Student Aid Secrets: Reduce Income to Increase Financial Aid

Filing the FAFSA 2016-2017 Edition Cover Paperback
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Summary: Here is the most important financial question you’ll be asked on the FAFSA: What is your income? (And: What is your parents’ income? What is your spouse’s income?) This article highlights how income affects your eligibility for financial aid — and how to potentially lower the impact.

The FAFSA (and most other financial aid formulas) is heavily weighted toward income:

  • Your income
  • Your parents’ income (if you’re a dependent student)
  • Your spouse’s income (if you’re married)

Income has a much greater impact on eligibility for need-based financial aid than assets (like the money you have in cash, checking, savings, or investments).

How Does Income Affect Eligibility for Need-Based Financial Aid?

Income affects financial aid eligibility in two main ways:

  1. Part of the amount you are expected to contribute to pay for college, your EFC (expected family contribution), is simply based on a percentage of total discretionary income. A higher income means a higher EFC, meaning you contribute more money.
  2. There are simplified versions of the financial aid formulas that apply when parent income falls below certain thresholds.

The Income Protection Allowance: Why It Matters

Before we talk about how your income can hurt you in financial aid formulas, let’s talk about something that can help you: the income protection allowance. Basically, it’s an amount of income that doesn’t get counted when figuring out your financial aid. It’s your survival money, and it’s protected.

If you are a dependent student, the student income protection allowance is about $6,000 — meaning there is nothing counted toward your contribution if you have $6,000 or less in yearly taxable and untaxable income. The parent income protection allowance typically varies from about $17,000 to about $37,000, depending on how many people are in your family and how many of them are in college.

Income above those income protection allowances is considered your “discretionary” income — and that’s what counts toward your contribution. The student contribution from income on the FAFSA is calculated as a flat 50 percent of discretionary income. The parent contribution from income is calculated on a sliding scale, from 22 percent to 47 percent of discretionary income.

Income Protection Allowance, Discretionary Income, and Student Contribution

So, generally speaking, if you’re a dependent student, every $10,000 increase in your parent’s income (above the income protection allowance) will cause about a $3,000 decrease in need-based financial aid and every $10,000 increase in your income will cause up to a $5,000 decrease in need-based financial aid.

Income Goes Up, Financial Aid Goes Down Diagram

Income Thresholds

There are two income thresholds built into the federal financial aid formula. Reducing income below these dollar amounts can have a big impact on eligibility for need-based student aid.

  1. Auto-Zero EFC
    • If you’re a dependent student and your parents’ income is less than or equal to the Auto-Zero EFC threshold ($25,000 in 2015-2016), and certain other criteria are satisfied, then your EFC (expected family contribution) is automatically set to zero.
    • A student with a zero EFC will qualify for a full Federal Pell Grant ($5,775 for the 2015-2016 academic year).
  2. Simplified Needs Test
    • If your parents’ adjusted gross income (AGI) is less than $50,000, and you meet certain criteria, your assets and your parents’ assets will be ignored on the FAFSA.

In both cases, your family must also meet certain additional criteria:

  • Your parent(s) must be eligible to file an IRS Form 1040A or 1040EZ; or
  • Someone in your household must have qualified for certain means-tested federal benefit programs during the last two calendar years
    • Supplemental Security Income (SSI)
    • Free and Reduced Price School Lunch
    • Temporary Assistance for Needy Families (TANF)
    • Supplemental Nutritional Assistance Program (SNAP)
    • Special Supplemental Nutrition Program for Women, Infants, and Children (WIC)

Strategies for Increasing Aid by Reducing Income

It’s not always possible to reduce your income (and giving up your job isn’t really a good solution). But, there are some choices you (or your parents) may be able to make to reduce income — at least during your college years.

Starting with the 2017-2018 FAFSA, the income you will report comes from what is called the “prior prior year.” The 2017-2018 FAFSA will ask you about income from your 2015 tax return, instead of your 2016 tax return. This makes it easier to complete your FAFSA, but it means that most of the strategies below won’t affect your EFC for the 2017-2018 academic year.

Good strategy: Avoid artificial increases in income

  • Capital gains distributions
  • Retirement plan distributions (including a tax-fee return of contributions from a Roth IRA)
  • Exercising stock options
  • Bonuses
  • Gifts
  • Distributions from a qualified education benefit (529 college savings plan, prepaid tuition plan, or Coverdell education savings account) that isn’t parent-owned

Potential workarounds

  • Adjust the timing of the income so it isn’t received during the current or prior tax year.
  • Offset capital gains with capital losses and business income with losses.
  • If you are the beneficiary of a qualified education benefit, and your parent isn’t the owner, consider switching ownership to your parent. Then it counts as an asset instead of income. (Or, wait until after financial aid applications are filed for your senior year in college to take a distribution.)
  • If your (or your parents’) income has changed or there was some special circumstance (like a conversion of a traditional IRA into a Roth IRA, inheritance, or life insurance proceeds, or some other one-time financial event), contact your college’s financial aid administrator for a possible adjustment.
  • Reduce adjusted gross income through exclusions from income that are not reversed by the financial aid formulas, such as the student loan interest deduction, tuition and fees deduction, employer-provided health insurance, health savings accounts, and flexible spending arrangements (cafeteria plans). There are also other exclusions from income, such as above-the-line deductions for moving expenses, educator expenses, alimony paid, the penalty on early withdrawal of savings, and the domestic production activities deduction.

Bad strategy: Shifting income from adjusted gross income to untaxed income

For example, increasing contributions to qualified retirement plans (like a 401(k) or IRA) may decrease AGI, but the contributions will be added back in to the total income, counted as untaxed income.

Tips on Using a Tax Preparer

If you use a professional tax preparer to file federal income tax returns, make sure the tax preparer is aware of the potential impact of tax minimization efforts on eligibility for need-based financial aid — especially if you are close to either of the income theshholds.

Sometimes, choices that reduce your tax liability have a much greater impact on financial aid eligibility.

For example, a tax preparer may choose to file an IRS Form 1040 instead of an IRS Form 1040A or 1040EZ to claim various exclusions from income. But, taxpayers who are required to file an IRS Form 1040, even if just to itemize deductions, may be ineligible for the simplified needs test and auto-zero EFC.

Similarly, a tax preparer may prefer the American Opportunity Tax Credit over the Tuition and Fees Deduction, since the direct financial benefit is greater, even though the tuition deduction may increase eligibility for financial aid by reducing AGI.

Recommendations

  1. File the FAFSA every year to maintain eligibility for student aid.
  2. Understand how your income and your parents’ income can affect your eligibility.
  3. Transfer any qualified education accounts to your parents’ name.

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