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Reducing student and parent income can yield increases in the student’s eligibility for need-based financial aid.
Federal, college, and most state financial aid formulas are heavily weighted toward income. Income has a much greater impact on eligibility for need-based financial aid than assets.
Income affects financial aid eligibility in two main ways:
So while there is no explicit income limit on the FAFSA or other financial aid application forms for financial aid eligibility, increases in income do lead to decreases in financial aid and there are some income thresholds built into the financial aid formulas.
Generally, every $10,000 increase in parent income will cause about a $3,000 decrease in need-based financial aid and every $10,000 increase in student income will cause up to a $5,000 decrease in need-based financial aid.
Financial aid formulas assess a portion of student and parent discretionary total income during the prior tax year. The formulas start by calculating total income figures for the student and parents. Total income is the sum of adjusted gross income (AGI) and untaxed income. Financial aid formulas start with AGI, as reported on the previous year’s federal income tax return, because it is easy to verify. AGI subtracts certain exclusions from income (but not deductions and exemptions) from the sum of earned income and unearned income. Total income adds some of the exclusions back in as untaxed income. (If student or parent income falls below the IRS filing thresholds, earned income is substituted for AGI.)
Next, the financial aid formulas subtract certain allowances from total income. These include allowances for minimal living expenses (called the income protection allowance) and allowances for income and FICA taxes, among other allowances. The student income protection allowance is about $6,000. The parent income protection allowance typically varies from about $17,000 to about $37,000, depending on the household size and the number of children in college. The remaining income is considered to be discretionary income.
The student contribution from income on the FAFSA is assessed as a flat 50 percent of discretionary income. The parent contribution from income is assessed on a bracketed scale, from 22 percent to 47 percent of discretionary income.
There are two income thresholds built into the federal financial aid formula. Reducing income below these thresholds can have a big impact on eligibility for need-based student aid.
In both cases, the family must also satisfy certain other criteria in addition to the income criteria. Either the parent must be eligible to file an IRS Form 1040A or 1040EZ or someone in the household must have qualified for certain means-tested federal benefit programs during the last two years (e.g., Supplemental Security Income (SSI), Free and Reduced Price School Lunch, Temporary Assistance for Needy Families (TANF), Supplemental Nutritional Assistance Program (SNAP) or Special Supplemental Nutrition Program for Women, Infants, and Children (WIC)).
Keeping this in mind, there are several good and bad strategies for increasing eligibility for need-based financial aid by reducing income.
Some of the good strategies include avoiding artificial increases in income, such as capital gains distributions, retirement plan distributions (including a tax-free return of contributions from a Roth IRA), exercising stock options, bonuses and gifts. Even tax-free income will count as part of total income, hurting eligibility for need-based aid. Distributions from a grandparent-owned qualified education benefit (e.g., 529 college savings plan, prepaid tuition plan or Coverdell education savings account) count as untaxed income to the beneficiary (the student) on the subsequent year’s FAFSA. There are several potential workarounds, depending on the type of income.
Bad strategies generally involve 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 total income as untaxed income.
When using 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.
Sometimes, choices that reduce a taxpayer’s tax liability will also 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.
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