Parents often worry about making a mistake that will ruin their student’s future. They worry more about what they don’t know than what they do know. Here is a list of some of the more common mistakes families make that affect college affordability and eligibility for student financial aid.
Saving for college in the child’s name instead of the parent’s name. Custodial bank accounts, such as an UTMA or UGMA, are reported as a student asset on the Free Application for Federal Student Aid (FAFSA). Student assets will reduce eligibility for need-based aid by 20 percent of the net worth of the asset. Some parent assets are sheltered by the financial aid formula; the remaining reportable assets are assessed on a bracketed scale with a maximum rate of 5.64 percent.
Saving for college in a grandparent-owned 529 college savings plan, instead of a parent-owned 529 plan. A 529 plan that is owned by the student or a dependent student’s parent is reported as a parent asset on the FAFSA, but any distributions from such a 529 plan are ignored. A 529 plan that is owned by anybody other than the student or parent, such as a 529 plan owned by a grandparent, aunt or uncle, is not reported as an asset on the FAFSA, but distributions from such a 529 plan are reported as untaxed income to the student. Untaxed income can reduce the student’s eligibility for need-based financial aid by as much as half of the distribution amount, a much harsher impact than the 5.64 percent reduction based on the net worth of the parent assets.
Trust funds almost always backfire. Most trust funds must be reported as an asset on the FAFSA, even if access to the principal is restricted. Unfortunately, the restrictions often prevent the family from liquidating the trust to pay for college, so the trust fund will reduce the student’s eligibility for need-based financial aid year after year.
Failing to file the FAFSA. You can’t get aid if you don’t apply. Some parents incorrectly believe that their child will not qualify for need-based aid. The financial aid formulas are complicated enough that it is difficult to predict whether the student will qualify for financial aid without applying. For example, the number of children in college at the same time can have a big impact on eligibility for need-based aid (e.g., having two children in college simultaneously is like cutting the parent’s income in half). Net home equity and retirement plans are not counted by the federal financial aid formula. It takes less than an hour for most families to file the FAFSA online.
Waiting to file the FAFSA. It is important to file the FAFSA as soon as possible after January 1. Students who file the FAFSA in January, February or March tend to receive more than twice as much grant money as students who file the FAFSA later. Many states and colleges have very early FAFSA deadlines, with some states awarding state grants on a first-come, first-served basis until the money runs out. Do not wait until federal income tax returns have been filed or the student has been admitted to a college. It is ok to use estimated income and tax information based on 1099 and W-2 statements, the last pay stubs of the year or the previous year’s federal income tax returns. The family will be required to update the information on the FAFSA after they have filed their federal income tax returns.
Artificially increasing income the year before the child enrolls in college and each subsequent year. Eligibility for financial aid during the academic year is based on income and taxes during the prior tax year, also known as the base year. Every $10,000 increase in parent income will reduce eligibility for need-based financial aid by about $3,000. Every $10,000 increase in student income will reduce aid eligibility by as much as $5,000. So, it is best to avoid artificially increasing income during the base year through capital gains and retirement plan distributions.
Failing to apply for scholarships. Many families wait until the spring of the senior year in high school to start figuring out how to pay for school. By then, half of the scholarship deadlines during the senior year alone have already passed. There are also many scholarships that can be won in younger grades. The sooner the student starts searching for scholarships, the fewer deadlines he or she will miss. Scholarships should be an integral part of the plan for paying for college. About one in eight college students uses private scholarships to pay for school, receiving on average about $4,000 per year.
Over-estimating the student’s eligibility for merit-based aid. Parents have a tendency to overestimate eligibility for merit-based aid and to underestimate eligibility for need-based aid. The student may be bright and talented, but that doesn’t mean that he or she will win a full-ride scholarship. There’s a lot of competition for scholarships. For example, there are more than 80,000 high school valedictorians and salutatorians each year. Some students do win a free ride each year, but most don’t. Less than 0.3 percent of college students have enough scholarship and grant funding to cover the full cost of attendance.
Failing to take advantage of the American Opportunity Tax Credit (AOTC). The AOTC provides a partially refundable tax credit worth up to $2,500 based on $4,000 in tuition, fees and textbook expenses. Internal Revenue Service (IRS) coordination restrictions prevent double-dipping, so taxpayers can’t use the same qualified higher education expenses to justify both a tax-free distribution from a 529 college savings plan and the AOTC. Thus, it is important to carve out $4,000 in college expenses each year that will be paid for with cash or loans, to qualify for the maximum tax credit.
Borrowing excessively to pay for school. Total student loan debt at graduation should be less than the student’s expected annual starting salary, and, ideally, a lot less. Keep student loan debt (and parent loan debt) in sync with income. Otherwise, the borrower will struggle to repay the debt and will need alternate repayment plans that make the monthly payment more affordable by stretching out the term of the loan. Unfortunately, a longer repayment term will increase the total interest paid over the life of the loan. Students who graduate with excessive debt have a tendency to delay life-cycle events, such as buying a car, getting married, buying a home, having children and saving for retirement.
Treating student loans like free money. After the student loans and other financial aid are applied to the tuition, fees and other institutional charges, the remaining credit balance is refunded to the student to pay for other costs, such as textbooks. Students sometimes use the refund to splurge on eating out, entertainment and gadgets. But, student loan money is a debt that must be repaid, usually with interest. Excess money can and should be returned to the lender to reduce the student’s education debt.
Choosing a college based on the amount of aid, as opposed to the net price. The net price is the difference between total college costs and the gift aid. Gift aid is the grants, scholarships, tuition waivers and other financial aid that does not need to be earned or repaid. The net price is the discounted sticker price, the amount of money the family will have to pay from savings, income and loans to cover college costs. If a $60,000-a-year college offers the student a $10,000 merit-based scholarship, the net price is $50,000, which is still much more than the family would pay for the student to enroll at a less expensive in-state public college with no financial aid.
Sending the student to a school that is more expensive than the family can afford. Before choosing a college, calculate the total net price for the student’s entire education. Also calculate the financial resources available to the family, including student income and assets, the student’s college savings plan, how much the parents can contribute from income, education tax benefits and a reasonable amount of student and parent education debt. If a college’s total net price exceeds the total financial resources available to the family, the student cannot afford to enroll at the college. Otherwise, the student will either drop out when he or she runs out of money or be forced to graduate with too much debt. Parents need to learn how to say “no” to their children.