Death and Taxes

‘It’s a well-known saying, “the only two things that are certain are death and taxes.”  It’s important to consider that statement when faced with  the flood of information about how to maneuver around the formula used to determine if your student is going to receive need-based financial aid to hlep pay for college.  Most of it is true, certain assets are shielded from the formula for example.  But there is much more to consider than simply trying to reduce the amount the family can pay for one year’s cost of college based on the formula.  This is called the Expected Family Contribution (EFC).  How does it all work?

First, need-based eligibility is determined by comparing what the formula says the family can pay (EFC) to the total cost of the college or university.  If the school costs $20,000 and the student’s EFC is $10,000, the student is eligible for $10,000 in need-based aid.

The aim of the game is to reduce the family’s EFC number, in turn increasing the amount of need-based aid the student is eligible to receive.  Understanding how the formula works, what is counted, what isn’t, what reduces the family’s determined cost, etc., allows us to look at the family’s finances and figure out what we can change or move around to affect the outcome.

However, focusing only on the financial aid strategy without understanding how it may impact other aspects of a family’s financial life could create bigger problems.  Also, if we don’t calculate the family’s EFC, before and after the maneuvering is done, we won’t know if it affected eligibility or not.  Our strategy might very well be pointless.

It’s worth an example to demonstrate the point.

Let’s assume the Smith family has 2 children, one a high school senior, the other in middle school.  Their annual income is $150,000 and they have $500,000 in taxable assets, aside from their 401k’s at work.  They haven’t saved but a few thousand in a 529 plan and they are scared.  Reading a blog on the internet they discover that only taxable assets are included in the need-based formula.  Qualified accounts such as annuities and retirement accounts as well as life insurance cash values are not.  They talk to their financial advisor about moving their taxable investments into an annuity to shelter that money from the formula.  Their financial advisor doesn’t understand how financial aid works and is also distracted by the large commission he sees coming from this transaction.  The Smith’s make the move.

Neither the Smiths nor their advisor considered the hefty tax liability they incurred by selling their appreciated investments to buy the annuity.  Besides that, they changed the complexion of their investments from paying capital gains on transactions to having the money taxed as income when taken out that annuity. There is also a penalty period associated with most annuities keeping the owner from taking money out over the first 7 plus years unless a hefty penalty is paid.  This is a significant difference and one that increases their tax liability and changes the management of their investments.

To make matters worse, there was no estimate done to determine exactly what the Smith’s EFC would be.  They could not know that despite their efforts to affect the formula, their income alone would preclude them from need-based aid at all but the most expensive of private colleges.  The annuity was in fact an effort in futility – an effort that cost them more money and reduced their liquidity without achieving an increase in financial aid.

The message: financial aid strategies, tax strategies, retirement strategies, etc., are not compatible.  Need-based student financial aid is not certain, but taxes are.   Before you act on something you’ve read or heard, consult with an advisor that understands student financial aid.

Call OptimumEd.  We can calculate your family’s cost as determined by the EFC formula and advise you correctly based 22 years of experience and expertise.


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