Parent income tends to be overlooked in FAFSA planning, which is unfortunate because for most families it’s the biggest piece– and one that has some real planning opportunities.
The chart below, from the EFC Formula Guide, shows the components of parent income. In addition to adjusted gross income (from the 2018 tax return), the FAFSA asks for a breakdown of each parent’s earned income, taxable income, untaxed income and “additional financial information.”
If you’ve been told to use a Roth IRA rather than a 529 for college savings, beware: Untaxed income is where you report that you withdrew from that account. So although you saved yourself 5.64% of the account’s value by not counting it as an asset, you increased EFC by 47% of the withdrawn amount.
Also counted in untaxed income:
- Pretax employee retirement contributions. This trips many families up in estimating EFC: the FAFSA4caster doesn’t instruct you to add those amounts back. For families maxing out retirement, this could increase your EFC by over $23,000.
- Child support received. In some cases, this combined with alimony, will minimize the financial gap between ex-spouses, so it can be something for divorcing couples to plan for.
What doesn’t count?
- 529 plan distributions. Even though a portion of most 529 plan distributions is untaxed income, it does not need to be reported for FAFSA purposes.
- Employer contributions to retirement accounts. Business owners do not need to include the employer portion of 401k contributions if they are not reported on Schedule 1.
“Additional financial information” is subtracted from other income. This includes parent earnings from federal work study, combat pay, child support paid, and education tax credits.
Once total income is calculated, adjustments are applied.
Most of the adjustments are tax-related: actual federal taxes paid, including payroll taxes; and a state/other tax allowance. These reduce income dollar-for-dollar. Why does this matter, since taxes are taxes? Think of retirement plan contributions. A family in the 22% tax bracket who contributes $19,000 pre-tax to a 401k would reduce their federal tax bill by $4,180, increasing their EFC by $1,965. If that family instead put $12,000 of their retirement contribution into Roth IRAs, their tax bill would increase by $2,640 but their EFC would decrease by $1,241.
State taxes are allowances calculated by applying a percentage to the Total Income in line 7 above, not actual taxes paid. So families can get a state tax break for 529 contributions without being penalized on the FAFSA. Furthermore, since state tax allowances are applied to Total Income, not taxable income, families with lots of untaxed income such as from child support received will receive larger allowances.
Lastly, two-parent households with one working parent who are able to add a low-paying job for the second parent can benefit from the Employment expense allowance. This is a maximum of $4,000, but in a two-parent household it can only be claimed if both parents work. And it’s limited to 35% of the lower income or a maximum of $4,000. $11,500 of income will get the maximum allowance; between the employment expense allowance and adjustments for taxes, that income would add virtually nothing to EFC.