Surprisingly, very little has been written about paying for college expenses through the use of stock options, employee stock purchase plans, restricted stock, and other equity grants. In fact, however, your ability to pay for college, and ultimately have more money for retirement, may rest on your company's stock plan and related financial planning.
Financial Aid Basics
Need-based student aid is awarded on the basis of financial need and comes in the form of work-study, student loans, grants, and scholarships. Need-based aid is awarded to students who demonstrate a need for aid based on the following formula:
cost of attendance (COA) – expected family contribution (EFC) = financial need
This financial need is reduced by any merit-based aid and scholarships that the student receives. Your EFC is determined by completing the FAFSA (Free Application For Federal Student Aid) and submitting it to a processing center (online or in hard copy), where the information about you and your child from the FAFSA will be entered into the Federal Methodology Need Analysis Calculation.
If your child has enrolled in a college whose yearly cost of attendance is $35,000 and your expected family contribution (EFC) is $21,000, then your child demonstrates a need for aid in the amount of the difference, or $14,000. The financial aid officer at the college will then try to fill that need with a package of work-study, student loans, grants, and scholarships that your child is eligible for from the college, state and federal governments, and private organizations.
Likelihood Of Receiving Financial Aid
The estimated average overall cost of a four-year public college in the United States for the 2015–2016 academic year is $28,000 per year; four-year private colleges in the US average $60,000 per year. According to the 2015–2016 Federal Methodology Formula to calculate financial need for student aid, a family of four that has one college student and no assets, doesn't make contributions to a qualified retirement plan, and files a joint tax return on $140,000 of adjusted gross income (or more) will typically not qualify for need-based student aid at the average four-year public college ($28,000). The same family with $210,000 of adjusted gross income will typically not qualify for need-based student aid at either a public or a private college ($60,000). Based solely on these levels of income, the family's expected contribution towards the cost of attendance (COA) will exceed the corresponding cost of attendance at both public and private colleges, and the student will not be eligible for need-based student aid.
Eligibility for need-based financial aid at the income levels referenced above applies to families with only one child in college. When parents have two or more children in college their portion (parental contribution) of the expected family contribution (EFC) gets split among all of the children in college, in which case one or all of those children may qualify for some need-based financial aid. Therefore, for financial aid purposes, having twins in college at the same time can be more beneficial than having two children in college five years apart.
Role Of Stock Compensation In Financial Aid Calculation
However, financial aid eligibility is based not just on the income of parents and students but on their assets as well. Your EFC is increased by some percentage of your assets, reducing your calculated financial need. Question 41 in the student section of the 2015–2016 FAFSA asks:
As of today, what is your total current balance of cash, savings and checking accounts?
Question 42 asks:
As of today, what is the net worth of your investments, including real estate (not your parents' home)? Net worth means current value minus debt.
Accordingly, parents answer the same questions in their section of the FAFSA on Lines 89 and 90, respectively.
The FAFSA defines investments thus:
Investments include real estate (do not include the home you live in), trust funds, UGMA and UTMA accounts, money market funds, mutual funds, certificates of deposit, stocks, stock options, bonds, other securities, installment and land sale contracts (including mortgages held), commodities, etc.
Investments also include qualified educational benefits or education savings accounts such as Coverdell savings accounts, 529 college savings plans and the refund value of 529 prepaid tuition plans. For a student who does not report parental information, the accounts owned by the student (and the student's spouse) are reported as student investments in Question 42. For a student who must report parental information, the accounts are reported as parental investments in Line 91, including all accounts owned by the student and all accounts owned by the parents for any member of the household.
The FAFSA instructions further explain:
Investments do not include the home you live in, the value of life insurance, retirement plans (401(k) plans, pension funds, annuities, non-education IRAs, Keogh plans, etc.) or cash, savings and checking accounts already reported in Question 41 (for students) and Line 90 (for parents). Investment value means the current balance or market value of these investments as of today. Investment debt means only those debts that are related to the investments.
For the most part, all non-retirement savings and investments will count against the parents at a maximum rate of 5.64%, including all vested options and grants that are in the money (i.e. the exercise price is lower than the market price). Thus, vested options and grants that are in the money reduce your eligibility for need-based student aid.
According to informal discussions with the Department of Education, the value that should be reported is the net value (after fees, commissions, taxes, etc.) of all types of vested stock options as if they were exercised and sold at market value on the day the form was completed. (For stock options, the value is just the spread, not the face value of the grant before exercise costs.) The same rules probably apply for employee stock purchase plans, restricted stock, and stock appreciation rights.
Reportable assets in the student's name are counted against them at a rate of 20% of the total net asset value when you file the FAFSA for the 2016–2017 academic year (the 2016–2017 FAFSA deadline is June 30, 2016). However, 529 college savings, 529 prepaid assets, and Coverdell Education Savings Accounts (ESAs) that are owned by the child are not counted as an asset of the student, but rather as assets of the parent(s) and assessed at a rate as high as 5.64%.
Asset Protection Allowance
Fortunately, parents receive what is referred to on the FAFSA as the Asset Protection Allowance. This usually ranges between about $15,000 and $28,000 for married parents aged between the mid 40s and the mid 50s. The Asset Protection Allowance is an amount of "reportable" assets that do not count against you when you complete the FAFSA.
Example: You have in-the-money vested options with a market value of $200,000. You have an Asset Protection Allowance of $18,000. Thus $182,000 will count against you at 5.64%, or $10,265, and so your student's aid eligibility decreases by $10,265. Assets in the student's name that are reportable on the FAFSA are assessed at 20% from the very first dollar because, unlike with parents, there is no asset protection allowance for students.
The FAFSA Rules On Income And Asset Information
The FAFSA is one aid form, but it is based on information from two years:
- assets that you have in the current year
- income from the previous year
The FAFSA requires information on your assets as of the day you complete the form, and traditionally the income questions have pertained to your income from the previous year. That rule will remain in place until October 2016, when the new so-called "prior–prior" filing format will go into effect. The transition to the new format will make parents' 2015 income more important than ever and create a lot of confusion as to how the rule works, how it will impact aid eligibility, when to file what, and to whom.
The New Prior-Prior Filing Format
In September 2015, the Obama administration changed the filing format of the FAFSA so that instead of using income from the year before college enrollment, it will use income from the year preceding the year before enrollment (i.e. the prior-prior year). In other words, students' financial aid eligibility will be based on income from two years before they start college, not one year before. When the changes become effective in 2016, students who are high-school seniors in the fall of 2016 will be able to apply for financial aid for their freshman (academic) year of college in 2017–2018. They will have to submit the FAFSA in October 2016 and use income-tax information from their parents' tax returns for 2015.
Alert: This means that, in the transition from the old rule to the new rule, parents with high-school seniors, college freshmen, and college sophomores today will use 2015 income to complete the financial aid form for next year and again for the following academic year—two years in a row. High school juniors and college juniors will be impacted by 2015 income for just one year when applying for aid.
- If your child enters college in 2016, you will use 2015 income-tax information.
- If your child enters college in 2017, you will use 2015 income-tax information.
- If your child enters college in 2018, you will use 2016 income-tax information.
- The process will roll forward from there—for students starting college in 2019, information from 2017 will be used, and so on.
Why The Big Change?
Today students complete the FAFSA with the prior year as their so-called base year—i.e. the first year of college aid is based on that year's income. While aid during college years can change according to a family's finances, that first year of aid is crucial to the decision about where the student will go to college. As financial aid deadlines occur between January and March, high-school seniors often must complete the FAFSA with estimated income numbers because their parents don't yet have their tax returns completed for the prior year. When those tax returns are filed, applicants must then go back and update their FAFSA information. That information lag holds up and complicates the financial aid system for students, parents, and colleges, so the rule change is not only long overdue but welcome—unless, that is, you have a high-school junior and you just sold stocks in 2015 while markets were at all-time highs.
What About The CSS Profile Form?
The FAFSA is used to determine federal aid: the Pell Grant for low-income students and eligibility for subsidized and unsubsidized Stafford Loans, as well as for small state grants. A big question is whether the College Board will follow the FAFSA change and use the prior-prior year method for its CSS Profile form. That form is used by over 200 private colleges and a handful of flagship public schools to determine student eligibility for the schools' own need-based grants and scholarships. Those are more valuable than loans, which must be paid back with interest. A handful of elite colleges are even committed to covering all need without loans. The College Board has stated the following on this topic:
"The College Board supports the simplification of the financial aid process as a means to reducing barriers to college. We believe the move to providing 'prior-prior year' data for the FAFSA and federal aid will make it easier for students and families to plan and pay for college. We are committed to supporting institutions as they make this transition. We are working closely with our members and leaders at colleges and universities to determine next steps for CSS/Financial Aid PROFILE, which provides students access to billions of dollars in institutional financial aid and allows higher education institutions to distribute their funds equitably and efficiently."
Note that the CSS does already ask for very basic information on prior-prior-year income. Colleges don't use prior-prior tax information submitted on the CSS in the calculation of expected family contribution (EFC), but rather for purposes of professional judgment in determining whether there was a big drop in income from the previous year. It is not intended to detract from a student's eligibility for aid.
Impact Of Equity Compensation On FAFSA Filing
This year, you still use today's asset information and last year's income information when completing the FAFSA. In October 2016, when applying for aid in 2017–2018, you will use the prior-prior filing format and use your 2015 income again. This could work against you, as the income from your equity compensation in 2015 is reflected in your tax return for 2015, which is the source of the information to answer the income-related questions on the following year's FAFSA (2016–2017 and 2017–2018 for high-school seniors and college freshmen and sophomores). In addition, equity compensation income reported on your 2014 tax return is now an asset too if you still have the cash proceeds or if you continue to hold the stock.
The only way to prevent cash proceeds from the stock sale from being counted as an asset on the FAFSA is putting them into an annuity or a life insurance policy in the parents' names or the student's name. If the proceeds are put into a 529 college savings or prepaid plan, the value of the account will be trusted as an asset of the parent, regardless of whether the parent or the student is the owner, and will thus count against the student's aid eligibility at up to 5.64% of the account's total value.
Using the example from above, if you have $200,000 in vested options, those options will count against you as an asset this year. In addition, if you also had income during the previous year from options that you exercised or from restricted stock that vested, that income will have to be reported on the FAFSA this year and will count against you in the income portion of your expected family contribution.
With incentive stock options (ISOs), when you exercise and hold the stock through the tax year that is used to report your compensation for your FAFSA, you have no income to report for the exercise. However, the ISO stock itself will show up on the form as an investment asset. Nonqualified stock options (NQSOs), in comparison, always trigger income at exercise, as restricted stock does at vesting.
On the FAFSA, as income increases, aid eligibility decreases. When reporting your current assets for this year on the form, make sure you use a current statement of your equity grant holdings to exclude options you exercised and restricted stock that vested last year. This will prevent double-counting them as both last year's income and this year's assets. If you continue to hold that stock, then it should be included like the value of any stock you own.
Part 2 to be featured next month and explains the basics of gift tax and introduces specific strategies for using stock grants to pay for college.
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Morgan Stanley Smith Barney LLC ("Morgan Stanley"), its affiliates and Morgan Stanley Financial Advisors do not provide tax or legal advice. Clients should consult their personal tax advisor for tax related matters and their attorney for legal matters.
CRC 1415636 03/2016