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Is There Any Way to Shelter Retirement Plan Distributions on the FAFSA?

Mark Kantrowitz

May 21, 2012

My question is simple: is there a way to withdraw money from my 401(K), at age 59 1/2, that will not be counted as income for FAFSA purposes? Although I receive an annual pension of $34,500, I fall short by about $20,000 to meet my annual expenses. Should I withdraw what I need for next year this year, so it doesn’t show in next year’s income, plus withdraw enough to pay off my car, so I can reduce my expenses for next year and require a smaller withdrawal that year, too? Obviously I wouldn’t withdraw any money if I didn’t need it. But the FAFSA will just see it as income and not take into consideration the expenses I’m paying off. — Myra C.

Even simple questions can have complicated answers, especially if they concern taxes and the Free Application for Federal Student Aid (FAFSA).

Retirees may begin taking distributions from a 401(k) without paying a 10% tax penalty starting at age 59 1/2. In some cases they may be able to take penalty-free distributions as early as age 55. Distributions from an IRA to pay for higher education expenses before age 59 1/2 are also not subject to the 10% tax penalty.

Even if the distribution is not subject to the 10% tax penalty, the amount of the distribution is still subject to ordinary income taxes.

Although the FAFSA ignores assets in qualified retirement plans, it does not provide special treatment for retirement income. Distributions from retirement plans count as income on the FAFSA. The FAFSA bases the calculation of the expected family contribution (EFC) on total income, which is the sum of taxable and untaxed income. Taxable income is based on the adjusted gross income (AGI) reported on the taxpayer’s federal income tax returns. AGI includes taxable distributions from retirement plans. Untaxed income includes tax-free distributions from retirement plans, such as a tax-free return of contributions from a Roth IRA, as well as voluntary tax-free contributions to retirement plans.

Since the EFC depends heavily on income, retirement plan distributions can significantly increase the EFC and reduce eligibility for need-based financial aid.

There are no loopholes that can be exploited to shelter retirement plan distributions made during the prior tax year on the FAFSA. There is one exception, which relates to the taxable income that is realized from converting a traditional IRA to a Roth IRA. Dear Colleage Letter GEN-99-10 allows college financial aid administrators to adjust income to exclude the income attributable to a Roth IRA conversion. But any distributions in excess of the conversion will still be treated as taxable income.

One workaround is to take the retirement plan distributions before the years during which the distributions will be counted on the FAFSA. The FAFSA is filed on or after January 1 because it is based on income from the prior year (PY). Income from the year before that — often called the prior prior year (PPY) — is not reported on the FAFSA. Timing the distributions to occur at least two years prior to enrollment can help avoid artificially inflating income when it will hurt eligibility for need-based aid.

If the child is already enrolled in college, some families will take a higher distribution one year in order to avoid taking a distribution the next year. This seesawing of the distributions can increase eligibility for need-based aid, especially if the family income is close to the $50,000 threshold for the simplified needs test or the $23,000 threshold for auto-zero-EFC. The simplified needs test disregards all assets and the auto-zero-EFC sets the EFC to zero if the family also satisfies certain other criteria, such as being eligible to file an IRS Form 1040A or IRS Form 1040EZ.

However, the family’s ability to manipulate the distributions may depend on the taxpayer’s age. Taxpayers who retire at age 55 instead of age 59 1/2 must make substantially equal periodic payments in order to avoid the 10% tax penalty. This usually results in an increase in income throughout the child’s college education.

A better approach may involve tapping into savings and investments in taxable accounts to pay for living expenses until the child’s senior year in college. Spending down non-retirement savings doesn’t count as income on the FAFSA. It also reduces the amount of reportable assets on the FAFSA.

As a general rule, all debts, including auto loans, mortgages, credit cards and student loans, should be paid off by the time one retires. There is no new income during retirement, just savings. It does not make sense to be paying a higher interest rate on debt than one is earning on savings. Paying off the debt will save the retiree some money.


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