Going to college is a turning point in the lives of many students. Getting there, however, takes a lot of work. After reviewing materials from all the colleges that interest you, you have to complete applications to a few final picks. On the financial side, you also have to consider whether you'll have the resources you need to go to your chosen school. As the first part of this article discussed, completing the FAFSA is often the first time students consider their financial situation.
Although the information the form asks for is relatively simple, what schools do with that information isn't quite as obvious. Knowing what sorts of financial aid packages you're likely to receive requires understanding a bit of how schools analyze your financial information to come up with a financial aid offer.
What colleges expect from you
The key to understanding how colleges use the information you provide lies in one particular calculation. Armed with your financial information, colleges calculate how much they can expect your family to contribute to your education. This figure, known as the expected family contribution (EFC), has nothing to do with how much your family actually contributes toward school expenses; instead, it's an artificial number based on a formula. Not all colleges use the same formula, however, so your EFC may vary from school to school.
Understanding the formula in detail takes a lot of work. (This pamphlet from the Department of Education can give you detailed information about exactly how the EFC is calculated.) However, in general, your family's EFC is the total of four parts: a percentage of the student's income, a percentage of any assets held in the student's name, a percentage of the parents' income, and a percentage of the parents' assets. For the 2007-2008 school year, the formula treats roughly half of any income the student earns and 20% of the student's assets as available to cover educational expenses each year. The contribution by parents, on the other hand, is a smaller percentage, ranging between 22%-47% of income and between 2.6%-5.6% of net assets.
How to maximize financial aid
There are many quirks in the EFC formulas that can help you minimize your EFC and thereby maximize the amount of your financial aid package. For instance, many types of assets are excluded from calculations of net worth. These include the value of your primary residence, IRAs and other retirement plan accounts, insurance policies, and annuities. As a result, if your parents decide to sell investment assets (in order to pay down their mortgage or to contribute more to a retirement plan), they may end up reducing the amount they're expected to contribute toward your education. However, you should be aware that private colleges only have to use the EFC formula for federal financial aid; they are free to use other formulas that include a broader range of assets and income to decide how to distribute other types of financial aid.
Still, there are some general rules of thumb to follow. First, since the EFC includes a higher percentage of the student's assets than of the parents' assets, it usually makes sense for your parents to keep assets they've put aside for your education in their names rather than putting them in your name. A good way for your parents to save is through 529 plans; these tax-favored accounts are generally treated as your parents' assets for financial aid purposes. While putting assets in the student's name sometimes reduces income taxes during your childhood, the effect on financial aid may more than offset any tax savings. Similarly, if you do have assets in your name, you should usually use them up first; doing so may result in more financial aid during future years. Again, keep in mind that although the EFC comes up with numbers for how much you and your parents are expected to pay, there's no requirement on how you actually split the expenses.
Other strategies your parents can use focus on managing their income. For example, while your parents may not have any control over their job income, they may be able to avoid selling investments that will trigger large capital gains while you're in school. Because capital gains show up on your parents' tax return as income, the EFC generally treats it as available income for financial aid purposes. Similarly, your parents should avoid taking money from retirement accounts to pay for school. Although they may qualify for an exemption from the usual penalties that apply to early withdrawals, the amount they withdraw is also added to their income.
Planning for school expenses is difficult. With the rules constantly changing, strategies that work this year may not work next year, let along 10 years from now. By being aware of the current rules, however, you and your parents can get the best financial aid to see you through your college years.
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The Fool offers a number of resources for saving for college. Check out the College Savings Center for general information. Also, Foolish expert Robert Brokamp has written an excellent book on the subject, The Motley Fool's Guide to Paying for School, which provides more in-depth advice about covering educational expenses.
Fool contributor Dan Caplinger has a while yet before he has to worry about his 2-year-old's college expenses, but he's already got a 529 plan started. He doesn't own shares of any of the companies mentioned in this article. The Fool's disclosure policy is always a learning experience.
