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  • Writer's pictureJason Flurry, CFP

Understanding FAFSA

What you REALLY need to know to avoid making costly mistakes

No matter how good a job you’ve done of planning for college, nothing can ruin your results faster than making mistakes on your financial aid forms. And it seems that few things cause more anxiety for parents than having to complete the FAFSA. I think it’s even more daunting than having to file your taxes, especially since you can have a professional complete it for you. Nevertheless, if you’re planning to apply for financial aid, tackling the FAFSA form is certainly an undeniable item on your to do list.

While almost everyone who applies for college encounters this form at some point, unfortunately over 70% submit their information with errors or inconsistencies. These mistakes can not only cause delays in processing, they can also cost you thousands, leaving you completely unaware that you’re overpaying for college.

One of the reasons this process is so complicated and confusing because there are 74 criteria that are used to calculate your family’s expected family contribution (EFC). Within that long list of personal and financial information, there are some things that count against you, some things that REALLY count against you, and some things that don’t count against you at all. Knowing which is which and reporting them correctly is the key to maximizing your financial aid award and making college more affordable.

What Counts Some of the main components to determine your expected family contribution have to do with what you make and what you have saved. That’s why many of the financial questions on FAFSA ask about your income, your adjusted gross income from your tax return, and your level of cash, savings, and investments. If you earn a salary from your job and receive a W-2 each year, your income is fairly easy to calculate. If, however, you are self-employed, you have to be a little more careful distinguishing income you earned personally compared to what you may show as earnings from your business. FAFSA only considers your individual earnings from line 7 and line 12 of your tax return. If you’re incorporated, you’re business is likely showing income on line 17 too. And then your adjusted gross income number is found at the bottom of the first page of your 1040. It is a function of all of these less a few possible deductions.

When you’re preparing to complete FAFSA, the instructions will tell you to get your statements out so that you can report your level of savings to the colleges where you’ll be applying. This is where many people make mistakes and I’ll tell you more about that in a minute. For now, just realized that the colleges are using FAFSA here to look for what you make and what you have available to help pay for college.

Two of the other main factors in determining your EFC have to do with how many household members you have and how many students you have in college at the same time. Everything in FAFSA is based on your household, so even if you have someone who you cannot claim on your tax return, they can still be a member of your household. And, if there’s someone like and ex or a grandparent who is planning to help pay for college, you don’t include their information on the form, as long as they don’t live in your household.

What really counts While your income and savings do count against you, there are several things that can really count against you in the financial aid formula. The first one is having money in the student’s name. And I often see this come up we were dealing with 529 plans. Section 529 of the tax code says that these accounts can be set up to provide tax advantages for college. They’re usually owned by a parent for the benefit of their children. That’s the tax code. The set of rules that governs how financial aid is distributed though, we’ll call that the “college code,” says that since those monies were set aside for college, the college gets determine how they’re going to be used in the financial aid formula.

In that college code, parents have a savings allowance they can use to protect some of their resources, since they have children to support and a need for emergency money. The amount of savings a parent has over that protection allowance is added to the family’s ability to pay for college. Normally that percentage is around 5.7%, which means that if you have $100,000 over your savings allowance, around $5,700 of it will be added to your EFC.

For students, there is no savings protection allowance. Anything and everything they have in their name gets added to your EFC right from the start. And, instead of having a 5.7% calculation to work with like parents do, the student’s assets are calculated at 20% per year. So, if you’ve done a good job saving into 529 plans because that was what everybody told you was the right thing to do, in the right way, for the right reasons, then you may be very unpleasantly surprised to learn that the college is penalizing you because of how you’ve chosen to save. The college code gives them the ability to do that, and while not all colleges take advantage of it, more and more of them are.

Please understand that I’m not saying the 529 plans are bad. You just need to be aware of how they can hurt you as you’re trying to apply for need-based financial aid. The new tax laws have expanded the uses of 529 plan dollars, so you may want to consider using those funds ahead of time to increase your level of financial need when you file your FAFSA.

Another area that can really count against you is the contribution you make to your IRA and retirement plan at work. The colleges see those contributions as free cash flow and figure that if you can afford to save money into those types of plans, you can also afford to share some of it with them – almost half in many cases! Colleges can take as much is 47% of your contribution amount and add it back into your EFC every year.

If you’re in a situation where a college is meeting 100% of your financial need, each extra dollar of EFC you report could cost you 47 cents in free money from the school. In other words, making a $10,000 contribution to your 401(k) at work could reduce your financial aid package by $4,700 in grants each year on your financial aid award. Ouch!

And here’s the rest of the story… Although you may be saving some money on taxes by contributing to your retirement plan, it’s very unlikely that your combined tax bracket is as high as 47%. Taking a 25% tax deduction and then losing 47% on your financial aid doesn’t work in your favor. Yet how many times have you heard anyone talk about that at a financial aid night or in a college planning workshop? Probably never, right? Only College Planning Specialists have the experience and qualifications to detect these kinds of scenarios and look out for your best interests. Following the advice of your financial planner or accountant in this area could cost you big time!

Keep in mind that I’m not suggesting that you stop saving for retirement. Just save it in a different account as you prepare for your family’s college years. You can use that account for retirement too when the time comes.

The only time I would recommend continuing to save into your regular retirement plans during the college years is when you’re getting a match on your contributions. You may still lose 47 cents on the dollar in financial aid by going this route, but you’re getting a dollar in free money through your company’s match on every dollar you contribute to the plan, plus your tax deduction. You can’t beat that!

Another area that can really count against you is something FAFSA calls “untaxed income.” This type of income can come from many different places, but I usually see it in the form of child support. Since these dollars are tax-free, the college willingly adds it your expected family contribution, even if it’s not required to be reported on your tax return as income.

And the final thing I’ll mention here that can really count against you is if you have a super high level of income relative to the number of people in your household. Most colleges will normally figure around 20% to 22% of your adjusted gross income as a base for calculating your EFC, but if your income is really high, let’s say $750,000 per year for a household 4, the colleges are going to take a much higher percentage of that when they run their calculation.

The only time it really makes sense to consider filing for need-based financial aid when you’re a high income earner is if you have multiple children in college at the same time. Because your EFC is calculated based on your household, it can be divided by however many students you have in college. Don’t automatically write off your ability to receive need-based aid just because you have a good income. Remember, income is only one of 74 criteria used in the financial aid formula.

What doesn’t count So far it may seem like everything you make and everything you have gets counted against you when you apply for financial aid, but fortunately there are some things that don’t count against you at all. The first and probably most overlooked area in this category are your retirement accounts. While the contributions you make to them each year are counted against you, the money that’s already in these plans does not have to be reported. Just know that if you do report them as a part of your cash, savings, and investments, the colleges will count them against you. There’s nothing in the system that says to them that you made a mistake by including them in with your other regular savings. People do it all the time and it can drastically overstate their ability to pay for college. Never include your retirement balances when you’re calculating your cash, savings, and investments. They’re not a part of the formula.

The next area where you can protect money you’ve saved for college is in the cash value of life insurance policies and annuities. Life insurance is one of the oldest savings vehicles in the world and it’s probably one of the most sacred in the sense that colleges don’t ask you to use monies you’ve saved there to pay for college. If you’ve structured your plan properly, you can save money in a cash value life insurance plan, let it grow tax-deferred, and withdraw the money tax-free to pay for college - and to also supplement your retirement. That way you can stay in control of your finances and not have the college tell you how to spend your own money.

Like traditional retirement accounts, annuities also require you to be almost 60 years old before you can access the money in your account without paying taxes and penalties. Because of that, they are grouped in with other retirement plans and excluded from the financial aid formula. If you report your annuity account balances or the value of your cash value life insurance on FAFSA, the colleges will include them as a resource for you to pay for college by adding them to your EFC. You have to make sure that you’re only reporting your regular savings accounts so that you don’t fall into this common trap and reduce your eligibility for free money.

There are two methods of financially calculation the most colleges use. What were talking about here with the FAFSA is the federal method. There’s also an institutional method that I will address in another article, but in the federal formula another area that is protected from the financial calculation is your home equity. There are no questions about what your home is worth or what you owe on it on the FAFSA form. So, if you built up quite a bit of home equity and you’re worried the colleges will penalize you for it, don’t be. As long as they use the federal formula, you’re fine. Just be sure to not include with your other cash, savings, and investments. If you do, they will add it in with everything else.

In addition to excluding your home-equity from the federal formula, the value of most small businesses is also excluded. If you own at least 50% of your company and employ less than 100 people, you don’t have to report any of the value of your business on FAFSA. It doesn’t matter if you own property or hold cash and other investments in company accounts. You’re exempt as a small business owner and you don’t have to report any of the value to the colleges.

The final area I’ll cover with you here that doesn’t count against you as you’re applying for financial aid is money held outside of your household. As I mentioned earlier, if your ex, a grandparent, or your rich uncle is planning to help you pay for college, and they don’t live in your household, you don’t have to include any of their income or resources on FAFSA. Just let them know that when it’s time to pay for college, you want them to send the money to you so that you can pay the college directly. Colleges often pay attention to where money comes from, and if they see you have help that hasn’t been disclosed otherwise, they can and do reduce subsequent financial aid awards to account for this “outside resource.”

The good news As daunting as this financial aid process can be, the good news is that most of the places where the majority of people save the majority of their money don’t have to be disclosed on FAFSA. If you’ve saved for retirement, provided financial security for yourself and your family through cash value life insurance, paid down your mortgage, and built up a successful business, none of it will hurt your ability to qualify for need-based financial aid. You just have to be diligent not to include any of these items in your calculations or let special situations confuse you into making costly mistakes.

When and what to file Financial aid season begins in October each year in the very first time you’ll file FAFSA will be in the fall of your child’s senior year in high school. It’s an annual renewable process, so you’ll need to plan to file each additional year your kids will be in college. You’ll use your tax returns from two years back, so for example, if you’re filing for aid in 2018 for the 2019–20 year, you’ll use your 2017 tax return on FAFSA. Also, if you use the IRS download tool inside of FAFSA, it will pre-populate all of the areas from the proper year related to that year’s tax return for you. That option doesn’t always work, but when it does, it can reduce errors and save you time.

For your assets, and remember it’s only those that really have to be disclosed, you’ll report those values as of the date you file. There may be strategies you can use to protect some of those assets and lower your expected family contribution. And if you have any questions about what those options are, please let me know.

What if I’ve already messed things up? The FAFSA form can be amended online if you make a mistake. In fact, if you feel you may have made a mistake in a previous year’s filing, you can go back to the prior year’s form and change it for a period of time too. If the adjustments make a material difference in your expected family contribution, the college can retroactively award you monies that you would’ve been eligible for had you not made those mistakes in the beginning. Similarly, if you didn’t file because you didn’t think you would qualify based on your retirement balances, home-equity, and business valuation, it may not be too late to file for the previous year and get reimbursed for monies you’ve already paid. We’ve had that happen quite a lot over the years.

Completing FAFSA is not as exciting is rooting for your favorite college team to win on a fall Saturday afternoon, but doing it correctly can provide you thousands in free money – which you can use to buy great tickets to see the game in person next time! Use the strategies and tips I’ve given you here to improve your chances of success. And, if you’d like to have someone review your form before you submit it, or review one you’ve already submitted to make sure there are no errors in it, I’d be happy to do that for you. You can get in touch with me here whenever you’re ready.



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