Financial assets belonging to children have a greater impact on a family's eligibility for federal financial aid than assets belonging to parents. Here's how to factor in this reality when creating a college savings strategy.
How Families Report Assets
To be considered for federal and state financial aid, students and families must report any parent assets and child assets on the FAFSA (Free Application for Federal Student Aid). Most colleges also use the information reported on the FAFSA to calculate aid from their own resources. (About 300 mostly private colleges use a different aid application for this purpose called the CSS/Financial Aid PROFILE. See sidebar.)
Parents' and Children's Assets Are Counted Differently
- The child's assets count for more. On the FAFSA, 20 percent of the child's assets may be counted in aid calculations. This is true even if the child's assets are funded by the parents or others.
- The parents' assets count for less. Up to 5.64 percent of the parents' unprotected assets may be counted in applications for federal or state aid.
- A portion of parent assets is protected. "Protected" means a percentage of the assets is not counted at all. A dependent child has no asset protection but parents and independent students do. The exact amount protected depends on several factors such as the number of parents and the age of the older parent. Using the FAFSA, for example, if an older parent in a typical two-parent family is 45 years old, the parents can shield $30,700 of their assets from the EFC calculation (based on the FAFSA for the 2014-2015 school year).
What's Counted As an Asset?
Counted as assets on the FAFSA are money and property owned by parents or student. This includes savings and checking accounts, cash, the net worth of a business with over 100 full-time employees or a farm that is not the family's primary residence, investment accounts, non-retirement tax-deferred savings plans such as 529 accounts, tax-exempt interest income, tax credits, investment property, and many other types of assets.
The assets that most impact all aid calculations are investments held in the student's name, even if the parents control the investment and are funding it themselves. Typical accounts of this type are mutual funds, stocks, CDs, T-bills, bonds, and money market funds. Cash or property given to the student also counts as a student asset. On the bright side, any 529 account owned by a student is counted as belonging to the parent, not the student.
Some Assets Are Not Counted but Still Affect Financial Aid
Retirement accounts. The FAFSA does not ask about accounts designed for retirement savings. But the contributions and withdrawals from these accounts must be reported on the FAFSA that covers the year in which the transactions occurred.
- Traditional IRAs. Withdrawals from these accounts must be reported as taxable income. Contributions to such accounts should be reported as untaxed income.
- Roth IRAs. Withdrawals of capital gains from such accounts should be reported as taxable income.
- 401(k) plans. Withdrawals from such accounts will count as taxable income unless the withdrawal is a loan. Contributions to such accounts should be reported as untaxed income.
- Pensions. Untaxed payments from pension plans must be reported as taxable income. Voluntary contributions to pension plans should be reported as untaxed income.
Assets held by others. Assets intended to help pay for college that are owned by others, such as grandparents, are not reported on the FAFSA. However, once the money is given to the student or spent on his or her behalf, it must be reported as untaxed student income on next year's aid applications. Since student income is assessed at much higher rates than parent income, this "gift" could significantly impact the amount of aid the student is eligible for. This could be avoided by transferring the assets to the parents so that they will be assessed at the parents' lower rate, or waiting until college is done to give the money to the student.
Parents should consider transferring assets held in the name of a college-bound child to their own names. They should make these transfers before the year covered by any aid application. Otherwise, they will have to report these assets as belonging to the child.
However, some types of accounts must remain in the child's name:
- Custodial accounts. These include accounts opened under the Uniform Gifts to Minors Act, the Uniform Transfer to Minors Act, or the Model Gifts of Securities to Minors Act.
- Custodial account exception. Parents may cash in custodial accounts belonging to their children and transfer the funds to a state tuition savings or prepaid tuition plan (also called a 529 plan) with the child as the beneficiary. Not all plans accept such transfers, however. They can also use the funds to benefit the child prior to the date they sign the child's freshman aid applications.
- Trusts. Most trust funds are considered to be owned by the child.
The college savings and investment accounts that parents should normally transfer from their child's name to their own name include:
- Series I and EE savings bonds. Parents must have originally purchased the bonds to make this transfer.
- Any noncustodial accounts. These include certificates of deposit, regular savings accounts, and other accounts opened in the child's name but not regulated by the custodial account laws mentioned above.
College savings investments typically yield capital gains, which may be taxable. (Gains from 529 accounts, Coverdell Education Savings Accounts, and some bonds are not taxed if used for eligible college expenses.)
For assets owned by the child, the age of the child determines the tax rate for investment gains of $2,000 or less. Effective for the 2013 tax year, dependents from birth to age 18 receive the first $1,000 of their unearned (investment) income in a single year tax-free. The next $1,000 is taxed at the child's rate. Remaining unearned income above $2,000 is taxable at the parents' rate. This rule also applies to children over 18 but under 24 who are full-time students.
The Smartest Way to Save for College
Moving investments, assets, and income sources around can be a minefield with substantial consequences on financial aid and taxes. Consult with a financial or tax advisor familiar with these implications before making such decisions. In most cases, keeping ordinary investment accounts in the parents' names is the smartest move, particularly for middle-income families.
Even with careful planning, some families will not qualify for financial aid. Those families may be better served by different asset management strategies. As always, the earlier parents act, the more options they'll have, and the more they'll save and earn.
Note: Financial information provided on this site is of a general nature and may not apply to your situation. Contact a financial or tax advisor before acting on such information.