I have two teen boys, ages 12 and 14 (yes, your prayers are appreciated). Like most teens, they don’t always listen. Since they were very young, though, I’ve explained to them that almost every decision they make or action they take in life will have a repercussion. Some will be good, and some will be bad, but in the end, they are responsible for the repercussions of their actions.
As parents, life complicates this adage significantly. Sometimes the actions we don’t take can hurt us. To confuse things even more, sometimes we do not even realize we are at a decision point, so of course we take no action and we unknowingly miss an opportunity.
The steps you need to take to minimize your EFC fall directly into this category, as you would need to take steps in your student’s sophomore year of high school or earlier to fully and effectively plan to minimize your EFC.
But no matter where you are in the FAFSA filing process, I’ll give you a few ideas to lower your EFC and to increase your needs-based aid for college. Note that some or all of these concepts may not be appropriate for everybody, so please consult a qualified college financial planning expert before proceeding.
Minimize Parents’ Income in Base Year
In Part 1 of my explanation of how EFC is calculated, we noted that the parents’ income (after reductions for taxes and an allowance) is included in the EFC at 47% on amounts exceeding $33,100. By far, this is the biggest contributor to the EFC of most families.
Since assets are assessed at only 5.64%, lowering parents’ income in the base year is 8 times more effective in lowering EFC than minimizing parental assets. But here’s the problem: the parental income that feeds your student’s FAFSA for their first year of college comes from the calendar year that spans the spring of their sophomore year to the fall of their junior year in high school (i.e., the “prior-prior” year from when college starts).
The biggest inflator of your EFC is the one you likely were not even thinking about at the time. Families should try to minimize their taxable income in the sophomore-junior year, but it’s not as simple as using the tax advice from your CPA.
For example, you can’t just increase your pretax contributions to retirement plans (such as 401(k)s or IRAs) to lower your taxable income as these contributions must be added back into income for the FAFSA. So FAFSA treats this situation as if you did not even make the contribution.
Worst yet, remember in Part 1where we learned that you get a deduction on the FAFSA for your income taxes? After increasing your retirement deductions, your income taxes on your 1040 (and the tax deduction on the FAFSA) will be lower, which will trigger a higher EFC.
Therefore, you may want to consider using a Roth 401(k) or a Roth IRA instead.
Why a Roth? Since you do not get a deduction for contributing to a Roth, there is no addback on the FAFSA form. Secondly, since your taxable income is not reduced by the amount of the Roth contribution (like it is with a regular IRA or 401(k) contribution), your federal income tax (and more importantly the tax deduction on the FAFSA) will be a bit higher.
Finally, Roth IRA contributions (but not the growth in the funds) can be withdrawn penalty and tax free at any time and can be used for college (see Parent’s Asset section below). You can also use a distribution from a regular IRA to pay for college and not have to pay a penalty.
However, since you likely received a tax deduction when you contributed to the regular IRA, you will have to pay income taxes on the amount withdrawn, plus you will have to report this IRA distribution as income on a future FAFSA.
Other non-taxable income such as municipal bond interest, child support, untaxed portions of IRA distributions (including Roth) or pension distributions must also be added back, so take any distributions prior to the base year if you can. (See the Parent’s Asset section below on how to time untaxed Roth distributions.) Parents do not need to report gifts or inheritance received as income, but the assets will be reported if still on hand when the FAFSA is filed.
Here are a few other ways you can lower your income in the base year:
- Business owners (to an extent) can defer income and accelerate deductions in the base year.
- For those of you with mutual funds that generate significant capital gain distributions, consider selling these funds (prior to the base year if at a gain, in the base year if at a loss) and investing the proceeds in Exchange Traded Funds (ETFs) which have significantly less capital gains distributions.
- Defer any stock option exercises until after the base year (or exercise in the year before the base year).
- If you are thinking about taking that leave of absence from work, or if you need time under the Family Medical Leave Act to care for a loved one, the base year is an ideal time to take it!
Student’s Income and Assets
After a student’s income is reduced by taxes and a $6,570 allowance, it is assessed at 50% for inclusion in the EFC. Most students with a part-time job will not breach this allowance.
However, any gifts or inheritance received or distributions from 529 plans held by those outside the immediate family (i.e., grandparents, uncles, aunts, cousins, etc) will need to be reported as untaxed income to the student.
Do not take distributions from these 529 plans held outside the immediate family until the student’s sophomore-junior calendar year, as that income will not be reported on the student’s final FAFSA.
Since student owned assets are assessed at 20% on the FAFSA (25% on CSS Profile), students can and should move assets out of their names.
Instead of leaving their hard earned money in a checking or savings account, students could contribute that money into a Roth IRA (up to the lesser of their earnings or $5,500). Since retirement accounts (including Roths) are not assessed on the FAFSA, none of the money shifted will be assessed.
One very positive aspect of the Roth IRA is that the student can withdraw the money contributed (but not the earnings) penalty and tax free for college at any time, but they should exercise caution. Withdrawals from the Roth will be added to the student’s income for FAFSA purposes as untaxed income, so the student should wait until at least his or her sophomore or junior year in college so that the income will not be included on their final FAFSA.
Students with excessive cash should also pay off any credit card or other debts they have. If they still have cash or investments on hand, they may want to fund their own UGMA/UTMA 529 plan. Since 529s owned by any immediate family member are assessed at the parents’ 5.64% rate (instead of 20%), students can decrease their EFC more than 14% of the amounts shifted.
Parents’ Assets – The Final Option
Unfortunately, families that may have missed the opportunity to minimize their base year income are left with parental asset minimization as the only significant option to reduce EFC.
Parents’ assets are assessed at 5.64%, and while that is much lower than the student’s asset assessment rate, many feel the assessment is not fair. After all, parents may have diligently saved for their student’s education and denied themselves vacations and other luxuries only to learn that their “reward” is to lose financial aid.
While the following strategies to shift assessable assets out of the parents’ names will reduce your family’s EFC, they may not be appropriate for everybody. For example, shifting $100,000 of cash earmarked for college to the family’s mortgage will lower the EFC by $5,640, but the family may be in an unenviable liquidity crunch if the sole breadwinner loses his or her job shortly thereafter.
Each family should consult a financial advisor before implementing one or more of these strategies:
- For households with home equity, apply for and establish a Home Equity Line of Credit (HELOC) with a reputable financial institution. Keep this HELOC in place just in case you need emergency funds in case of a job loss or other cash squeeze.
- Pay down debt – After the HELOC is in place, parents with excess cash should pay off credit cards, car loans, or their own student loan debts.
- Make home improvements – Thinking of re-doing your kitchen or your master bathroom? Why don’t you speak to a contractor and pay for those improvements now? Home equity is not assessed on the FAFSA, so these improvements will not decrease your FAFSA financial aid. Even if you file the CSS profile (which does include home equity), the fair market value or assessed value of your house will not go up immediately, and if it eventually does a few years later the increase will be less than the amount of your improvements.
- Make gifts to grandparents (or aunts or uncles or cousins). For 2018, each individual can make gifts of up to $15,000 to any one individual without having to file a gift tax return. Therefore, a married couple could shift $30,000 to each grandparent or a total of $120,000 each year if all four grandparents are alive, and the grandparents could contribute those funds to a 529. The grandparents’ 529 money should not be used to pay for college until the student’s sophomore-junior calendar year, as these 529 distributions (from 529s not held by immediate family members) will be treated as income to the student on the FAFSA and assessed at 50%.
- Contribute to a Roth IRA (if you meet income limitations) or consider a non-deductible IRA contribution. Either IRA contribution will remove the assets from being assessed for financial aid purposes, but you can only contribute $5,500 (or $6,500 if you are 50 or over) per person per year. The Roth IRA rules allow you to withdraw your contributions tax and penalty free at any time, and you may be able to withdraw the earnings penalty free if you are under 59-1/2 (but you will still owe income tax on the withdrawn earnings). Withdrawals from a regular IRA for college would be penalty free, but the portion of the withdrawal relating to income would be subject to regular income tax.
- Shift cash into a 529 plan if your state gives you a state tax deduction. The cash will still be assessed at FAFSA’s 5.64%, but if you get (for example) a state tax deduction at 3.07% like we get here in Pennsylvania, you narrow the impact of the FAFSA assessment. While FAFSA will assess on the 529 balance each year, using your 529 money for school in the early years (in lieu of subsidized loans or other tax credits) is often not the best strategy.
Cautionary Advice for Parents
Unfortunately, there are some college financial advisors out there that see the complexity of college funding as an opportunity to put a commission in their pockets by selling you an insurance product or an annuity. My colleagues have covered this area well, so I will simply refer you to a terrific article written by Troy Onink in Forbes a few years back.
Declaring Independent Status
Wouldn’t it be wonderful if we could all lower our EFC by excluding the parents’ income and assets altogether! You can if the student qualifies for independent status, but qualifying for independent status is more easily said than done. The complete criteria for declaring independent status is specific and limited.
If your high school student is unmarried and without children or dependents, and they are not serving on active duty in the US Armed Forces, one of the following statements must be true to claim independent status:
- At any time after turning 13, both parents are deceased, the student was in foster care, or the student was a ward or dependent of the court.
- The student has a legal guardian as determined by the court or the student was an emancipated minor.
- The student was homeless or self-supporting and at risk of being homeless
With respect to claiming independent status, it doesn’t matter if your parents choose not to pay for your college. It also doesn’t matter if your parents do not take you as an exemption on their tax return. It also does not matter if the student is financially independent. You must answer yes to one of the ten questions listed.
If your student does qualify for independent status, only the student’s income and assets are included on the FAFSA. An independent student will qualify for the simplified EFC formula (and not have to report their assets) if they meet the criteria listed on page 6 of the 2019-2020 EFC Formula Guide.
For those independent students that do not qualify for the simplified formula, the student’s assets will be assessed at 20% (not 5.64%), and the asset protection allowance for those under 26 is $0.
Hopefully you will be able to leverage a few of these ideas to squeeze a few more dollars of aid out of the system. As I noted earlier, most parents are unaware that they should be focusing on financial aid during their students’ sophomore year of high school. You can change this!
Former Notre Dame Football coach Lou Holtz once said, “Life is 10 percent what happens to you and 90 percent how you deal with it.” In this spirit, forward this article on to other parents who have high school freshmen and sophomores, and make them aware that this planning opportunity awaits them.
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Bob is the President and Founder of College Funding Solutions, and a Financial Advisor with OneSource Retirement Advisors in Malvern, PA. A licensed CPA in Pennsylvania, Bob is a CFP® Professional and holds the AICPA’s Personal Financial Specialist (PFS) Credential. He holds a BS in Accounting from Villanova University and an MBA from Kenan-Flagler Business School (UNC-Chapel Hill). His career includes 9 years of Big 4 Manager-level tax experience and 15 years of pharmaceutical forecasting experience.