Does a "Safety Net" Affect Eligibility for Student Financial Aid?

We are parents of a high school junior looking to learn about the best places to put our money for when we fill out that first FAFSA in two years. My husband insists that we have a "safety net" of at least $10,000 in an account for emergencies (like large car maintenance costs, accident deductibles, etc.). Currently that money is in our money market account, where we also set aside money for our annual property taxes.

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From all I read, though, it needs to be in a place that the formula wouldn't consider "usable" for college tuition. What are the possibilities for having such a safety net that you can get to instantly, if needed, but not having them be part of the EFC? Should we move it to one of our Roth IRAs? Keep it in the money market account?

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— Amy W. Every family should maintain a rainy day fund for emergencies regardless of the potential impact on eligibility for need-based student aid. This provides a safety net for unforseen expenses, such as auto repair or replacing a furnace, or for temporary unemployment.

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A typical rule of thumb is to save 3-6 months worth of income in the rainy day fund. This rule of thumb is based on the average duration in unemployment. This rule of thumb also assumes that the family will reduce spending to just the essentials during periods of unemployment. Essential expenses include food, clothing, lodging, utilities, medical care, insurance, taxes and debt payments. However, this 3-6 months rule of thumb was based on unemployment statistics that no longer reflect the typical experience of unemployed people. During the current economic downturn, the duration of unemployment has increased significantly. From 1948 to 2008, the average unadjusted duration of unemployment ranged from a low of 1.5 months between recessions to a high of 5.0 months during a recession and for a few years afterward. The maximum average duration from 2008 to 2011, however, has increased to 9.6 months. The median unadjusted duration of unemployment followed a similar pattern, ranging from 0.5 months to 3.0 months from 1948 to 2008, with the peak median duration increasing to 6.0 months from 2009 to 2011. The percentage of people who have been unemployed for 27 or more weeks has doubled from a fifth of the unemployed in 2002 to 2008 to two fifths in 2009 to 2011. These statistics were obtained using the Bureau of Labor Statistics (BLS) data retrieval tool, unemployed persons by duration of unemployment. The BLS also published two relevant charts, Duration of unemployment in February 2011 and Duration of unemployment, 1994-2010. For additional information, see Issues in Labor Statistics: How long before the unemployed find jobs or quit looking? Accordingly, it may be best to save 6-12 months worth of income in the rainy day fund. This rule of thumb can be adjusted based on educational attainment and residential location. People who have a Bachelor's degree have a duration of unemployment that is about a third below average. People who live in high unemployment states have a duration of unemployment that is as much as a quarter above average. Two-income families may have more flexibility, unless the couple works at the same company, which adds a risk of simultaneous layoffs. The rainy day fund should be kept in a liquid form, where the funds are immediately accessible. There should also be no risk of loss to principal. For example, one can keep the rainy day fund in a bank savings account or a money market account. Some people keep the money in a bank certificate of deposit (CD), since one can withdraw the money from a bank CD at any time by paying a penalty of 3 months interest. But it is best to keep at least a few thousand dollars immediately accessible. A typical rainy day fund will not affect the student's eligibility for need-based financial aid because a portion of parent assets are sheltered by an asset protection allowance. The asset protection allowance varies from one year to the next, but it is typically about $46,000 plus or minus $3,000 for parents of college-age children (median age 48). Any reportable assets above this threshold are assessed according to a bracketed scale, reducing aid eligibility by at most 5.64% of the net asset value. (The asset protection allowance is based on the age of the older parent. It is the present value of an annuity which will supplement Social Security retirement benefit payments to equal the moderate family income. It varies annually based on changes in the inflation rate.) Attempting to shelter the money from need analysis may make it less accessible for emergencies, defeating the purpose of the rainy day fund. For example, paying down credit card debt or a mortgage may shelter the money from need analysis, but one cannot rely on credit cards or a home equity loan during an emergency. Access to credit is often restricted after job loss. Sheltering the money may also hurt eligibility for need-based financial aid. For example, while a Roth IRA may shelter assets on the FAFSA, any distributions from the Roth IRA will count as income on the next year's FAFSA. This will artificially increase income and decrease financial aid at a time when the family is struggling financially. While a return of contributions from a Roth IRA may be tax-free, the distribution will count as untaxed income on the FAFSA, reducing aid eligibility by as much as half of the amount of the distribution.