Financial aid 101: planning opportunities for CPAs.

EXECUTIVE SUMMARY

* COLLEGES AWARD FINANCIAL AID IN THE FORM OF scholarships, grants, loans and work-study awards based on the financial need of a student. The formula used to determine financial need is: financial need = cost of attendance (COA) - expected family contribution (EFC).

* THE EFC IS DEPENDENT ON THE INCOME AND ASSETS of parents and student and is determined by filing the free application for federal student aid (FAFSA) every year that a child will be in college.

* Generally, any income and assets parents have in excess of $100,000 will significantly reduce their eligibility for financial aid for children in college.

* The federal methodology is used by most institutions for awarding financial aid, but some private colleges and a select group of elite schools use other methodologies.

* CPAs CAN PROVIDE A VALUABLE SERVICE TO THEIR clients by assisting in the filing of the FAFSA form and planning to maximize financial aid awards.

With college costs increasing faster than the rate of inflation and the annual price tag at many private colleges now exceeding $40,000, financing a college education has become more daunting than ever. CPAs increasingly are being asked for advice on how to save for college and how to maximize financial aid awards. While it is tempting to recommend saving in a child's name because of the lower tax rate or investing in prepaid tuition plans to gain immunity from tuition hikes, such actions can dramatically reduce financial aid awards. Estimating financial needs and devising tax-effective investment strategies are important (see "Other Considerations," page 83), but relying exclusively on tax-favored investments for college can negate the fruits of hard work and planning if the result is a reduced financial aid award.

CPAs can play a key role in advising clients on investment and tax strategies to finance college education. In this article we'll analyze the federal financial aid formula, explain the effects of different factors on financial aid awards and offer planning opportunities CPAs can consider for their clients.

THE FORMULA

Colleges awarding scholarships, grants, loans and work-study programs based on the student's financial need use the following formula: Financial need = cost of attendance (COA) - expected family contribution (EFC).

COA is the total yearly cost including tuition and fees, on-campus room and board (or a housing and food allowance for off-campus students), books, supplies, transportation, loan fees and miscellaneous expenses, including an allowance for the rental or purchase of a personal computer. The EFC is dependent on the income and assets of parents and student. Exhibit 1, page 81, diagrams the components of the EFC.

The EFC is determined by filing the free application for federal student aid (FAFSA) every year that a child attends college. This is an additional service CPAs could provide their clients and is easily done at the time the client's tax return is prepared. The FAFSA should be filed after January 1 of each year; it can be filed electronically at www.fafsa. ed.gov. Computation of the EFC is a process akin to filling out an income tax return. To maximize financial aid awards, CPAs need a sound understanding of the rules.

To illustrate how the financial aid formula works, let's assume the following facts for the Jones family for 2004:

Family:    Size (2 parents, 2 children)                        4
           Number of children attending college                1
           State of residence                      Massachusetts
Parents:   Age of the older parent                            50
           Earned income of parent 1                     $40,000
           Earned income of parent 2                     $20,000
           Adjusted gross income                         $63,000
           Contributions to 401(k) plans                  $6,000
           Assessable assets                             $50,000
Student:   Earned income                                  $4,000
           Adjusted gross income                          $4,200
           Assessable assets                              $5,000

The calculations of the EFC for the Jones family are presented in exhibit 2, page 82, and explained below.

PARENT CONTRIBUTION

Parent contribution depends on the adjusted available income (AAI), which is a combination of available income (AI) and contribution from assets. To arrive at the AI, the untaxed income and benefits (UIB) are added to the adjusted gross income (AGI) and certain taxes and allowances are subtracted from it. The UIB include employee contributions to tax-deferred retirement plans and deductible IRA and Keogh contributions, tax-exempt income, untaxed withdrawals of IRAs and Roth IRAs, pension distributions and other untaxed income, such as gain on the sale of a personal residence. In the case of the Jones, the parents' contribution of $6,000 to their 401(k) plans will be added to their AGI of $63,000, resulting in total income of $69,000 (see exhibit 2).

The allowances to be deducted from total income include federal income and Social Security taxes (including Medicare taxes--$3,129 and $4,590, respectively, for the Jones family), a calculated allowance for state and other taxes based on the state of residency, an income protection allowance and an employment expense allowance. The allowance for state and other taxes depends on the level of income and the state of residency; for incomes of $15,000 or more, the allowance percentage ranges from 0% to 7%. For the Jones family, based on their residency status in Massachusetts, the allowance is 5% of total income (5% x $69,000), or $3,450. The income protection allowance (IPA) calculation is based on the number of members and the number of college students in the family. Tables for these amounts are available on www.ifap.ed.gov. For the Jones family of four with one child attending college, the IPA is $21,330.

The employment expense allowance is the lesser of $3,000 or 35% of each parent's earned income. For two-parent families in which only one parent earns income, the employment expense allowance is zero. For the Jones family, the employment expense allowance is $3,000, lesser of $3,000 or $7,000 (35% of $20,000 earned income of parent two.) The total allowances of $35,499 are subtracted from their total income of $69,000 to derive the available income (AI) of $33,501.

The second component of adjusted available income (AAI) is the parents' contribution from their assessable assets. This depends on their discretionary net worth (DNW), which is found by subtracting an education savings and asset protection allowance (APA) (available from tables) from the assessable assets. Assets are disregarded in the computation if both the adjusted gross income of the parents and their combined earned income are less than $50,000. Assessable assets include cash, savings and checking accounts, and net worth (investment value minus investment debt) of investments such as stocks, bonds, mutual funds, businesses and/or investment farms. Annuities and life insurance contracts, retirement accounts, automobiles and personal residences are not assessable, but a second home is. The APA is based on the age of the older parent ($42,800 for the 50-year-old father). The resulting DNW of $7,200 ($50,000-42,800) is assessed at a fixed 12% rate ($864).

The total of the contribution from income ($33,501) and assets ($864) equals the Jones's AAI of $34,365. Based on the graduated rates for AAI (available from tables), the parents' expected contribution is $11,157. At the maximum AAI rate of 47%, the parents' assets are assessed at the rate of 5.6%. (This is derived by multiplying the maximum AAI rate of 47% and the fixed asset conversion rate of 12%.)

Note that the parents' contribution to the EFC is divided by the number of children in college. If the Jones family had two children in college, the EFC for each child would be approximately halved.

STUDENT CONTRIBUTION

The student's adjusted gross income also is offset by allowances for federal income and Social Security taxes, state tax and a fixed income protection allowance (IPA) of $2,440. However, the AI of students is assessed at 50%--a much higher rate than parents. For the Jones child with adjusted gross income of $4,200, the allowances are Social Security taxes ($306), state taxes ($168) and IPA ($2,440). The total allowances of $2,914 are subtracted from the total income of $4,200 to derive an AI of $1,286. The student contribution from income is 50% of that, or $643.

The student's assets, including UGMA/UTMA accounts, also are assessed in the computation of student contribution. The $5,000 in assets for the Jones child is assessed at 35% (resulting in a $1,750 contribution from assets). The total contribution from the Jones child is $2,393 ($643 + $1,750), bringing the total EFC of the Jones family to $13,550 ($11,157 + $2,393).

CPAs or their clients can access a financial aid calculator that determines the parent and student contribution to the EFC at www.finaid.org.

EFC FOR DIFFERENT INCOME AND ASSET COMBINATIONS

Exhibit 3, page 83, presents the numbers for several income and asset levels. In each case we've assumed a family of four residing in Massachusetts with one child in college. Earned incomes of the parents are in the ratio of 2 to 1. The older parent is age 50. The exhibit depicts the parents' contribution to the EFC at three earned-income levels and three asset levels and the student's contribution at three income levels and three asset levels.

Families with high income and assets often are ineligible for financial aid. If parents' income is in excess of $100,000 and assessable assets are higher than $100,000 (referred to as the 100-100 rule of thumb), their EFC (of $30,139) significantly reduces their eligibility for financial aid.

THREE METHODOLOGIES

The computations explained above are based on the federal methodology (FM) used by most colleges. The FM expects students to contribute 35% of their assets and parents to contribute up to 5.6% of their assessable assets, not including home equity. But there also are two other methodologies. More than 300 private colleges use the FM in dispersing federal financial aid but use the institutional methodology (IM) for their own financial aid pools. IM requires students to contribute only 25% of their assets, and parents to contribute 3% to 5% of theirs. However, IM includes home equity in the parents' assets, and some schools include other assets as well. A third methodology, the consensus approach (CA), is used by 29 elite colleges including Yale, Stanford and Duke. The CA combines the parents' and student's assets and expects families to contribute about 5% of the total. This is intended to discourage families from shuffling assets between generations.

EFFECT OF PREPAID PLANS, EDUCATION IRAs AND 529 PLANS ON FINANCIAL AID

Payments from prepaid tuition plans (known as qualified state tuition plans or QSTP) reduce eligibility for federal financial aid dollar for dollar. In comparison Coverdell Education Savings Accounts and section 529 plans are treated as assets of the plan custodian, rather than the beneficiary. If the parents are the custodians, the plans are assessed as an asset of the parents (up to 5.6%); if the custodian is a grandparent or other relative, they are not assessed at all. Withdrawals from 529 plans for qualified education expenses are not counted as untaxed income and benefits of the student.

PLANNING OPPORTUNITIES AND STRATEGIES

A good understanding of the federal financial aid formula and effective planning help to maximize financial aid awards. CPAs should advise their clients to start the planning process as early as possible, certainly no later than the student's sophomore year in high school, so the family can reduce its assessable assets before filing for aid.

Since the federal methodology (FM) looks at the most recent tax filing in assessing income and asset valuations, families that report lower incomes and assets quality for higher financial aid awards. Remember, too, that when determining the EFC, a student's discretionary income and assets are assessed at 50% and 35%, respectively. High income and assets in the child's name are the worst possible combination. CPAs can explore the following strategies with their clients in order to maximize financial aid awards.

PLANNING STRATEGIES FOR PARENTS' INCOME

* Shift income (for example, bonuses and capital gains) to the years prior to and after a student is in college.

* Reduce AGI (by up to $3,000 by selling any capital assets that will generate losses in the year before you file the FAFSA application.

* Take advantage of the employment expense allowance. If one parent owns a business, hire the other.

* Don't sell a personal residence at a nontaxable gain because the gain is classified as untaxed income and benefits.

PLANNING STRATEGIES FOR PARENTS' ASSETS

* Pay off credit cards and auto loans because consumer debt is not deductible from assessable assets.

* Pay down or pay off your mortgage.

* Accelerate expenditures for large cash items such as autos, computers and significant home improvements to the year prior to filing the FAFSA.

* Don't withdraw from tax-deferred retirement accounts for college expenses.

* Put excess savings into annuities, insurance contracts and Roth IRAs that are nonassessable assets.

PLANNING STRATEGIES FOR STUDENTS' INCOME

* Limit students' income to the permissible allowances.

* Sell appreciated assets that are in a child's name before the senior year of high school.

* Sell capital assets that generate losses in the year before filing the FAFSA to reduce AGI.

PLANNING STRATEGIES FOR STUDENTS' ASSETS

* Make all investments in the name of the parents instead of the student.

* Pay college costs by spending assets in a child's name before spending parents' assets. Spend student's assets for educational expenses such as private high school, SAT review courses, summer camp or even a computer.

* Own a section 529 college savings plan in the name of the parents (better yet, a grandparent, aunt or uncle) rather than the student.

* If permissible, spend trust assets in the student's name or convert them into nonassessable assets.

* Don't receive large cash gifts, as they are counted as untaxed income and assessed at 50%.

Sometimes other considerations are more important than financial aid. Evaluate the tax implications of paying down a mortgage or hiring a spouse, for example. CPAs are in an excellent position to assist clients in making these types of decisions.

Applying a careful consideration of planning strategies, CPAs can advise their clients on ways to maximize financial aid awards. CPAs who develop expertise in this area can expand their practice by providing a value-added service for which demand is likely to grow fast.

Exhibit 2: 2005-06 EFC: Jones Family

                                         Parents            Student

Adjusted gross income (2004)        $63,000             $4,200
Tax-deferred income                   6,000                 --
Total income                                  $69,000            $4,200

Allowances against income
  Federal income taxes paid (1)       3,129                 --
  Social Security taxes paid          4,590                306
  State and other tax allowance       3,450                168
  Income protection allowance        21,330              2,440
  Employment expense allowance        3,000                 --
  Total allowances                             35,499             2,914

Available income (AI)                          33,501             1,286
Assessment of AI                                                    50%
Student's contribution from AI                                      643

Assessable assets                    50,000              5,000
Less: Education savings and asset
protection allowance                 42,800                 --
Discretionary net worth               7,200              5,000
Asset conversion rate                   12%                35%
Contribution from assets                          864             1,750

Adjusted available income (AAI)                34,365
Expected family contribution
  (EFC)                                       $11,157            $2,393

(1) Assumptions for federal income tax calculation:

All income is taxable at ordinary rates.

Itemized deductions equal 25% of earned income for parents.

Income tax takes into account maximum allowable Hope credit for
parents. Child credit is not considered.

Student claimed as dependent by parents and student claims a standard
deduction.

Exhibit 3: Paying Your Fair Share

Parents' Contribution to EFC

             Earned                Earned                  Earned
             income                income                  income

Assets
             $60,000               $80,000                $100,000

  $40,000    $10,750    $60,000    $20,143     $80,000     $29,011
  $50,000    $11,157    $70,000    $20,707     $90,000     $29,575
  $60,000    $11,721    $80,000    $21,271    $100,000     $30,139

Student's Contribution to EFC

Assets
              $3,000                $4,000                  $5,000

   $1,000       $528     $5,000     $2,393     $15,000      $6,338
   $2,000       $878     $7,500     $3,268     $17,500      $7,214
   $3,000     $1,228    $10,000     $4,143     $20,000      $8,088

Assumptions for federal income tax calculations:

Adjusted gross income is 105% of earned income, and all income is
taxable at ordinary rates.

For the parents, tax-deferred income equals 10% of earned income, and
itemized deductions equal 25% of earned income.

Income tax takes into account maximum allowable Hope credit or
education expense deduction for parents. Child credit and alternative
minimum tax are not considered.

Student claimed as dependent by parents and student claims a standard
deduction.

RESOURCES

AICPA Resources

CPE

Paying for College: Tax Strategies and Financial Aid (DVD # 181481JA; VHS # 181480JA).

Toolkit

College Financial Literacy Toolkit, www.aicpa.org/ flnancialliteracy/financial_toolkits/college_toolkit.asp.

Other Resources

Publications

* Don't Miss Out: The Ambitious Student's Guide to Financial Aid (29th edition) by Anna J. Leider, Robert Leider, Anna Leider, Octameron Associates, 2004.

* Paying for College Without Going Broke by Kalman A. Chany, Geoff Martz, Princeton Review Series, 2005.

Web sites

* Free application for federal student aid, www.fafsa.ed.gov.

* The EFC formula, 2004-2005, www.ifap.ed.gov.

* Financial aid calculator, www.finaid.org/calculators.

* National Institute of Certified College Planners, www.niccp.com.

RELATED ARTICLE: Other considerations.

Many affluent clients may not qualify for financial aid. If the assessment process shows your client is not eligible, it's time to consider alternatives.

Clients can benefit greatly from your experience in analyzing the probable costs of a college education and developing a prudent plan for saving towards the goal. Very often the client will need guidance not only on the amount of savings required but also the investment approach and the vehicle to use for housing the education funds. There are many tools available to help CPAs, including new resources on the AICPA's Web site at www. aicpa.org/PFP.

In recent years, the popularity of 529 savings accounts has literally exploded. These plans bring significant benefits--the ability to save on a tax-deferred basis and to take qualified withdrawals from the plan on a tax-free basis. Many states provide residents with current tax deductions on their state income tax returns, further enhancing the effectiveness of 529 plans.

MARC J. MINKER, CPA/PFS, is managing director at Mahoney Cohen Private Client & Family Office Services in New York. His e-mail address is mminker@ mahoneycohen.com.

College Aid

College costs are rising faster than inflation. About 60% of full-time undergraduates received grant aid.

Source: Trends in College Pricing, www.collegeboard.com. 2004.

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MAHENDRA R. GUJARATHI, PhD, is professor of accountancy and RALPH J. McQUADE, CPA, is associate professor of accountancy at Bentley College in Waltham, Massachusetts. Their e-mail addresses are [e-mail] and [e-mail], respectively.