What college aid strategy is best?

Your clients’ 2015 income will be used to determine their children’s need-based college aid eligibility for the next two academic years, making the decision about whether to sell appreciated stocks in taxable accounts even more tricky and important.

Another consideration is whe-ther you think the market is poised for a decline from the current highs that would erode the value of those investments, if your clients choose not to sell.

Under current FAFSA rules, students filing for financial aid for the 2016-17 academic year will use their parents’ 2016 tax returns, reflecting 2015 income, same as always.

Under new FAFSA rules that go into effect for the 2017-18 academic year, students will use the same 2016 tax return, again reflecting 2015 income. That’s because the new FAFSA rules will require that students use tax forms from the prior year instead of the current year, reflecting income from two years prior, not one year prior.

TAXABLE DISTRIBUTIONS

Many mutual funds are set to make large taxable distributions to shareholders in 2015. While many investors in recent years saw their taxable account values climb but were not required to take taxable distributions, this year will be a different story.

Your investment income and the investment itself count against college aid eligibility.

The unearned income (interest, dividends and capital gains) that shows up on a student’s or parents’ tax returns for 2015, either from selling an investment or from distributions from a mutual fund, will therefore get counted on the student’s financial aid forms for the 2016-17 and 2017-18 academic years.

The asset value itself will get counted on the aid forms, too, while it is sitting in a brokerage account or in cash or savings after the sale of the investment.

Depending on the aid formulas used by the colleges, the value of reportable assets in parents’ names will be assessed at up to 5% to 5.64%, and in students’ names at 20% (most public universities and some private), 25% (at 200 private colleges and UNC Chapel Hill, Georgia Institute of Technology, University of Virginia, William & Mary and University of Michigan at Ann Arbor) and only 5% (at 23 private colleges called the 568 Presidents’ Group).

UNREALIZED GAINS

For example, if your client has an investment worth $50,000 that has an unrealized gain of $15,000, just the value of that investment gets reported on the aid forms. As soon as it is sold and the $15,000 gain is realized for tax purposes, then the capital gain income will be reported as part of the parent’s adjusted gross income on the aid forms, the FAFSA and CSS Profile.

Assuming your client is in the 25% tax bracket or above (the capital gains tax rate is zero in the 10% and 15% brackets), you will pay capital gains tax at 15% to 20% (as high as 23.8% for some taxpayers), or $2,250 to $3,000 on the $15,000 gain, and raise the child’s expected family contribution by about half of the after-tax income, or $6,500.

So how to decide what strategy is best for your client?

If the client’s child owns the asset and has no other income, the child will be subject to the kiddie tax and pay $2,100 in capital gains tax. The student’s income protection allowance in the aid formulas would offset about $6,400 of the $15,000 in capital gain income. So, after taxes and the student’s income allowance — a combined $8,500 — the income from the sale would increase the student’s expected family contribution by about $3,250.

If the child does not qualify for need-based college aid, then sell the asset and focus on the most tax-efficient way to deal with the capital gain income.

AID ELIGIBILITY

If the child is a high school senior enrolling next year or a student already enrolled in college and does qualify for need-based aid, then selling the asset will impact the child’s aid eligibility for the upcoming two years, but not subsequent years. If the child is a college junior, the client could wait until January 2016 and then sell, because the resulting income would be in the 2016 tax year, which would only get reported on financial aid forms when applying for aid for the 2018-19 academic year and their child (presumably) already will have graduated.

Troy Onink is the chief executive of Stratagee.com, where he leads the new College InSource Partner Program.