To some extent, financial aid process is a zero-sum game: the college will first expect you and your kids to contribute a certain amount based on your assets, earning power and other factors, and then will use different kinds of financial aids, like student loans, grants or scholarship, to meet the gap. Therefore, as I mentioned in the last post, it is important to have the right financial "structure" -- the optimal mix of assets between different kinds of accounts -- in place by the time your kids start the college application, to lower college's expectation for your share of the contribution.
To understand what is the right mix, it is crucial to understand how financial needs are being established. First, take a look at the most important formula in the financial aid game:
Cost of Attendence - Expected Family Contribution (EFC) = Financial Need
Yes, the financial need is based on the cost of the school your kid will attend, and an "expected" amount financial aid officers will calculated based on your overall financial status. As you cannot influence the cost of attendence once you pick up the school, what you can do is to play by the rules and lower your EFC as much as possible. (Your kids may choose to attend a "cheaper" schoool, but you might still want to minimize yur EFC, because EFC calculation is irrelevant of how expensive or how inexpensive of the school.)
EFC is usually determined by the following factors:
- Parent Income
- Allowances against Income
- Parent Assets
- Number of Family Members in the Household
- Number of Children currently Enrolled in College
- Non-Custodial Contribution
- Student Income & Assets
Once you are into this process, you might soon realize that there are two sets of formula to determine EFC: the Federeal Metholody (FM), which is used to determine eligibility for federal aid, and the Institutional Methodology (IM), which is used by most colleges and universities in determining institutional scholarship funds.
To date, the best comparison between FM and IM I found is from Brown University's Office of Financial Aid. Its page summarizes both methodologies and compares them head-to-head.
If you carefully study the information, you may receive some hints about how to best arrange your assets for maximum financial aid eligibility:
- Both FM and IM exclude retirement plans in the net assets calculation; retirement plans include 401(k), Roth IRA, pension plan, etc.
- In FM, home equity from your primary residence is excluded from calculation. IM does include home equity in the assets calculation.
- Student is expected to contribute up to 35% of assets under his/her name annually for the college expenses.
- Value of prepaid tuition plans will not be included in the net assets, but Education IRAs and college saving plans (like 529) will be included. However, distribution from prepaid tuition plans will be considered "outside resources," which will reduce financial needs dollar by dollar.
- Not much can you play with your income at the years of college: even your contributions to 401(k) and your social security benefits, which do not necessarily show up in your tax return, will be included to calculate your earning power. Also, tax-free distribution from Roth IRA for educational purposes can be included in your income stream.
In the next part, I will play with a financial aid calculator, and draw some early conclusion on how to best position assets to balance retirement savings and college savings. Keep tuned.
(This article is a component of the 10-part "Saving for College" series at PFBlog. If you want to read from the start, follow the links at this Table of Contents page.)
