As families make arrangements to send their children off to college, those plans need to include saving money to pay for college expenses too. It's important for families to understand how much financial aid they're going to receive, as well as their expected family contribution.

In this article, we're going to remove some of the mystery around the expected family contribution (EFC) calculations. As part of that explanation, we're going to walk through each section of the EFC worksheet. We'll explain the impact that family income, expenses, and assets can have on contribution projections. Finally, we'll provide some examples to demonstrate how the formula works in practice.

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The Expected Family Contribution, or EFC, is defined as the amount of money a family is projected to contribute towards a student's college costs. The data used in the calculation is based on information the student and their family supplied when completing the Free Application for Federal Student Aid, or FAFSA.

Once the FAFSA is analyzed, a Student Aid Report, or SAR, is sent back to the student's family. If the application is found to be complete and accurate, the SAR will include the Expected Family Contribution.

The EFC formula consists of three separate calculations: one for dependent students, another for independent students without dependents other than a spouse, and the final formula is used for independent students with dependents other than a spouse. In this article, we're going to focus on the most common scenario: dependent students. However, the calculation of the EFC is the same under all scenarios.

The determination of EFC is divided into two sections. The first section has to do with the income and assets of the student's parents. The second half of the formula takes into consideration the annual income and assets of the student.

The objective of this first series of calculations is to figure out the total income stream for the student's parent(s). The starting point is the parents' adjusted gross income, or AGI, which is found on IRS Form 1040 (line 37), Form 1040A (line 21), or on Form 1040EZ (line 4).

To this income, are added untaxed income and benefits. This includes earned income credits, child tax credits, welfare, and Social Security. Next, the untaxed portion of income is added back to the parents' income. This includes payments made to any tax-deferred savings or pension plan; tax deductible IRAs, SIMPLE IRAs, as well as Keogh plans. Tax-exempt interest income, untaxed distributions from IRAs, and child support is also added to parents' income.

Essentially, the form requires every known source of income to be reported on the worksheet, taxed or untaxed.

This next section acknowledges the fact parents don't get to keep all their gross income; they need to pay taxes too. Here the EFC formula generously allows an income credit to be taken for state and federal income taxes, and FICA taxes (Social Security and Medicare). Nominal allowances are also made for employment expenses, as well as "income protection."

Unfortunately, not only are all sources of income up for grabs, but also liquid and non-liquid assets are eligible too.

The EFC formula also needs to assess the value of all cash, savings, and checking accounts. Investments are also eligible, and generally, the formula takes the form:

Investment Value - Investment Debt = Net Worth of Investments

Investments include rental properties, land owned, second homes, trust funds, 529 plans, Coverdell savings accounts, stocks, bonds, mutual funds, money market funds, and certificates of deposit.

Investment debt equals the money owed on investments and real estate other than a principal place of residence.

Investments typically do not include the value of any life insurance plan, pension funds, annuities, and other retirement accounts such as IRAs and Keogh plans. Investments also exclude the principal place of residence (primary home).

The total of all the eligible assets are considered the parents' net worth. From this value, an education savings and asset protection allowance is taken before the asset conversion ratio of 12% is applied. In effect, 12% of all eligible assets (less the allowance) will count as money that can be contributed towards college costs. Keep in mind that most students go to school for 4 years, so the 12% conversion ratio basically states that 4 x 12%, or 48%, of eligible assets can be used to pay for college.

The parents' contribution is the sum of the Total Income and the Contribution from Assets. The EFC formula takes this total, and divides it by the number of students in college, to develop the contribution to each college or university. Overall, the calculation is very aggressive because it not only goes after a parent's income, but also their assets.

Generally, the student's portion of the EFC formula follows the same process as it does with parents, with several important exceptions. Unfortunately, there are even fewer protections offered students.

Instead of using an asset conversion ratio of 12%, students are asked to give up 20% of their assets each year. Again, this translates into a contribution of 4 x 20%, or 80% of the student's assets.

The Expected Family Contribution formula is very aggressive with respect to income. Since the calculation includes taxable, as well as non-taxable income sources, there isn't much a family can do to protect income from the EFC formula.

On the other hand, there are ways to protect assets from being eligible. As mentioned earlier, the formula specifically excludes money held in pension funds, annuities, and other retirement accounts such as 401(k) plans, 403(b) accounts, IRAs, and Keogh plans. Thankfully, parents aren't asked to give up their retirement money to send their children off to school.

In fact, by specifically excluding retirement money from contributions, the government is actually encouraging parents to fund these types of accounts. This is arguably the single most effective way of lowering the EFC.

We're going to finish up this article by providing several examples to illustrate the level of contributions some families might face. Before that happens, it's important to emphasize how the EFC is used. The primary purpose of the calculation is to determine "need." This is defined in the following manner:

Need = Cost of Attendance (COA) - Expected Family Contribution (EFC)

It's safe to assume the EFC remains constant, regardless of the cost of attendance. This means that once Need is demonstrated (COA > EFC), then Need will increase as the cost of attendance increases. That is to say, more aid will be offered as the cost of college increases. This is demonstrated in the examples provided below.

In this first example, we have a family of four with one full time student. The parents have $50,000 in AGI, paid $3,600 in federal income taxes, own $5,000 in liquid assets and investments, and have $4,000 in untaxed income. The student in this example has $6,800 in income, paid $150 in federal income taxes, and has $2,500 in assets.

In the above scenario, the EFC calculation yields a value of $5,660. Therefore, if the cost of attendance were $16,000, the family's demonstrated need would be $16,000 - $5,660, or $10,340. On the other hand, if the cost of attendance were $6,000, the family's demonstrated need is $6,000 - $5,660, or $340.

In this second example, we have a family of four with one full time student. The parents have $100,000 in AGI, paid $9,900 in federal income taxes, own $50,000 in liquid assets and investments, and have $4,000 in untaxed income. The student in this example has $6,800 in income, paid $150 in federal income taxes, and has $2,500 in assets.

In this second scenario, the EFC calculation yields a value of $24,150. Therefore, if the cost of attendance were $16,000, the family's demonstrated need would be $16,000 - $24,150, or $0. On the other hand, if the cost of attendance were $36,000, then the family's demonstrated need is $36,000 - $24,150, or $11,850.

It's interesting to note that a doubling of income in the examples above yielded nearly a four-fold increase in expected contributions.

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