Personal Finance > College
Beat the financial aid trap
Three college savings strategies whether you need financial aid or not.
March 7, 2002: 10:48 a.m. ET
By Staff Writer Jeanne Sahadi

graphic NEW YORK (CNN/Money) - If ever there were a fitness test for parenthood, it would have to include a quiz on advanced calculus. The subject has nothing to do with parenting, of course, but it does make most people's eyes cross.

And that's the point: The quiz would simulate conditions under which parents must choose the best way to save for college in light of ever-changing tax laws and a byzantine financial aid system.

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In the same way that it's important to have the right mix of investments when trying to meet your college savings goal, so, too, is it important to have the right mix of accounts, especially if you are banking on financial aid.

You have several choices when it comes to investing for college, including 529 savings plans, Coverdell Education Savings Accounts (formerly Education IRAs), custodial accounts (UGMAs/UTMAs), and taxable brokerage accounts. Each has different rules and tax implications, and each is counted differently when it comes to financial aid eligibility.

Here we'll look at three savings scenarios for parents of young children: one in which you anticipate you'll need a lot of financial aid; one where you anticipate you'll need at least some aid; and one in which you anticipate paying full fare for college.

Take a load off

If you think you'll rely heavily on aid, then a good rule of thumb is to save nothing in your child's name. That's because in determining the "expected family contribution" (EFC) toward college costs, federal financial aid formulas count 35 percent of a child's assets, but only up to 5.65 percent of parental assets. So the more assets your child has, the less aid he or she is likely to get.

Private aid formulas are more complex, but the idea is the same. In fact, private aid formulas may also count assets in the name of a student's sibling as part of the EFC, said Mark Kantrowitz, founder of

Another good rule of thumb is to give greater priority to your retirement savings than to college savings. There are two reasons for this: first, your child has resources to draw on besides you to help pay for college, but no one's going to give you a scholarship to retire; and second, your 401(k) and IRA savings are not treated as assets in determining the EFC.

So if you think you'll depend on aid, then whatever money you're planning to save for college should go into a taxable account in your name, said Kalman Chany, a financial aid consultant for families and the author of Paying for College Without Going Broke. The account is treated as a parental asset. To curb some of the costs of your taxable investments, invest in tax-efficient mutual funds and tax-free bonds, said certified financial planner James W. Van Metter of Bronxville, N.Y.

When investing, remember, "the more time you have the more aggressive you can be early on," Kantrowitz said. In other words, growth stocks rather than bonds should make up the bulk of your portfolio when your child is young. As your child grows, your investments should gradually grow more conservative until his or her junior year in high school, when you want your college savings to be safe from market volatility and housed instead in the money market or in short-term bonds. (For more asset allocation advice, click here.)

Divvying up the load

If you anticipate you'll need some aid but will cover at least half of the tuition costs yourself, the advice above still applies. In addition to a taxable account, however, you might also invest some money in a 529 savings plan, Van Metter said. Contributions may be tax-deductible in your state and withdrawals are now free of federal tax.

A 529 savings plan may affect aid eligibility, however. The account itself is treated as an asset of the owner (the person who opened the account), not the student. But the earnings portion of the withdrawals are treated as the child's income, which is assessed up to 50 percent in determining EFC. The rule on withdrawals may change in the next few years in light of the fact that withdrawals were just recently deemed tax-free. But if the rules don't change, one way to balance your 529 with your need for aid is to leave the 529 untapped until the third or fourth year of college. That way, you can maximize your child's aid eligibility during the first two or three years of school and use the 529 to pay for Junior's last lap around the quad.

Another savings option if your child is very young is a variable universal life insurance policy, said Van Metter, who is licensed to sell life insurance. Variable life is a complex product that you should not buy without doing thorough research, but it does offer two advantages when it comes to college savings: The policy is sheltered from aid formulas and you can take out the contributions you've paid in without penalty assuming there's enough left in the policy to keep it going.

But doing so will reduce your death benefit and result in an opportunity cost for the remainder of your policy money since the insurer, to eliminate its risk, will move an amount equivalent to your withdrawal into a fixed-return account, said Jim Hunt, a life insurance actuary with the Consumer Federation of America who runs a life insurance evaluation service for CFA.

Variable life insurance products also can be expensive, Hunt said. That expense can be reduced, however, if you purchase a policy from a company that doesn't charge commissions, such as USAA Life or Ameritas, he noted.

Put the load on me

If you think you'll be able to foot the bill for college yourself or if you have a very high income and suspect you won't qualify for aid, you'll want to maximize your investment flexibility and tax advantages.

Assuming you've taken care of your retirement savings, Chany recommends you put some money into a custodial account (UGMA/UTMA) since it's a tax-advantaged way to transfer money to a minor -- the account investments may earn a certain amount tax-free every year (up to $750 in 2001) and some or all of the rest of the earnings are taxed at the child's rate. He suggests, however, only putting in enough to earn the tax-free income.

He then suggests you put $2,000 into a Coverdell Education Savings Account (ESA) each year if you meet the income requirements. Qualified ESA withdrawals are tax-free. And, thanks to the Tax Relief Act of 2001, money from an ESA may now be used for pre-college education expenses, which may come in handy should you send your child to private school.

The bulk of your savings should then go into a 529 savings plan, Chany said. There are no income limitations on who may open an account, the lifetime contribution limits run as high as $270,000, and the money may be used at any college.

Other aid factors to consider

As the college years approach, if you anticipate needing financial aid, you should strategize the timing of your withdrawals, since aid decisions are based on your financials in the tax year before the school year in which the aid is used. (In other words, if your child is entering college in September 2002, your 2001 financials will be the basis for aid decisions.)

One of the key strategies is to keep your income as low as possible since income is a heavily weighted factor in needs assessment. Federal aid formulas count up to 47 percent of parental income toward the EFC, as opposed to just 5.65 percent of parental assets.

That's why Kantrowitz recommends you don't incur capital gains in the year before aid is needed. Capital gains count both as income and as an asset. "It's double-counted," he said.

The best move, he said, is to realize any gains in the tax year before the one on which an aid decision will be based. If you have more than one child in school at the same time, you should realize all your gains in advance of the first child going to college, Kantrowitz said.

(For more tips on how maximize aid eligibility during the high school years, click here.) graphic


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