Behold, FAFSA season is upon us! Well, not entirely– the FAFSA isn’t available until January 1. Nonetheless, confusion and questions about the FAFSA abound already.
One of the more confusing aspects of the FAFSA is how retirement plan contributions are counted. “Wait,” you say, “I thought my retirement plan doesn’t count on the FAFSA!” It’s true that your retirement plan balance doesn’t count as an asset. However, your discretionary contributions to the plan in the base year (the year ending December 31 of your student’s senior year in high school) do get added back to your income.
What are discretionary contributions to a plan? They are contributions you choose to make. (Let’s not get into a philosophical discussion about whether a responsible adult “chooses” to make contributions to their retirement plan!) Did you contribute to your 401(k) plan? That’s a discretionary contribution.
On the FAFSA, once you’ve completed information about your AGI and certain other tax-related questions, you’ll be prompted to report Untaxed Income. This includes “Payments to tax-deferred pension and retirement savings plans” and “IRA deductions and payments to self-employed SEP, SIMPLE and Keough plans.”
So in a sense, contributions to your 401(k) during the base year and college years hurt you in two ways:
- They reduce the amount of cash flow you have available to pay for college, and
- They reduce one of your biggest allowances against income: federal taxes paid.
Here are some tips for those whose students aren’t high school seniors yet: If you don’t max out your 401(k) each year, then max it out the year before you’ll be filing and contribute less in your base year. That will both reduce the amount you add back to income and increase the deduction against income for federal taxes you pay in the base year. If you do max out your 401(k) each year and can afford to continue doing so during the college years, consider switching to the Roth option (if your employer offers it) during the base year and college years. (You may wind up contributing less if you’re looking at tax-adjusting your contribution.) Or make IRA contributions (traditional or Roth, depending on your AGI) in the year before your base year and reduce your base-year 401(k) contributions by a comparable amount.