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Five College Financial Aid Pitfalls to Avoid

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Financial aid rules for college have become so complicated, you almost need a Ph.D to sort through it.

The process of organizing family finances to maximize the help you and your student can receive with sky-high tuition bills seems to become more complex each year, and the potential pitfalls are many.

These five missteps can be especially costly, but if you plan ahead, you can steer clear.

1. Don't misunderstand what a college is offering.

Many families run into trouble when they fail to comprehend the nature of the aid a college is offering, according to Mark Kantrowitz, publisher of finaid.org and fastweb.com, websites focused on strategies for paying for college. Some letters announcing financial aid, he said, "do not adequately distinguish between the loans and the grants, or may not include interest rates, monthly payments," or more. Also, in some cases, "they treat the loans as though they reduce the cost," but in fact, only grants do that.

Kantrowitz said he has posted on one of his websites a sample loan, with interest rate and maturity, and asked readers to calculate the ultimate cost and choose between six possible answers. Fewer than one-sixth of respondents get it right, he said. "The only people who get it right more than 50 percent of the time are mathematicians," he said.

(Read More: Annual Interest and Debt Maturity)

The key to understanding what a college is really offering, Kantrowitz said, is to ask questions. If you aren't sure how much of the proffered aid is in loans—and sometimes money is listed as coming from a federal program like Parent Plus, and not explicitly described as a loan—then ask. Also ask whether grants will be spread evenly over four years, or if they are "front loaded" into the initial year and likely to shrink over time.

2. Try not to succumb to sticker shock.

It can be daunting to contemplate a high-priced private college, but Kantrowitz stresses that the key for families is what the net cost of attending will be. Often, he says, the pricier schools can offer more financial aid, so that in the end they are no more expensive than the local state university.

Net price calculators on college websites enable families to estimate what the net cost of attending would be, and "some of the low-income students who would have a very low net price don't even try the calculators," Kantrowitz said.

3. If at all possible, avoid drawing on retirement accounts.

If you haven't saved enough for college, or your finances have hit a rough patch, that big fat retirement account can look awfully tempting—but there are myriad reasons why tapping it is a bad idea.

For starters, while a loan from a 401(k) is not counted as income for financial aid purposes, the cash from the loan in your bank account counts as an asset. Then there are the penalties: If you don't pay the loan back within five years, it's counted as a distribution and you owe taxes and a penalty. And if you are withdrawing, you are not allowed to make new contributions, which means you also lose the employer match.

"By borrowing from your 401(k), you're hurting yourself more than if you use" a federal loan program, Kantrowitz said. "Also, that five-year repayment is not going to give you much relief."

It gets worse if you take a withdrawal. Emily Wittmann, founder of the consulting firm Witt's End Marketing & Media, discovered that the hard way. Wittmann has not been steadily employed for some time, but she accumulated a sizable 401(k) account with a previous employer. Like many people changing jobs, she decided to take that account with her when she left the company, and converted it to an IRA.

Consulting clients have been scarce in recent years, and with the family's income suffering, Wittmann opted to tap her IRA to help cover their living expenses. But withdrawals are possible only with IRAs, not loans. So Wittmann is paying taxes on the withdrawal, and the early-withdrawal penalty. And now, with her oldest daughter a high school senior, colleges are counting the money as income, cutting her eligibility for aid.

"I knew I was going to get the penalty and the taxes," she said, but now "everyone is telling me, 'Don't expect anything'" in terms of financial aid.

4. Be careful how you take that gift from Grandma.

If you have parents offering to help with the costs of college, that's great—but make sure you plan together so the benefit is maximized. For example, if a grandparent writes a check directly to the college, that is counted either as untaxed income to the child—and reduces your aid eligibility by 50 cents for every dollar—or counted as a resource, reducing eligibility dollar for dollar.

If a grandparent writes a check to the student a few years before college, it's counted as an asset to the child, not income, and 20 percent of children's assets are counted as resources. But if the check goes to the parents, 5.64 percent or less of parents' assets are counted as resources. The bottom line: "If they're giving money to the family to help pay for college, it's better to give it to the parent," Kantrowitz said.

5. Don't be late.

This is the simplest advice of all, but it's critical. "The biggest thing we tell people is to make sure you are applying for financial aid on time. That is the biggest reason people don't get considered for the maximum aid," said Karen McCarthy, a policy analyst with the National Association of Student Financial Aid and Administrators. Federal and state programs, not to mention those offered by colleges, have different deadlines, and some take applications at any time, she said.

Some families wait to file aid requests until they have their taxes completed for the prior year, especially since the Free Application for Federal Student Aid, or FAFSA, asks for tax information. But if you wait, you risk missing deadlines for certain aid program, which can come as early as February—but McCarthy said that's not necessary.

"If you have not filed your tax return, go ahead and file the FAFSA," she said. "You can use estimated tax information in there and then once your taxes are filed, they will send you a reminder to put in actuals. By doing that, you're still considered to have met the early deadline."

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