To all the Sophomore Families
If you’re a parent of a high school sophomore (or younger) and reading this, congratulations! Today you’re going to learn some things you can do that will benefit you far more on the FAFSA than the last-minute moves families can make just before filing the FAFSA.
Filing the FAFSA is a lot like filing your taxes: You can definitely wait until it’s due and just fill it out, but you’ll save a bit of money if you understand in advance how it works. The most important thing about the FAFSA is this: Parent income is the biggest component of your Expected Family Contribution (for the vast majority of families), and income is based on “prior-prior” year. That means that if you’re filling out the FAFSA for the school year starting fall of 2021—next fall—you’re using 2019’s income. If your student is currently a high school senior, that means the FAFSA is using the income year and tax return from the year that started January of sophomore year and ran through December of junior year.
So if your student is currently a sophomore, you have a month left before your first FAFSA income year to strategize. And in order to strategize, you should understand the lay of the land.
The FAFSA first takes all parent income—wages, business income, passive income (such as from a rental property), interest and dividend income, capital gains, IRA distributions (taxable and nontaxable), child support received, untaxed income such as pretax contributions to 401ks and IRAs, etc.—and totals it. Then, allowances are subtracted. Those are:
An Income Protection Allowance based on family size, roughly equivalent to the federal poverty level for a family of your size
Your actual federal income taxes paid plus allowances for state and FICA taxes
An Employment Expense Allowance if all parents in the household work
Additional adjustments are made reflecting child support paid (subtracted), education tax credits received (added back to taxes paid) and a short list of other items.
Those numbers are added and subtracted to calculate the parents’ Available Income. This income is then assessed in various brackets—much like income taxes—with income in the top bracket—Available Income above $35,101—assessed at 47%. That means every incremental net dollar of income costs you about 47 cents in the FAFSA. And if you wait until senior year to figure this out, there’s nothing you can do about it.
But as a sophomore, you do have some options. The first is to get as much income into 2020 (pre-FAFSA) as possible. Some specific actions you can take—which you should discuss with your tax advisor before implementing—include:
If you have any taxable investments with embedded capital gains, sell them before the end of the year. If that’s money that’s to be used for college, invest them in your 529 so that they don’t generate dividend or capital gain income for you during the coming years. If you intend to keep them in a taxable account, reinvest in tax-efficient ETFs instead of mutual funds to minimize future income. Next year and in subsequent years, be rigorous about tax loss harvesting to offset your income.
If you have any embedded losses in a taxable account, hold onto them until Jan. 1 so that you realize the loss on next year’s taxes.
If your student has an UTMA or UGMA account, sell the assets before the end of the year so that the capital gain is realized in 2020 and, if they’ll be used for college, transfer them to a custodial 529. (You can’t transfer an UTMA directly to your parent-owned 529; contact your plan for instructions on converting the UTMA funds.)
If you are a business owner, consider deferring normal year-end expenses into early 2021 so that they reduce next year’s income instead of this year’s.
Then, since actual taxes paid are subtracted from your income, accelerate your deductions into this year. Some specific options—which you should again discuss with your tax advisor—include:
If you pay enough mortgage interest to itemize, pay January’s mortgage payment in December to get the deduction in 2020 instead of 2021.
Make next year’s charitable contributions this year—a double bonus in 2020 since the CARES Act allows for $300 of cash charitable contributions to be deducted even if you don’t itemize.
If you don’t fully fund your 401k or IRA every year, increase the amount you’re contributing in 2020 so that you get the deduction this year, then decrease by a corresponding amount next year.
You can employ the same strategy with an HSA account and make larger contributions for 2020 and smaller for 2021.
For 2021, you might consider some of the following:
Changing some or all of your pre-tax retirement contributions to Roth to increase your taxes paid, which are subtracted from your income.
Recognizing capital losses in investment accounts
Reducing deductible expenses on your personal tax return
Increasing business expenses that are immediately deductible (not depreciated)
Note that since state taxes are a calculation, not actual taxes paid, 529 contributions should be scheduled to maximize state tax benefits, not to minimize them.
Keep in mind, if you implement any of these changes, that you will have four income tax years used for the FAFSA. Pursuing aggressive strategies that aren’t affordable for four years, such as Roth instead of pre-tax 401k contributions, will result in future years’ EFCs being higher if those strategies can’t be maintained. But any of these strategies will result in far greater benefit on the FAFSA than a last-minute scramble to hide your assets come fall of senior year.
See the FAFSA Formula Explained for more details.
