Many parents saving for their children's college expenses are concerned about the potential impact of saving on financial aid. The interaction of saving in general and financial-aid eligibility is a very complex issue. Put simply, a student's financial need is determined by the difference between the cost of attendance at a school and the student's expected family contribution.

A student's expected family contribution (EFC) can be considered the amount of college expenses the student and family are expected to shoulder. The cost of attendance is the estimated sum of tuition and fees, room and board, books and supplies, transportation, and miscellaneous expenses. For any given level of cost of attendance, the larger the EFC, the smaller the student's need, and the less amount of aid the student is eligible.

In calculating a dependent student's EFC, 35% of a student's assets and up to 5.64% of parents' assets are considered available to pay for the student's college expenses. Therefore, assets held in the student's name would reduce the student's financial need much more than assets held in the parents' names would.

So, how are various savings options treated in the EFC calculation?

• 529 Savings Plans: Assets held under a parent's name are considered as parents' assets and assessed at a marginal rate of up to 5.64% in the EFC calculation.
• 529 Prepaid Plans: Assets in a 529 prepaid contract usually reduce the student's cost of attendance by the value of the contract and thus reduce the student's aid on a dollar-for-dollar basis.
• Coverdell Education Savings Accounts: Assets are considered as the student's assets and assessed at a 35% rate in the EFC calculation.
• UGMA/UTMA Accounts: Assets are considered as the student's assets and assessed at a 35% rate in the EFC calculation.
• Mutual Funds: Assets held under a parent's name are considered as parents' assets and assessed at a maximum of 5.64% rate in the EFC calculation.

How Is EFC Calculated?

Depending on the source of financial aid, either a federal methodology or an institutional methodology may be used to determine a student's EFC. Established by Congress and administered by the U.S. Department of Education, the federal methodology is used to determine a student's EFC for federal financial-aid purposes. The institutional methodology is used by many colleges and universities to calculate a student's EFC for non-federal financial-aid purposes. A major difference between the two is that the institutional methodology takes into consideration home equity and the federal methodology does not.

Because federal financial aid makes up the majority of total student financial aid, this article discusses in detail the federal methodology for the calculation of EFC.

Most federal financial-aid programs require that students fill out a Free Application for Federal Student Aid form. The form collects information on a student and parents' income and assets, family size, etc. After the form is submitted, the central processing system at the Department of Education applies the federal methodology formula to determine a student's EFC and confirms some of the eligibility requirements through computer matches with other agencies.

A dependent student's EFC comes from the student's contribution from income and assets and parents' contribution from income and assets, calculated as follows. (A good calculator that estimates EFC is located here.)

1. Start from the parents' adjusted gross income as reported on the tax return for the previous year.
2. Add back tax-exempt income such as earned income tax credit and contributions to a retirement plan.
3. Subtract several allowances, including income protection allowance (to cover living expenses), federal and state income tax allowance, Social Security tax allowance, and employment protection allowance. The result is called available income.
4. Parents' discretionary net worth is calculated by summing up parents' financial assets excluding home equity and subtracting an asset protection allowance.
5. Twelve percent of parents' discretionary net worth is added to parents' available income to get parents' adjusted available income.
6. The parental contribution from income and assets is then determined by applying a progressive schedule to the adjusted available income. 

1. Start from the student's adjusted available income as reported on the income tax return for the previous year.
2. Add back some tax-exempt income and benefits.
3. Subtract several allowances, including federal and state income tax allowance, Social Security tax allowance, and income protection allowance. The result is available income.
4. Fifty-percent of the student's available income is considered available to pay for college expenses.
5. Thirty-five percent of the student's assets are considered available to pay for college expenses.

It is also worth noting that a student may qualify for a simplified EFC formula if his of her family income level falls below a certain level  and neither the student nor the parents were required to file an IRS Form 1040 for the previous tax year. Because the simplified formula does not take assets into consideration in the EFC calculation, saving in this case will not affect the amount of financial aid the student is eligible for at all. Students with family income below $13,000 are automatically eligible for a zero EFC.

Although saving in general may affect the amount of financial aid a student is eligible for, in most cases it is the amount of loans that will be affected because only students with very low EFCs are eligible for grants.

Colleges and universities usually try to meet students' financial needs with aid packages that consist of grants, loans, and work study. Unlike grants, loans must be repaid. The more families save for college, the less they will need to borrow. In choosing which savings option to use, parents may want to keep in mind that assets held in a parent's name would have a much lesser impact on financial aid than assets in the student's name would.