If you’re a parent of a high school sophomore (or younger) and reading this, congratulations! Today you’re going to learn some things you can do that will benefit you far more on the FAFSA than the last-minute moves families can make just before filing the FAFSA.
Filing the FAFSA is a lot like filing your taxes: You can definitely wait until it’s due and just fill it out, but you’ll save a bit of money if you understand in advance how it works. The most important thing about the FAFSA is this: Parent income is the biggest component of your Expected Family Contribution (for the vast majority of families), and income is based on “prior-prior” year. That means that if you’re filling out the FAFSA for the school year starting fall of 2021—next fall—you’re using 2019’s income. If your student is currently a high school senior, that means the FAFSA is using the income year and tax return from the year that started January of sophomore year and ran through December of junior year.
So if your student is currently a sophomore, you have a month left before your first FAFSA income year to strategize. And in order to strategize, you should understand the lay of the land.
The FAFSA first takes all parent income—wages, business income, passive income (such as from a rental property), interest and dividend income, capital gains, IRA distributions (taxable and nontaxable), child support received, untaxed income such as pretax contributions to 401ks and IRAs, etc.—and totals it. Then, allowances are subtracted. Those are:
- An Income Protection Allowance based on family size, roughly equivalent to the federal poverty level for a family of your size
- Your actual federal income taxes paid plus allowances for state and FICA taxes
- An Employment Expense Allowance if all parents in the household work
Additional adjustments are made reflecting child support paid (subtracted), education tax credits received (added back to taxes paid) and a short list of other items.
Those numbers are added and subtracted to calculate the parents’ Available Income. This income is then assessed in various brackets—much like income taxes—with income in the top bracket—Available Income above $35,101—assessed at 47%. That means every incremental net dollar of income costs you about 47 cents in the FAFSA. And if you wait until senior year to figure this out, there’s nothing you can do about it.
But as a sophomore, you do have some options. The first is to get as much income into 2020 (pre-FAFSA) as possible. Some specific actions you can take—which you should discuss with your tax advisor before implementing—include:
- If you have any taxable investments with embedded capital gains, sell them before the end of the year. If that’s money that’s to be used for college, invest them in your 529 so that they don’t generate dividend or capital gain income for you during the coming years. If you intend to keep them in a taxable account, reinvest in tax-efficient ETFs instead of mutual funds to minimize future income. Next year and in subsequent years, be rigorous about tax loss harvesting to offset your income.
- If you have any embedded losses in a taxable account, hold onto them until Jan. 1 so that you realize the loss on next year’s taxes.
- If your student has an UTMA or UGMA account, sell the assets before the end of the year so that the capital gain is realized in 2020 and, if they’ll be used for college, transfer them to a custodial 529. (You can’t transfer an UTMA directly to your parent-owned 529; contact your plan for instructions on converting the UTMA funds.)
- If you are a business owner, consider deferring normal year-end expenses into early 2021 so that they reduce next year’s income instead of this year’s.
Then, since actual taxes paid are subtracted from your income, accelerate your deductions into this year. Some specific options—which you should again discuss with your tax advisor—include:
- If you pay enough mortgage interest to itemize, pay January’s mortgage payment in December to get the deduction in 2020 instead of 2021.
- Make next year’s charitable contributions this year—a double bonus in 2020 since the CARES Act allows for $300 of cash charitable contributions to be deducted even if you don’t itemize.
- If you don’t fully fund your 401k or IRA every year, increase the amount you’re contributing in 2020 so that you get the deduction this year, then decrease by a corresponding amount next year.
- You can employ the same strategy with an HSA account and make larger contributions for 2020 and smaller for 2021.
For 2021, you might consider some of the following:
- Changing some or all of your pre-tax retirement contributions to Roth to increase your taxes paid, which are subtracted from your income.
- Recognizing capital losses in investment accounts
- Reducing deductible expenses on your personal tax return
- Increasing business expenses that are immediately deductible (not depreciated)
Note that since state taxes are a calculation, not actual taxes paid, 529 contributions should be scheduled to maximize state tax benefits, not to minimize them.
Keep in mind, if you implement any of these changes, that you will have four income tax years used for the FAFSA. Pursuing aggressive strategies that aren’t affordable for four years, such as Roth instead of pre-tax 401k contributions, will result in future years’ EFCs being higher if those strategies can’t be maintained. But any of these strategies will result in far greater benefit on the FAFSA than a last-minute scramble to hide your assets come fall of senior year.
There are 5 comments
College Senior and sophomore next year. Does contributing to a Roth 401K make sense in the next 2 years instead of a regular pre-tax 401K? I do see where my income tax paid would be higher contributing to a roth. Do those taxes paid off-set the increase aid I may see? Is there a rule of thumb for how big a difference it could make?
Thank you for all of these great articles.
Is that a college soph or high school sophomore? If it’s college, it won’t make a difference because you’re past your last FAFSA income year. And it could have the opposite result if you’re eligible for the AOTC and increasing your income raises you above the threshold to claim that (AGI>$160k). If it’s high school, then the amount of EFC decrease would be 47% of the amount of additional tax paid. So that would depend on your tax bracket. For example, if you were here in OR in the 22% federal bracket, switching $10k to Roth would lower Available Income by $3,000 which would lower your EFC by $1,410. Of course it also depends on your school’s financial aid policies– do they meet all of your need or not. But if you’re in high school and don’t know, then you’re just doing the planning that’s available to you. One thing to think about with respect to affordability of this strategy is, you could contribute the same net amount to retirement but as Roth. So in the above case, a $7,000 Roth contribution would be the same net amount as a $10,000 pre-tax contribution.
It would be helpful for your readers to know the threshold above which it really won’t make any difference regarding federal and most state aid – they will not get anything more than student loans no matter what they do. If they don’t have this information they could make a lot of financially costly decisions with no financial aid benefit to show for it. I would suspect many folks who have a lot of the resources you describe are not going to be able to reduce their AGI to the point where any need-based grants they might get are not offset by their losses. They, as sophomore parents, could best help their children by supporting and perhaps requiring them to invest their time in causes and non-profits they care about instead of low-paying jobs to help them buy things, and requiring strong academic performance. They could work to ensure their students have every opportunity to be involved and leave high school with a well-rounded experience and a worldview that looks outside of their own personal needs. They could help by providing academic support where needed, supplies and technology, a good study environment at home free of tv, phone, and social media, and perhaps an allowance so they are less concerned with cash in their wallets. This type of activity, along with the all-important academics, will help them find scholarships that are not based on financial need.
This is a great point. If only there were a specific threshold, then this would be easy. Instead, a great deal depends on the family and the schools the student is interested in. There are families with AGIs in excess of $250,000 who receive need-based financial aid because of their family size, school choice, etc. That’s why I recommend that families early in the process– sophomores especially– plan as though they will be eligible for need-based financial aid. This is in part because so many families wait until senior year to think about the FAFSA and then they get all worked up about their assets, which really won’t have a significant impact on their financial aid package. And yes, merit aid ends up being more beneficial for many families and is largely based on grades and test scores (when those become widely available again). Every family approaches college differently and understanding the levers of need-based financial aid at the point at which those levers can be moved is helpful to many.
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