When Saving for College Is a Bad Idea

Is there a time when saving for college is a bad idea? With student loan debt repeatedly in the news as one of the country’s biggest financial problems, it’s a question worth asking. And the answer? Maybe.

When Saving for College Is a Bad Idea

For some families the need for college financial aid is clear-cut. When parents have low incomes and few assets, there’s little need to strategize when it comes to applying for financial aid. The same is true at the wealthy end of the spectrum: Parents will likely be expected to pay their children’s college bills in their entirety.

But what about everyone else? The majority of middle-class families, and even many upper-middle-class families, may well qualify for some degree of financial aid. Could saving for college reduce their eligibility for help compared with other families?

In fact, there are perfectly permissible money strategies that can help reduce the amount that colleges will expect a family to contribute to its child’s cost of attendance: tuition and fees, room and board, and books and supplies. Some might call this gaming the college financial aid system; others might consider it smart planning based on knowing how financial-aid formulas count different types of income and assets.

We’ll let you make your own decisions about what you feel is fair and ethical. But before you can do that, you need to know how financial-aid formulas work and what your options are for maximizing your aid award.

Key Income Cutoffs

Schools calculate what families can spend on college using two components: the parents’ income and assets, and the student’s income and assets. When household income is less than $30,000, the family’s expected financial contribution (EFC) toward the cost of attendance is zero, explains Kristen Moon, an independent college counselor and founder of Moon Prep. If someone in the family receives a federal benefit such as welfare, it helps substantiate that the family needs financial aid.

When household income is less than $50,000, some income is counted toward the family’s EFC, but no assets are counted. Bank account balances, plus the value of any stocks, bonds and mutual funds, don’t count in this case. Aid formulas expect parents to contribute 22% to 47% of their income after subtracting an income-protection allowance for taxes and basic living expenses. The formula protects about $6,400 in student income, then expects 50% of a student’s income beyond that to go toward college expenses.

Because financial-aid formulas have so many inputs – including income, assets, family size, parent age and the number of children in college – it is difficult to estimate an upper income limit at which a family would not be eligible for any financial aid, but $180,000 in annual household income is a possible cutoff. However, it is far better to file the Free Application for Federal Student Aid (FAFSA) and see what aid you qualify for than to assume you won’t qualify for any and potentially miss out. (For more, see 5 Ways to Fund a College Education.)

Income and Assets That Reduce Eligibility the Most

Whether assets are held in a student’s, parent’s or grandparent’s name, as well as the type of asset, affects how FAFSA’s formula determines EFC. In addition, student income is treated differently from parental income. By understanding which types of income and assets count against you the most, you can strategize to reduce your EFC and maximize your student’s aid award.

1. Unnecessary Income

Realizing capital gains by selling appreciated assets (such as stocks and bonds), taking retirement account distributions and even withdrawing Roth IRA contributions will hurt you, because these will all be counted as income on the FAFSA, says Mark Kantrowitz, publisher and vice president of strategy at the college scholarship search website Cappex.com. If you can take any of these actions before the tax year that applies to your first FAFSA filing – or postpone them until after your child graduates – you may qualify for more aid.

2. Assets You Aren’t Required to Report

Common mistakes that families make on the FAFSA can hurt their aid. These include listing the family’s principal home as an investment (FAFSA exempts the family’s principal home from its asset calculations) and listing retirement plans as investments (FAFSA doesn’t require you to report the assets in qualified retirement plans such as individual retirement accounts (IRAs), 401(k)s, 403(b)s and pensions).

3. Assets in the Student’s Name

Financial-aid formulas protect a certain amount of parents’ assets depending on the number of parents and their age, but they assume that nearly four times as much of the student’s assets are available than they do the parents’ assets, says Joshua Wilson, partner and chief investment officer at WorthPointe Wealth Management in Dallas.

While the top asset contribution rate for parental savings is 5.64%, the contribution rate for all student assets is 20%. For every $100 a parent has in savings, colleges will expect them to contribute a maximum of $5.64 toward the child’s college costs. For every $100 a student has in savings, colleges will expect them to contribute $20.

In most situations it’s better to have money in the parent's name than in the child's name, Wilson says. People often make the mistake of transferring money into the student’s name or leaving new money in the student’s name. “If your child is working to pay for college, make sure they aren’t saving any earnings,” Wilson says. “That savings will only hurt their aid the next time they apply.”

Instead, working students should take money they would have saved and apply it to any student loans they’ve taken out. “Then apply for new loans for the upcoming semester after you’ve depleted your savings account by paying down old loans,” Wilson says. “I know it sounds silly, but having money in your account hurts you.” This also reduces the size of the loan the student will have to repay after graduation.

Other possibilities include having the student contribute to an IRA, which won’t be counted in financial aid calculations, or transferring the student’s savings into a 529 account, which is treated as a parental asset even if it is in the student’s name. (For more, see Why Small Retirement Savings Count.)

If your family can afford it, another option may be to have the student forgo paid employment in favor of an unpaid professional internship that provides the type of work experience that will help after college. Of course, if the internship happens to pay, just use the strategies outlined here to protect the money.

4. Help From Relatives

A 529 account that a grandparent opens for a student isn’t counted as an asset, “but when the money is withdrawn to pay school expenses, this money is counted as income for the student,” Moon says. “So either way they get you.”

FAFSA considers financial support provided by anyone other than the student’s parents to be untaxed income to the student. The hit to financial-aid qualification from college expense contributions by grandparents or other relatives can therefore be significant. Of course, those contributions are effectively a form of financial aid and do help the student, just perhaps not as much as the adults trying to help would expect.

An alternative is to have grandparents contribute to a 529 that is in the parents' name. Another option is for the student not to take any distributions from the grandparent-established 529 until after filing the last FAFSA of his or her junior year. (For more, see Reduce Tuition with a Work-Incentive Program.)

More Ways to Shield Assets

Some families might find the following strategies to be acceptable ways to keep their hard-earned assets instead of being required to contribute them toward the cost of their child’s college education. Others might see them as unethical, though it could be argued that they are no more unethical than taking income tax deductions. All of these strategies follow the rules, so feel free to employ whichever ones you are comfortable with that apply to your situation.

1. Save, Save, Save for Retirement

Experts always recommend that parents save for their own retirement before saving for their children’s college education because while children can borrow to pay for an education, parents can’t borrow (at least not enough) to fund their retirement. But another great reason for parents to put retirement savings first is that the money in a qualified retirement plan, such as a 401(k) or IRA, contributed before the tax year that coincides with your first FAFSA filing (called the base year) will be considered an asset and will not be counted toward your EFC. Contributions you make for the tax year that you report with the FAFSA, however, are considered untaxed income, so last-minute contributions won’t help your child qualify for more aid.

2. Pay Down Debt

If you have assets that colleges will expect you to spend to pay for your child’s college expenses but you’re also carrying debt, you might want to put extra money toward your credit card bills, auto loan and/or mortgage. That way you’re saving money on interest payments and potentially increasing your child’s financial aid eligibility. Even if you end up increasing your offspring’s eligibility for loans rather than grants, the student loans will likely have better terms than your credit cards or auto loans (though perhaps not better terms than your mortgage).

3. Cover Your Life

It’s always a good idea to make sure you have enough life insurance, and even though you have a child who is about to go to college, he or she, as well as younger siblings and your spouse, might still depend on your income or other contributions to running the household. You might want to use some of your savings to increase your life insurance coverage, ideally with an affordable term policy. If something happens to you, the money you spend on premiums will benefit your family more than putting those savings toward college would have. (For more, see Strategies to Use Life Insurance for Retirement and Is Your Employer-Provided Life Insurance Coverage Enough?)

4. Proceed with Planned Purchases and Upgrade Your Home

Don’t blow money on unnecessary purchases just to whittle down your savings to try to qualify for more aid, as such aid might come in the form of loans, and you might wish you’d held onto your cash instead. But it might make sense to go ahead and buy the new car or get the new roof you actually need sooner rather than later. Personal possessions such as automobiles, furniture, books, computers and jewelry aren’t factored into the FAFSA equation. A new roof might contribute to your home equity, which FAFSA also doesn’t count as long as the home is your primary residence. You could also move to a more expensive home or renovate your existing one. Other items you might consider purchasing are a computer your child can take to college or a used car that your child can drive to school and work.

Ethical Considerations

No one wants to pay more than they have to for anything, and if your child has been an excellent student and you’ve worked hard to help him or her succeed, you probably feel you deserve all the aid you can get as long as you play by the system’s rules. No one would encourage you to voluntarily pay more in taxes than you’re required to by law; they would tell you to take every deduction and use every tax avoidance strategy to which you’re legally entitled. So why are things any different when it comes to qualifying for college financial aid? Does it matter if you are violating the spirit of the rules even if you’re technically complying with them?

That’s up to you. But in one respect financial-aid ethics are crystal clear: “There is a difference between positioning income and assets to maximize aid eligibility – such as saving in the parent’s name instead of the child’s name and paying down debt – and lying about the existence of assets,” Kantrowitz says. “If you lie or mislead on the FAFSA, you can be subjected to a $20,000 fine and up to five years in jail, plus disgorgement​ of the aid. Moreover, some colleges will expel students who lie on the FAFSA.”

The Bottom Line

Every family hopes to get as much scholarship and grant money as possible for college. So will these strategies make that happen, or will they just result in schools offering students more loans to make up the difference between the expected family contribution and the cost of attendance? “A lot depends on the college’s packaging philosophy,” Kantrowitz says. “In some cases the increased aid will be in the form of loans. In some cases it will be in the form of grants or a mix of grants and loans.”

Students with more financial need might be more likely to qualify for subsidized loans on which the government pays the interest while the child is in school and for the first six months after graduation. (Federal Direct Loans: Subsidized vs. Unsubsidized explains the details.) Further, while financial-aid formulas might be said to penalize savings, that doesn’t mean you shouldn’t save for college at all. “Saving for college increases choice and flexibility,” Kantrowitz says. “It not only reduces debt, but lets the student enroll at a more expensive college than the student would otherwise be able to afford.” (For more, see College Education Cliches: Fact or Fiction?)