For high school seniors, May and June bring about thoughts of graduation and hopes for the future. Meanwhile, family members think about how to financially reward their college-bound offspring. But a substantial gift may impact a freshman college student's financial aid package. Consider these ways to give a graduation gift that won't negate financial aid.
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Don't Hand Over Cash or Checks
Giving money to the student is one of the fastest ways to obliterate their aid package, says Rick Darvis, co-founder of the National Institute of Certified College Planners in Plentywood, Mont.
"A cash gift from (anyone) other than a parent is reported as income on the (federal) financial aid form," says Darvis. "(Student) income is assessed at a 50% rate. That means that a gift of $10,000 could potentially cost $5,000 in financial aid."
The Free Application for Federal Student Aid, or FAFSA, asks a pointed question in the "student's untaxed income section." It wants to know the amount of: "Money received, or paid on your behalf (e.g., bills), not reported elsewhere on this form." This includes cash gifts from grandparents, noncustodial parents and anyone outside the immediate family. Cash gifts given from these sources directly to the student subtract 50 cents in need-based federal aid for every dollar given. Gifts from custodial or married parents to students are counted as a student asset and subtract 20 cents to 25 cents in financial aid for every dollar given.
The FAFSA bases your federal financial aid package on your financial status from the year before. If students receive a cash gift after filing the FAFSA, the gift won't immediately impact their aid package, but it will subtract from next year's award.
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Darvis admits that tracking such gifts is difficult. Though cash gifts to students frequently go unnoticed by the Internal Revenue Service, getting caught comes with penalties. According to the Department of Education, families caught omitting information on their federal financial aid application could face fines of up to $20,000 and jail time.
Don't Pay Institutions, Either
Paying the school directly is a no-no, too, says Jim Lundgren, CEO of Access College Foundation, a nonprofit college education organization in Temecula, Calif. When colleges receive checks from benevolent relatives, Lundgren says that they regard those funds as outside resources and can subtract money dollar for dollar from a student's aid package.
"If your school offers you a $10,000 grant and they see that you have $10,000 coming in, they can take that grant away," Lundgren says.
While handing cash to either the college or the student can result in repercussions, noncash gifts such as a car, laptop or school supplies aren't assessed at all, says Darvis.
Invest in 529 Plans With Caution
Even dropping funds into a 529 plan could cause the family to lose financial aid. In the federal aid formula, the government takes away up to 5.6 cents in aid for every dollar stored in a 529 account in the parent's or student's name, according to the Department of Education. A 529 account held by grandparents or other relatives won't be factored into the federal formula, but will be considered by private colleges who use the CSS Profile methodology to determine aid eligibility.
Gifts stored in a checking, savings, UGMA or UTMA account held in the student's name can subtract up to 25% from a student's aid package. By contrast, 529 accounts subtract far less and could carry benefits for the donor as well as the beneficiary. Don Roberts, a Chartered Financial Consultant with Sapient Financial Group, a financial services firm in Austin, Texas, says that gifting in a 529 can make sense for aging relatives looking to lighten their estates.
"Right now you can gift $13,000 per year per individual," without worrying about gift tax, says Roberts. "With a 529 plan, I can actually contribute up to five times that amount at once. That means I can move up to $65,000 out of my estate without paying a gift tax."
Under current law, a gift of $13,000 or less qualifies for the annual gift tax exclusion, meaning the recipient does not pay income taxes, and no IRS tax forms need to be filed. The 529 plans come with an accelerated gift option that allows donors to gift up to five years' worth of annual contributions at once without incurring gift tax. According to the IRS, individuals can gift up to $65,000 per beneficiary while married couples can gift up to $130,000 to a student without any gift tax ramifications.
The catch is that the government prorates large gifts made by donors that use the accelerated gift option. A $50,000 gift made this year from Grandma will be averaged out and considered a $10,000 gift each year for the next five years. If Grandma wants to donate an additional $5,000 next year, the IRS will look upon that amount as $2,000 above the $13,000 gift tax exclusion, even though the total of her gifts from both years is well under the $65,000 accelerated gift option limit. While Grandma won't owe gift tax, she will have to file the gift tax form accounting for the $2,000 overage.
There's another benefit to gifting into a 529. Besides offering a lower assessment rate, 529 funds can only be withdrawn by the account holder. If Junior decides that a Caribbean cruise is better than attending college, he can't use your 529 plan account money to take the cruise.
Think Outside the FAFSA Formula
If the student is receiving sizable need-based aid and your gift isn't large enough to incur gift tax, put the gift into a savings vehicle that's outside of the financial aid formula.
"A (permanent) life insurance policy is completely off the radar screen for financial aid purposes," says Martin L. Greatorex, a certified college planning specialist and owner of The College Navigator, a college planning firm in Milford, Conn.
According to the Department of Education, funds stored in a cash value life insurance policy won't count against a student in the federal financial aid methodology, provided that the student withdraws the money by taking a loan against the account rather than surrendering it. Should the student surrender the account, any money taken out will count as income and will subtract from their financial aid package by up to half.
Greatorex adds that relatives can also donate to a Roth IRA held in the student's name. To have a Roth IRA, students need to have earned income and can only contribute up to the maximum amount that they've earned, or $5,000 per year, whichever is less. Parents can put their own money in the IRA account for the student as long as the student meets the income requirements. Students can pay for college using contributions to a Roth but must wait five years before withdrawing earnings.
Like life insurance plans, Roth IRAs aren't counted in the federal aid formula. The amount of aid is determined based on a student's income and asset levels from the previous year, so Roth savings won't count against students in their freshman year. But once students start taking withdrawals, money pulled from a Roth counts as income from a financial aid standpoint and can heavily impact the student's aid package for subsequent years, according to the Department of Education.
Darvis says that relatives can avoid the financial aid ding by setting up a monetary gift as a "loan" that they plan to forgive after the student has graduated. Or they can save it for the student's final school year, when other financial aid sources tend to run dry.
By gifting with financial aid in mind, gifts go further and grads come closer to a debt-free college tenure.