There are two formulas by which the EFC of a family can be computed:
- the Federal Methodology; and,
- the Institutional Methodology.
Federal Methodology (EFC) Formula
The Federal Methodology Formula (FM) is a federal formula used to calculate the standard EFC explained above. It is used by every accredited college in the United States to determine how much federal money can be disbursed by the college to cover the student’s COA. Most states also use this formula as a basis to distribute state financial aid funds.
Simplified EFC Formula
The Simplified EFC Formula may be used for a “dependent student” if ALL three of the following criteria are met:
- The student’s parents filed or are eligible to file Form 1040A or 1040EZ, or the parents are not required to file any income tax return. Sometimes a Form 1040 is filed even though a 1040A or 1040EZ could have been filed. In such a case, a student or parent should indicate eligibility to file a 1040A or 1040EZ on the FAFSA form by checking that these forms were filed. OR anyone included in the parents’ household size received benefits during the base year from any of the designated means-tested Federal benefit programs: (SSI, Food Stamps, Free and reduced price lunch program, TANF and WIC).
- The student filed or is eligible to file Form 1040A or 1040EZ or the student is not required to file any income tax return. (See above discussion of the case of filing a Form 1040 when a 1040A or 1040EZ could have been filed.) (Note: For an “independent student,“ neither the student nor spouse can have been required to file a Form 1040.)
- The adjusted gross income of the student’s parents is $49,999 or less and the earned income of both parents is $49,999 or less (excluding any income of the dependent student). (Note: For an “independent student”, the student and spouse must have a combined adjusted gross income of less than $50,000.)
The advantage to this exception is that assets of the parents and of the student are not assessed in the EFC formula. However, a student who qualifies for the Simplified EFC Formula still has to complete the asset Section (for both the student and the parent) if the student wants to be considered for certain types of non-federal financial aid from the college the student will be attending.
Note: If the only purpose of filing a Form 1040 is to claim the American Opportunity Credit or Lifetime Learning tax credits, this does not disqualify the student from this exception.
In a case where the parents are required to use Form 1040, such as claiming itemized deductions instead of the standard deduction, it may be beneficial for the family to plan their income and expenses in order to file an IRS “short form” and to keep their adjusted gross income under $50,000.
Example: A child had $100,000 in a trust fund (The $100,000 alone would equate to an EFC of $20,000.). The parents were both teachers and had a combined income of $49,000. The itemized deductions on their upcoming year’s tax return were estimated to be $10,900. At the advice of their financial advisor, they timed the payment of their itemized deductions so that they would use the standard deduction on their tax return. The parents are now eligible to file an IRS “short form” and have income less than $50,000. The student now qualifies for the Simplified EFC exception, and neither the student’s nor the parents’ assets are assessed.
In order to qualify for Form 1040EZ, the following conditions must be met:
- Filing status is single or married filing jointly.
- Under age 65 on January 1, 2017, and not blind.
- Cannot claim a student loan interest deduction or an education credit.
- Taxable income (Form 1040EZ, Line 6) is less than $100,000.
- Income consists entirely of wages, salary, tips, unemployment compensation, taxable scholarships and fellowships, qualified state tuition program earnings, or Alaska Permanent Fund dividends, and no more than $1,500 of taxable interest.
- Cannot claim an adjustment to income.
- Standard deduction only.
- No tax credit claimed other than the earned income credit for taxpayers without a qualifying child.
- Did not receive advance earned income credit payments.
In order to qualify for Form 1040A, the following conditions must be met:
- Taxable income (Form 1040A, Line 24) is less than $50,000.
- Income consists entirely of wages, salary, tips, taxable scholarships and fellowships, interest, dividends, payments from pensions, IRAs, or annuities, taxable social security and railroad retirement benefits, Alaska Permanent Fund dividends, qualified state tuition program earnings, and unemployment compensation.
- No adjustment to income other than an IRA contribution deduction or a student loan interest deduction.
- Standard deduction only.
- No tax credits other than the credit for child and dependent care expenses, the credit for the elderly or the disabled, the adoption credit, the child tax credit, the additional child tax credit, the education credits and the earned income credit (EIC).
Zero EFC Formula
The Zero EFC Formula may be used if BOTH of the following criteria are met:
- The student’s parents filed or are eligible to file Form 1040A or 1040EZ, or the parents are not required to file any income tax return. (Note: For an “independent student” with dependents other than a spouse, the student must not have been required to file Form 1040.)
- The parents’ adjusted gross income is $24,000 or less, or if the parents are not tax filers, the sum of their earned incomes is $24,000 or less. (Note: For an “independent student” with dependents other than a spouse, the student’s adjusted gross income must be $24,000 or less.) The advantage of this exception is that the student is automatically considered to have an EFC of zero.
Note: Independent students with no dependents other than a spouse do not qualify for the automatic zero EFC exception.
Institutional Methodology (EFC) Formula
The Institutional Methodology formula (IM) is an alternative formula used by about 300 private colleges to calculate an Institutional EFC. It is used as the basis for distributing the individual college’s own private funds. The College Board determines this formula and makes annual changes to it.
Federal financial aid funds are distributed on the basis of the FM, even though the college uses the IM to distribute its own private funds.
The Institutional EFC is usually higher than the EFC calculated using the FM formula. The IM takes into consideration items such as the personal residence and family farm assets. The FAO also has the discretion to add back certain income items such as depreciation or business losses. The FAO can also add back asset items that have been disposed of prior to the filing of the financial aid application, but were in the family’s possession during the year.
The IM formula gives several options to the FAO at the college. For example, the FAO may request that depreciation expense be added back to AGI or that the value of annuities or life insurance be counted as an asset. The financial advisor should get the specific college’s policy as to the IM options that they use.
The family’s EFC should be calculated using both the FM and IM formulas. This is to prevent an unpleasant surprise for the client who only has the EFC calculated using the FM formula and has a student that attends a college that uses the IM formula. This scenario would be similar to calculating a client’s income tax liability without considering Alternative Minimum Tax (AMT).
Comparison of the Federal and Institutional Formulas
Following is a summary comparison of the FM and IM formula:
- The IM formula does not recognize the “Simplified EFC” or the “Zero EFC” exception in its calculations.
- The IM formula does not allow an income protection allowance for the student’s income.
- The IM formula has a minimum student contribution from the student’s income. The amount is from $1,800 to $2,400, depending on the student’s year in college and independent student status.
- The IM formula includes the equity of the home and the family farm assets in its calculations.
- The IM formula includes the amount of any flexible spending account contributions and Medical Savings Account (MSA) in its income calculations.
- The IM formula includes an allowance against income for unreimbursed medical expenses in excess of 3.5% of the parents’ financial aid income.
- The IM formula will disallow losses (losses shown on the face of the Form 1040 tax return Schedule C, D, E, F, etc.) that lower AGI.
- The IM formula (at the option of a particular college) may disallow depreciation expense taken on the tax return. This may be a reason to lease versus purchase a business asset during college years. If a college disallows depreciation expense, then it stands to reason, any taxable gain (which is included in AGI) attributable to depreciation recapture should not be considered as income by a college that uses this option.
- The IM formula (at the option of a particular college) may have an allowance against income for elementary, junior high, or high school tuition paid for members of the household (not including the student).
- The IM formula’s tables for (1) allowances for state and other taxes paid, (2) income protection allowance, (3) asset protection allowance, and (4) asset assessment rate for parents’ assets, are different than the FM formula’s tables for dependent or independent students. In most cases, the differences in these tables are not material.
- The IM formula (at the option of a particular college) may include the retirement assets of the student.
- The IM formula includes the assets of the student’s siblings (the siblings must be under age 19 and not college students). They are included as an asset of the parents and will be assessed at the parents’ rate.
- The IM formula assesses both dependent and independent student assets at a 25% rate (compared to 20% under the FM).
- The IM formula assesses independent student income at a 70% rate.
- The IM formula assesses parents’ income at a maximum rate of 46%.
- The IM formula has an asset protection allowance which is based on the income of the parents and not on the age of the older parent.
- The IM formula assesses parents’ assets at a separate rate of either 3, 4, or 5%.
- The IM formula allows a deduction against parents’ income to recognize the need for parents to save for younger children’s college expenses.
- The IM formula does not allow dividing the parental contribution by the number in college. It allows a lesser percentage for each additional child enrolled in college: 60% of the parental contribution when 2 are enrolled, 45% of the parental contribution when 3 are enrolled.
- The IM formula assesses both the college savings plans and prepaid tuition plans as an asset of the parents.
Summary of Financial Aid (EFC) Formulas
The financial advisor must be aware of the differences between the two formulas used to determine a client’s EFC. The strategies selected for a client may depend upon which formula the college that the child attends utilizes to calculate the EFC. Therefore, it is imperative that the client performs an accurate and timely college selection search.
The financial advisor should determine the student’s current and projected status as either an “independent” or a “dependent” student. If the student is considered an “independent” student, either by meeting one of the criteria or by “professional judgment” of the financial aid officer, there may be a great financial aid benefit to the client. The financial advisor should make every attempt to obtain “independent” status for the student.