Why Agents Should Be Careful With Financial Aid Planning

Paying for higher education is foremost on many Americans’ minds.  An entire industry has evolved to help individuals maximize financial aid to soften the blow of the tuition bill.  

Financial aid can come in many forms, such as scholarships, grants and loans. Aid also can come from many sources, including federal or state governments, institutions of higher education, or banks. 

Financial advisors may be quick to suggest cash value life insurance to bolster a student’s financial aid award package, but the impact of cash value life insurance on federal financial aid may be negligible at best. This is because the federal methodology is primarily an income test (not an asset test), and federal need-based aid is available only to the most financially needy students. 

Let’s examine some the components of the federal financial aid formula (i.e., the federal methodology) that are used to determine a student’s expected family contribution. We will explore the three types of financial aid provided by the federal government: loans, grants and federal work-study. 

The federal methodology is primarily an income test.

To be eligible for federal financial aid, every prospective student must file the Free Application for Federal Student Aid, or FAFSA. Although the FAFSA is relevant for graduate and professional students, we will approach the FAFSA through the lens of a parent and their dependent child who plans to attend an institution of higher education. (See chart 1).

The inputs from the FAFSA are put into the formula prescribed by the federal methodology and are used to determine a student’s expected family contribution (EFC), in other words, how much money a student and her/his parents can be expected to contribute towards the cost of a higher education.  The difference between the EFC and the cost of attendance is referred to as the student’s unmet need.  As far as federal financial aid is concerned, this need can potentially be filled with loans, grants, or Federal Work-Study.  The idea behind financial aid planning is to manipulate a family’s balance sheet and income statement to reduce the EFC and thus increase the amount of the student’s need and the financial aid for which she/he will qualify.

The federal methodology uses income from two tax years prior to the start of the academic year for which the student is applying for aid (2018 tax year data will be used for the 2020-2021 FAFSA).  Income includes adjusted gross income (AGI) as well as certain other income that was not subject to tax such as contributions to a 401(k) plan or other tax-deferred retirement plan.  In the calculation of EFC, a student’s income is assessed at 50%, whereas parents’ income is assessed on a sliding scale up to 47%, and reaches 47% at over $19,000 of income.

The same countable/noncountable rules apply to parents’ assets as well as students’ assets. However, in the EFC formula, students’ assets are assessed at 20% whereas parents’ assets are assessed at 12%. “In other words, the most parents will have to contribute is slightly more than 12 cents for each additional dollar of assets.”

A solidly middle-class family may already have the bulk of their net worth tied up in noncountable assets, such as equity in their primary residence and retirement accounts. Moving $100,000 from a CD into a cash value life insurance policy would theoretically lower that family’s EFC by $12,000. And that decrease in EFC will likely not be enough to get that student any additional federal financial aid to which they were not already entitled. 

All student and parent borrowers are eligible for federal loans — regardless of need.

Federal financial aid is designed to help fill the gap between the cost of attendance and the EFC (the unmet need) or to be available as part of the EFC if the family doesn’t have the cash on hand. 

Unsubsidized student loans are available to all student borrowers regardless of financial need. They are non-need-based loans; all students regardless of their EFC are eligible. However, unsubsidized loans are only offered in limited amounts, which depend on a student’s year in school.

If Mom or Dad does not have an adverse credit history, and sometimes even if they do, they will be able to get a PLUS loan from the federal government. PLUS loans are also non-need based, and can be disbursed up to the total cost of attendance, minus other financial assistance received.

The point to highlight here is that purchasing a cash value life insurance policy does not increase the amount of money a parent can borrow from the federal government and does not increase the amount of unsubsidized loans an undergraduate student can borrow from the federal government.  Showing more or fewer countable assets on a family’s balance sheet does not impact eligibility for these loans, at all. These are non-need-based loans and EFC is irrelevant in determining the amount of non-need-based loans that may be borrowed. 

Only the financially neediest of students will be eligible for need-based federal aid. 

The remaining aid that is available from the federal government is referred to as need-based aid and includes subsidized loans, grants and work-study. Subsidized loans and federal work-study are awarded to students with “financial need.”

Subsidized loans, however, do not increase the amount of federal loans a student will be able to borrow; subsidized loans indicate that a portion of the student’s federal loan will receive preferential interest treatment. As far as Federal Work-Study, every school will have different funding levels for the program. However, the number of hours worked cannot exceed a student’s total Federal Work-Study award.  

There are currently four federal grant programs available to borrowers. Financial need is irrelevant for two of the grants. The Pell Grant and the Federal Supplemental Educational Opportunity Grant are available only to students with “exceptional financial need,” a higher showing of financial need than is required for subsidized loans and for Federal Work-Study. Grants, unlike loans, do not have to be repaid if the terms of the grant are fulfilled. Not all schools participate in the FSEOG program, and those that do give priority to Pell Grant recipients. 

Students who receive subsidized loans, grants and Federal Work-Study are more likely to be from families receiving federal means-tested benefits such as food stamps, Medicaid, Supplemental Security Income, or the free or reduced-price school lunch program. These families may have incomes close to or below the poverty guidelines. Low-income families get various benefits when it comes to the EFC calculation. Assets do not count in the EFC calculation for certain families with an AGI of $50,000 or less.

It will be very difficult for middle-class families to compete with low-income families for need-based federal financial aid because the federal methodology weighs income so much more heavily than assets. The purchase of a cash value life insurance policy is unlikely to change a family’s financial profile enough to create a picture of poverty (i.e., “financial need” or “exceptional financial need”) and qualify that student for subsidized loans, grants or Federal Work-Study.

Because the federal methodology is primarily an income test (not an asset test) and federal need-based aid is available only to the most financially needy students, repositioning assets into cash value life insurance is unlikely to have a dramatic impact on a student’s EFC and their eligibility for need-based federal aid. Further, all students and parents are eligible for federal loans, regardless of need.  

Cash value life insurance is probably one of the most versatile and valuable financial products on the planet. However, positioning it to enhance a student’s federal financial aid award because cash value life insurance is a noncountable asset (a) likely will not work and (b) likely cheapens its worth in the eyes of the consumer. Further, the reputation of the individual financial advisor or firm that recommends such a strategy may be called into question.  

The time to have the conversation about cash value life insurance is not two years prior to a child’s attending college. That time was probably right around the time the child was born. Encourage a young family to purchase permanent protection that can be used in innumerable ways to their benefit — and guess what! It doesn’t impact their child’s eligibility for federal financial aid.

Allison Anne Hoyt, JD, CLU, is technical director, Nationwide Advanced Consulting Group. Allison may be contacted at [email protected].