Many families– and also many financial professionals– believe that reducing their adjusted gross income by increasing 401k contributions will result in a lower Expected Family Contribution from the FAFSA. Unfortunately that’s not the case: the FAFSA uses total income, not adjusted gross income. What does that mean for non-finance nerds?
The FAFSA calculates “Available Income”– the income you could spend to pay for college– as follows:
- Adjusted gross income from your tax return (via the IRS data retrieval tool).
- Plus untaxed income. You will manually add (almost) all of your untaxed income including 401k and IRA contributions, HSA contributions and any untaxed alimony or child support.
- Minus federal tax liability. You then subtract your actual federal income tax liability– not what you paid or had withheld, but what you actually owed.
- Minus allowances for state and payroll taxes.
- Minus the Income Protection Allowance (based on family size) and other allowances as applicable.
Thus, pretax retirement contributions in FAFSA income years actually increase your EFC: Not only do you add them back to your income in the formula, but because they reduce your tax liability they reduce your allowances against income.
Families trying to manage their income for purposes of the FAFSA might consider making Roth contributions instead of pre-tax in their FAFSA income years. In either case– pre-tax or Roth– the dollars contributed to retirement accounts are not counted as assets, but that’s a smaller piece of the overall puzzle. And of course, your retirement contribution strategy should be considered as part of your overall tax and retirement planning picture.
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