you would wait to use it until after the student has completed their last FAFSA. But that also means the student needs to borrow more in the early years to avoid tapping the grandparent 529.
Contributing to the parents’ 529 plan account. You can always give the parents money to deposit into their 529 account. But many states allow anyone to contribute directly to a 529 account, even if they don’t own it, and to get the tax deduction for doing so. Check with the plan the parents use to see if you can get a tax break for your contribution. Grandparents contributing smaller amounts might do best by the student by going this route. That’s because parent assets are the aid formulas’ version of Most Favored Nations: parents get an “Asset Protection Allowance” that shields a portion of their assets—usually around $19,000 in the FAFSA—and only 5.64% of assets above the allowance count towards the EFC. In addition, distributions from a parent-owned 529 don’t count as income anywhere in the aid formulas. So that $10,000 that cost the student $5,000 in aid when it came out of a grandparent 529 would only cost a maximum of $564 in foregone aid if it came out of the parents’ 529 account.
Gifting to the student after graduation. A strategy that maintains full aid eligibility for the student is to have the student take out loans while in college, then gift them the money to repay the loans after graduation. Most need-based aid packages include loans as a significant component. At a minimum, the student will be offered a subsidized direct student loan; in addition, the family may not be able to actually pay the EFC which will translate to more borrowing. After the last FAFSA has been filed, grandparents can gift up to the annual federal gift tax exclusion ($14,000 per grandparent per giftee) to help pay off student loans. In this case, the grandparents’ funds are never reported on the FAFSA so they never increase the family’s EFC. If this is the best path for your family, it is wise to either set up a separate account to hold the money you’ve committed or update your IRA beneficiaries to name the student as a beneficiary in the amount you intend to give them to ensure that you’re able to uphold your end of the bargain.
Whichever of these paths you choose, the most important tactic in your plan is this: Talk to the parents and the student about your desire and ability to help. There may be other factors or resources that you aren’t aware of that would lead to one or another of the above strategies. Students trying to plan their college path are better able to do so when they understand the resources available to them.