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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.

Your ability to pay for college, and have more money for retirement, may rest on your company's stock plan and related financial planning.

Part 1 of this series helps you understand the impact that equity grants have on financial-aid eligibility. Part 2 covers the gift tax rules and the effect of the tax treatment on your strategy. Part 3 looks at the so-called "kiddie tax" and at specific strategies for using stock grants and tax credits to pay for college.

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. (An EFC calculator is available at the website CollegeBoard.com.)

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

Financial-aid eligibility is based not just on the income of parents and students but on their assets as well.

The average overall cost of a four-year public college in the United States is at least $28,000 per year. Four-year private colleges in the US average at least $60,000 per year. According to the 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) typically does not qualify for need-based student aid at an average four-year public college ($28,000). The same family with $210,000 of adjusted gross income typically does 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) exceed the corresponding cost of attendance at both public and private colleges, and the student is therefore not 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. The student section of the FAFSA asks:

As of today, what is your (and spouse's) total current balance of cash, savings, and checking accounts? Don't include student financial aid.

It also asks:

As of today, what is the net worth of your (and spouse's) investments, including real estate? Don't include the home you live in.

Parents answer the corresponding questions in their section of the FAFSA.

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. For a student who must report parental information, the accounts are reported as parental investments, 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 for students and 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.

Vested options and grants that are in the money reduce your eligibility for need-based student aid.

Reportable assets in the student's name are counted against them at a rate of 20% of the total net asset value. 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%.

Value To Use

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.

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

Students' financial-aid eligibility is based on income from two years before they start college.

The FAFSA requires you to report your assets as of the date of application. It uses income from the year preceding the year before enrollment. In other words, students' financial-aid eligibility is currently based on income from two years before they start college, not one year before. Therefore, stock compensation that is taxable in the current year will affect eligibility for financial aid two years from now.

Example: Taxable stock compensation recognized in 2021 will affect eligibility for financial aid in the 2023–2024 academic year. If your child will start college in 2023, you will use 2021 income-tax information when you file the FAFSA in the fall of 2022.

Sometimes called the "prior-prior year" approach, this method allows FAFSA-filing to start in October, as opposed to January of the following year. Instead of estimating income on the FAFSA, you report numbers from a tax return that has already been filed. You then file a new FAFSA for each subsequent year of college under the same rules, as your income changes.

What About The CSS Profile Form?

The FAFSA is used to determine federal aid: the Pell Grant for low-income students; eligibility for subsidized and unsubsidized Stafford Loans; and small state grants. 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.

Note that even before the change in FAFSA income-reporting, the CSS asked for very basic information on prior-prior-year income. While colleges did not use prior-prior tax information submitted on the CSS in the calculation of expected family contribution (EFC), they considered it for purposes of professional judgment in determining whether there was a big drop in income from the previous year.

Impact Of Equity Compensation On FAFSA Filing

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 treated 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. (See the section ISOs: Taxes for details.) 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.

Next Article

Part 2 explains the basics of gift tax and introduces specific strategies for using stock grants to pay for college.

The late Troy Onink was the CEO of Stratagee.com, a firm providing college-funding advice to families. He was also a blogger at Forbes.com. This article, now kept current by the editorial staff of myStockOptions.com, was published solely for its content and quality. Neither the author nor his firm compensated us in exchange for its publication.