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.
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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.
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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.
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