Taxes and Your FAFSA

With the school year beginning, now is a great time to focus on financial aid for your college-age dependents. If you are applying for financial aid for college for your child, you are required to complete the Free Application for Federal Student Aid (FAFSA) from www.fafsa.ed.gov; the same form is also used for state and college aid, although there may be another form and additional information requested for these purposes. Much of the information is tied to your federal income tax data.

Which Tax Information Is Used?

Parents and students are required to contribute a certain percentage of their income toward the payment of college expenses (this is part of the expected family contribution, or EFC). The portion of the parent’s income taken into account depends on family size, the number of family members enrolled in post-secondary education, and other factors. (In addition, 50% of the student’s prior-year earnings over a set amount are also taken into account.)

In order to determine available income, data from tax returns are used. The 2010-2011 FAFSA form is based on the 2009 income tax return. If the return has not been filed by the time the FAFSA form is submitted (e.g., you are on extension for filing your return), there is an income estimator that can be used to simulate the tax return’s data; then a return must be submitted after it has been filed.

Key information to be provided includes:

• Adjusted gross income. This is your gross income reduced by above-the-line deductions, such as alimony payments, health savings account contributions, and deductible IRA contributions.
• Wages, salaries, and tips. Information is required for a father or stepfather and mother or stepmother. Information is obtained from W-2 forms as well as guaranteed payments reported on Schedule K-1 by a partnership or limited liability company taxed as a partnership.
• Untaxed income. You must also indicate whether you’ve received any income exempt from tax, such as tax-exempt interest; child support payments; workers’ compensation; housing and other living allowances (paid to military personnel, clergy, and others); the untaxed portion of pensions and IRA distributions; veterans’ benefits (other than for education); and deductible contributions to pensions, savings plans, simplified employee pensions (SEPs), savings incentive match plans for employees (SIMPLEs), and Keoghs.

What Asset Information Is Needed?

In addition to your income, you typically must provide information about your assets. Under financial aid formulas, both parent and student are required to devote a certain portion of their assets toward education costs (this is also part of the EFC). Parental assets used for college expenses are capped at 5.6% (students must use 35% of their assets).

Key information to be provided includes:

• Current bank account statements.
• Stock, bond, and other investment account information.
• Information about business/farm interests.

The federal financial aid formula does not take into account equity in a home, the value of a family business (with 100 or fewer full-time employees), or money set aside in retirement savings plans such as 401(k) plans and IRAs; state and private school formulas may take these assets into account.

Getting Help

The FAFSA form is supposed to be a simple financial aid application that you complete online by yourself. However, if you need help with the financial information on the form, consult with your accountant or other financial advisor.

Early planning. For those who have some years before they need to face the FAFSA, working with a CPA can help a family arrange ownership of assets and college savings strategies to better qualify for aid in the future. For example, a student’s assets in a Uniform Gift to Minors Act (UGMA) or Uniform Transfer to Minors Act (UTMA) custodial account are counted as the child’s assets; funds in a 529 plan on behalf of the child are not viewed as the child’s assets.

Current strategies. Parents should be encouraged to reduce their income where possible. For example, they may want to take capital losses in excess of capital gains to create a $3,000 deduction from ordinary income. They may also want to defer income to years after aid is needed (e.g., by agreeing to defer the receipt of a year-end bonus until retirement).