Four money mistakes to avoid and keep your financial aid

[August 30, 2018]   By Gail MarksJarvis

CHICAGO (Reuters) - Parents may think they can stop paying attention to financial aid after their child has decided on a college, but those offers generally apply to only the first year.

That means families have to reapply for financial aid each year a child will be in college.

Many of the money decisions people make during this crucial period could make or break their financial aid package.

The following are four mistakes to avoid:

1. Bad timing from help from grandparents

Grandparents may mean well by offering assistance, but if they give money at the wrong time, it can dent an aid package.

For example, if a grandparent gives $10,000 from a 529 college savings account that they own, colleges count that as student income. Income in a child's name counts a lot more than parental assets or income, so it could substantially cut into aid.

A solution for grandparents who want to help is to wait, said Mark Kantrowitz, publisher and director of research for savingforcollege.com.

Once past Jan. 1 of a student's sophomore year, colleges usually stop scrutinizing family income. So money from a grandparent's 529 can typically be used without impairing aid - unless the student goes to college for a fifth year.

Grandparents could also wait until after graduation and instead help pay off student loans, said Kalman Chany, financial aid consultant and author of "Paying for College Without Going Broke."

2. Too much gain

Parents often plan to cash out investments to pay for college, but once the calendar crosses Jan. 1 of your child's tenth-grade year, selling can be a costly mistake.

Any capital gain on an investment would hit the first tax return used in the Free Application for Student Aid (FAFSA) and would thereby reduce financial aid.

One solution could be to sell losing investments to offset any gains. If that is not possible, Chany suggested holding on to investments and instead borrowing money to pay for the first two years of college. Selling during junior and senior years of college will typically not hurt your aid offer.

 Messages and artwork are pictured on the top of the caps of graduating students during their graduation ceremony at UC San Diego in San Diego, California, U.S. June 17, 2017. REUTERS/Mike Blake/File Photo

3. Taking a second mortgage

For parents thinking about financing a college education by cashing out equity in their house with a second mortgage, there will be consequences for holding on to the large stash of cash in your bank account – not to mention interest costs to the loan.

A better solution, according to Chany is to use a home equity line of credit. With this set-up, you only withdraw money when you need it to make tuition payments and it will not just sit on your balance sheet.

Ironically, taking money out of your house may also boost your aid package with some colleges. If the school is among those that counts your home as an asset, reducing your equity stake in the property could make you eligible for more aid.

4. Raiding retirement accounts

Although you will not be penalized by the IRS if you use a traditional IRA to pay for college, you will get taxed on anything you take out as income. The real problem with this approach for aid is that will be adding to your taxable income, and so colleges will expect you to pay more.

The same goes for distributions from a Roth IRA, even though no penalties would be incurred and there will be no income tax if you only remove your own contributions, which have already been taxed.

Instead, Chany said, borrowing from a 401(k) and using the money immediately to pay for college should not hurt aid This is a risky move overall, however, since if you lose your job and cannot pay back the funds, you will face penalties.

Even riskier is putting college needs first, since those retirement accounts are not easily replenished.

"It's not a good idea to raid these funds because you will be closer to retirement when your child finishes college," Chany said.

(Editing by Beth Pinsker and G Crosse)

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