I am aware that any pre-tax 401k contributions reduce taxable income (lower AGI), and that those contributions are added back into income for FAFSA aid calculations as untaxed income. I have read in multiple articles how these pre-tax 401k contributions hurt one’s financial aid and result in a higher EFC. What I do not understand is that if one did not make pre-tax contribution to a 401k at all in a given year, then the income amount used for calculations for the FAFSA would be exactly the same as if contributions were made seeing as those contributions get added back to determine actual income.
Naturally, income taxes would be reduced when making pre-tax 401k contributions. Unless the FAFSA weighs the amount of taxes paid more than income, I don’t see how making pre-tax 401k contributions would actually reduce financial aid. I only see an upside in making these 401k contributions in that income taxes would be reduced and financial aid would stay the same.
If anyone can explain this in more detail, I would appreciate it greatly. No need to discuss the merits of Roth vs. Traditional - that I am clear on.
i think (NON EXPERT HERE) that you are right; what you read was wrong.
and lets be clear. if you are looking at FAFSA only schools (vast majority in the US) you have to have a really low EFC to see any federal grants ($6K efc) or federal money.
And many many many FAFSA schools give no grants at all. their financial aid is loans; sometimes subsidized if your EFC is less than the cost of attendance.
Ok, thanks. Now I have found some additional useful information when looking at the actual FSA EFC Formula Guide and it’s calculations : Yes, it’s correct that parent’s income will be the same regardless of 401k contributions on the FAFSA, but income taxes paid are listed as allowances against income, thus the lower taxes paid by contributing to a 401k can increase EFC and potentially reduces financial aid.
The only way to really see the estimated net effect is to plug in the numbers.
Because…if a husband and wife EACH make the max 401 k contribution…this could add $40,000 or more onto what their taxable income was…for FAFSA financial aid calculation purposes. That’s a large amount. It doesn’t add taxable income…the FAFSA adds back in the contributions you made as additional income.
But the advantage to these accounts is that the actual balances in them are are not counted as assets.
@BelknapPoint I’m sure I missed something important.
Yes this is the key point. Your net (after tax) income from which the EFC is determined will be higher once the untaxed contributions are added back.
One thing to note is that employer contributions are not added back. So it might still be advantageous to contribute to the extent of any matching contributions. Or just contribute to a Roth 401(K) if that option is available (so you actually pay the tax on the contributions).
Also note that self employed people can benefit very substantially if they incorporate their business and make SEP-IRA contributions (up to $58,000/25% of salary) since these are all counted as employer contributions not as employee contributions.
Employer SEP contributions don’t appear on a W-2 as they aren’t withheld from wages. More specifically they are not “voluntary contributions” which is what FAFSA asks for, because the amount contributed is at the sole discretion of the employer each year. Likewise matching contributions are not reported. If you have a funded employer final salary pension plan then the amount that goes into it from the employer isn’t reportable for FAFSA purposes either (hardly surprising since that is a figure you won’t even know).
That is not how I understand it. These contributions are not “additional income” added to pre-tax income. These contributions are “untaxed income” which are added to AGI (which has those contributions already removed). EFC is based on “Total income”, which would be the same whether voluntary 401k contributions were made or not.
The difference of EFC lies in how much in taxes are paid (all else being equal). My calculations show that by making contributions which reduce taxes by a given amount, at least with the rough numbers I am working with, the EFC only goes up by only about half of the amount which is saved on taxes when making the 401k contributions.
Plus with the added benefit of having this money in a retirement account that isn’t counted as an asset as opposed to in savings, it seems like an obvious choice to make the 401k contributions when possible.
Indeed, but you still have to pay tax when you ultimately withdraw the money. Will your tax rate be half your current rate after you retire? Why not just contribute to a Roth 401(K) if available?
To clarify, one’s net (after tax) income after the untaxed contributions are added back is exactly the same as it would be if one did not make any contributions. That is why they add it back, because it is part of “Total Income” which EFC is determined from. “Total Income” stays the same regardless of how much is contributed to a 401k. However, the amount of taxes paid would change, and that amount gets deducted from the Total Income to determine EFC.
Good point. And, yes it makes sense to max out Roth IRA contributions before making 401k contributions beyond any employer match first. But one can do both.
Your total income for financial aid purposes will be your taxable income PLUS the contributions you made to tax exempt retirement plans….
Important to remember…the colleges will be calculating your need based aid…not you. Some have threshold for getting certain amounts of need based aid. For example…incomes less than a certain amount will be eligible…but more by even $1 won’t be.
Whether or not it makes sense to max out Roth IRA contributions before 401(k) contributions, after a full employer 401(k) match is achieved, depends in large part on what the employee expects their tax rate structure to be in retirement as compared to their current tax rate structure. In other (and simpler) words. Pay the tax now on the money being saved, or later on in retirement when the dollars saved are being used to pay expenses?