How Can One Shelter Parent Assets on the FAFSA?

How Can One Shelter Parent Assets on the FAFSA?

My daughter is going to college next year. We have to file the

FAFSA in October. We have money in our savings account that we

saved for emergency reasons and some for my daughter’s college. Will

this affect her chance in getting grants or loans? What should we do?

— G.N.

Money in a savings account counts as an asset on the Free Application

for Federal Student Aid (FAFSA) and may affect eligibility for

need-based student financial aid.

Most personal finance experts recommend keeping 3 to 6 months salary

in an

emergency or rainy day fund.

The size of the emergency fund is based on the average duration of

unemployment. During the current economic downturn, some people

recommended increasing the size of the emergency fund to 6 to 12

months salary.

The FAFSA does not have an exclusion for money in an emergency

fund. This is in contrast with the CSS Financial Aid PROFILE Form,

which subtracts an allowance for emergency reserves from assets. The

PROFILE is a supplemental form used by about 250 mostly private

colleges for awarding their own institutional aid funds. This is one

of the few areas in which an institutional need analysis formula may

yield a lower expected family contribution than the federal need

analysis methodology.

Despite the lack of an exclusion for emergency funds on the FAFSA, the

impact of parent assets on the student’s eligibility for need-based

aid is often small. If the parents qualify for the simplified needs

test, all assets will be disregarded on the FAFSA. To be eligible for

the simplified needs test, the parents’ adjusted gross income must be

less than $50,000 and the parents must have been eligible to file an

IRS Form 1040A or 1040EZ. (There are other ways of qualifying for the

simplified needs test, such as by qualifying for certain means-tested

federal benefit programs.) Even if the family does not qualify for the

simplified needs test, the FAFSA ignores the net worth of

the family’s principal place of residence, the value of any small

businesses owned and controlled by the family, and assets in qualified

retirement plan accounts. There is also an asset protection allowance

based on the age of the older parent that shelters about $40,000 to

$50,000 of parent assets for most parents. (The asset protection

allowance is based on the present cost of an annuity which would, at

retirement, supplement Social Security benefit payments to a moderate

living standard. The asset protection allowance can vary significantly

from one year to the next based on changes in the Consumer Price

Index.) Any remaining reportable parent assets are assessed according

to a bracketed scale, with a top bracket of 5.64 percent.

Approaches to Sheltering Money Often Backfire

There are ways of reducing the impact of parent assets to zero, but

each method has its own flaws. Most approaches involve saving or

investing the money in a non-reportable asset, such as a qualified

retirement plan account. (Investing the money in a small business or

using it to pay down the mortgage on the family home may work for

federal and state student aid, but not for money from the college’s

own need-based financial aid funds.)

The flaws in these approaches do not make them suitable solutions for

sheltering an emergency fund.

One approach is to save the money in a Roth IRA, which is not reported

as an asset on the FAFSA. Given the low annual

contribution limits on a Roth IRA, using this strategy will take

several years to implement. So long as one does not take a

distribution from the Roth IRA while the student is enrolled in

college, it will have no impact on need-based aid eligibility. But the

family cannot take any distributions from the Roth IRA, not

even a tax-free return of contributions. A tax-free return of

contributions will be reported as untaxed income on the

FAFSA. Regardless of whether the distribution is taxable or not, it

will reduce aid eligibility by as much as half the distribution

amount.

Another approach involves saving the money in a whole life or cash

value life insurance policy. These are not reported as assets on the

FAFSA because they are treated like qualified retirement plan

accounts. (Note, however, that there has been so much abuse of this

provision that the favorable treatment of these life insurance

policies may be eliminated in the future.) Any distributions from

such a life insurance policy will count as untaxed income on the

FAFSA, and may also involve high surrender charges. One could borrow

from the life insurance policy’s cash balance, but then the interest

payments merely substitute for the income the money would have earned

had it remained invested. Any unpaid interest will be added to the

loan balance, causing the borrower to be charged interest on

interest. This accrued but unpaid interest will eventually be treated

as income by the IRS. The interest payments also cannot be deducted on

the borrower’s federal income tax return, unlike the interest on

student and parent education loans. Even if the family does not take a

distribution or loan from the cash balance, the return on investment

after commissions and expenses is lousy, among the worst available. These

products are more to the benefit of the salesperson than to the

insured.

Both of these approaches suffer from a critical flaw, in that they

tend to limit access to the investment. A rainy day fund must be saved

in an easy-to-access liquid form, such as a savings account or money

market account. If an emergency arises, the family will need quick

access to the money. Most methods of sheltering money from need

analysis are not very liquid and will result in a significant penalty

by reducing the student’s eligibility for need-based financial

aid. This will hurt the family even further at a time of severe

financial distress.

Source: Fastweb

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