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Approaches to Sheltering Money Often Backfire
There are ways of reducing the impact of parent assets to zero, but each method has its own flaws. Most approaches involve saving or investing the money in a non-reportable asset, such as a qualified retirement plan account. (Investing the money in a small business or using it to pay down the mortgage on the family home may work for federal and state student aid, but not for money from the college's own need-based financial aid funds.) The flaws in these approaches do not make them suitable solutions for sheltering an emergency fund. One approach is to save the money in a Roth IRA, which is not reported as an asset on the FAFSA. Given the low annual contribution limits on a Roth IRA, using this strategy will take several years to implement. So long as one does not take a distribution from the Roth IRA while the student is enrolled in college, it will have no impact on need-based aid eligibility. But the family cannot take any distributions from the Roth IRA, not even a tax-free return of contributions. A tax-free return of contributions will be reported as untaxed income on the FAFSA. Regardless of whether the distribution is taxable or not, it will reduce aid eligibility by as much as half the distribution amount. Another approach involves saving the money in a whole life or cash value life insurance policy. These are not reported as assets on the FAFSA because they are treated like qualified retirement plan accounts. (Note, however, that there has been so much abuse of this provision that the favorable treatment of these life insurance policies may be eliminated in the future.) Any distributions from such a life insurance policy will count as untaxed income on the FAFSA, and may also involve high surrender charges. One could borrow from the life insurance policy's cash balance, but then the interest payments merely substitute for the income the money would have earned had it remained invested. Any unpaid interest will be added to the loan balance, causing the borrower to be charged interest on interest. This accrued but unpaid interest will eventually be treated as income by the IRS. The interest payments also cannot be deducted on the borrower's federal income tax return, unlike the interest on student and parent education loans. Even if the family does not take a distribution or loan from the cash balance, the return on investment after commissions and expenses is lousy, among the worst available. These products are more to the benefit of the salesperson than to the insured. Both of these approaches suffer from a critical flaw, in that they tend to limit access to the investment. A rainy day fund must be saved in an easy-to-access liquid form, such as a savings account or money market account. If an emergency arises, the family will need quick access to the money. Most methods of sheltering money from need analysis are not very liquid and will result in a significant penalty by reducing the student's eligibility for need-based financial aid. This will hurt the family even further at a time of severe financial distress.