I’ve been playing around with the NPC to try to understand what factors into the equation better. I already understood that 401K contributions are added back into your income for the computation. However, I was surprised to learn, I believe, that the 401K contributions have an even greater affect. I entered two scenarions:
Max out on my 401K ($24K since I’m 50). So my wages went down by 24K, but I noted that I made $24K in contributions.
No 401K contributions. My wages were $24K higher than the previous case.
I expected the same EFC. However, for case 2, my EFC was lower (approx $1,600). It seems like not only is added back in for case 1, but the college feels that it’s more discretionary income and therefore, more can be used for college.
Of course, if I don’t contribute to the 401K, that increases my assets.
Is that other people’s understanding of how this works?
^^^
It could be. When the $24k is retained instead of contributing to the 401(k), the tax advantage goes away and taxable income (and therefore the amount of tax) increases. Part of the EFC formula is dependent on the amount of taxes paid: more tax paid should lower the EFC, generally speaking.
That seems in the ballpark for parent income being assessed.
So I may get more financial aid by not contributing to my 401K, but it is offset by paying more income taxes and the assessment of the extra assets ($24K). It’s also offset by the fact that I have less in a tax-advantaged account. Seems like it’s still a good deal to contribute to the 401K, but maybe not as a good deal.
One other point. Assuming a ROTH 401K gives you the same benefit as a regular 401K (we can debate that anothe r day), then it seems more beneficial to contribute to a ROTH 401K during the financial aid base years since you will get more aid with the same tax advantage. Opinions?
Well in case 1 you have $24 k in wages (taxed income) and $24 k in pretax 401k contributions (untaxed income).
The income from working (wages) gets a deduction for state tax and social security tax with the FAFSA formula as well as federal income tax paid.
In case 2 you have more taxed income $48 k and no 401k contributions, so higher deductions for state, soc sec and federal taxes on FAFSA.
Now try and answer the question about if you can file 1040A and have means tested federal benefit with yes and what happens?
Is the EFC for case 1 now $0? Auto zero EFC for income under $25,000 and can file 1040A and federal means tested benefit. It should not count untaxed income then. Nor assets.
And is EFC for case 2 the same or lower? It should not take into account assets. Simplified method, under $50,000 income, can file 1040A and federal means tested benefit.
Does your employer match any of your contribution? That is not included in income or taxed in the year contributed. Getting a $1600 lower EFC would not have been a good deal for me if i had to give up that match, and of course putting money into your 401k, IMO, is better than paying taxes on it even if you ‘save’ $1600 in tuition. $1600 now or $24000 in retirement? Easy choice for me.
I agree, if you can, it’s still a great idea to contribute to a 401K .
If you have a ROTH 401K as an option, I think it’s much better, all other things being equal, to contribute to the ROTH 401K than a regular 401K. In this option, you get the tax savings, you don’t have more assets to be assessed and you get the better financial aid treatment.
The decision to contribute to a regular or Roth IRA/401(k) (assuming both regular and Roth are available) should mostly hinge on whether or not you think your tax rate will be higher or lower in retirement than it is at the time the contributions are made. A higher tax rate in retirement tilts toward Roth contributions (take the tax hit now), while a lower tax rate in retirement tilts toward regular contributions (take the tax hit later). While many of us may be able to make a reasonable projection about what our taxable income will be in retirement, I don’t know of anyone who has a crystal ball able to predict what tax policy and tax rates will be like that far down the road. The pessimist in me says that tax rates when I’m retired won’t be any lower than they are now, given budget deficits and the reckoning that is soon to take place with the big entitlement programs. But that’s nothing more than a guess.
I did qualify my comment with “all things being equal”. Of course they are never equal and one option will always be better. Because I don’t know many of the variables in retirement (tax rate, other income affecting marginal tax rates, social security, etc), I have always believed it’s advantageous to have some money in both buckets: Tax-free and tax-deffered. How much in each bucket? No idea. Clearly a large amount (at least a third) gives you flexibility. But if you tell me I can remove $6,000 more income (by having a ROTH 401K) for financial aid purposes, that’s a pretty compelling reason to do a ROTH 401K while my kid is in college.
Absolutely agree that the tax you do not pay on the Traditional 401k Contributions hurts your FA. However, forgetting about FA for a moment, a bird or in this case deduction now, is worth more than in the future. Especially as you can in theory invest whatever taxes you save, so with a Roth you are investing 24k, but with a traditional you could be investing 24k plus your tax refund/savings you get from doing the 401k. That money, up to $6500 could be put in a Roth IRA.
I hate for this thread to devolve into a Roth basis Traditional but one part of the conventional wisdom tree makes no sense to me and that is that if you expect a lower tax rate in retirement, then a conventional makes more sense.
The catch is with a ROTH you are paying the tax rate on the initial investment with tax free capital gains. On conventional, you are paying tax on both. I’ll use simple numbers rather than an attempt to guess at actual tax brackets. Let’s say your effective tax rate is 20% today and expect it to be 10% in retirement. If you invest 100,000 over a period of years and let it ride for at least two decades, you should have a balance of $300,000 or more. Again, don’t debate the rate of return. 20% on 100,000 initial investment is $20,000 in taxes. 10% on 300,000 is $30,000 in taxes. ROTH wins even with lower tax rate in retirement.
I just take the tax hit today and my IRAs and 403b are ROTH.
I’d prefer for this discussion to say a ROTH 401K is no better or worse than a 401K. If you make that assumption, I’m trying to come up with a scenario where the ROTH 401K is not better.
One point for the previous two posters: It’s not fair to compare the same amount investment in both alternatives. If your current tax rate is 33%, then it takes $15K of pretax money to invest $10K in a ROTH. It takes $10K of pretax money to invest $10K in a regular 401K.
@privateID that’s fair but my point is most arguments for one or the other are too simplistic. If you area in a higher tax bracket, there is a greater chance you will hit IRS limits for either scenario so your investment is the same even if your current tax bill is different. If someone is in a lower tax bracket but only investing $200/month, the tax savings isn’t enough to go conventional.
I would be curious to run NPC’s like the OP did to see if I could replicate those results. I would have to guess the change in taxes paid. I’ll stick with ROTH either way but it’s a curious point.
I agree with the OP’s assessment that Roth is better for Finaid than Traditional retirement account and that in general maximizing taxes paid will increase finaid. I just want to mention that many generous schools ask for a copy of W2 that usually shows both Roth and Traditional 401k deductions so it may be difficult to cry poverty when you put 24K/year into retirement account. Roth IRA investments do not show anywhere but it will only be $6.5K. I am not claiming that large retirement deductions will necessary change finaid but who knows…
Additionally all this financial gymnastics only works when the school met full need of the student and financial package included need based aid. You probably explored NPC from a meet-full-need school.
This scenario happened to us this year… so here’s a real-world data point. We revised the FAFSA after the conventional IRA contribution, and the grant aid was reduced by nearly the amount saved in taxes. Surprised and annoyed.
CCDD14 - I have always been a saver. I’ve been in the position to max out my 401K for the past few years. I’m not crying poverty, but all of a sudden I was being offered need-based aid. At the start of this college process, I was expecting merit aid and then I realized that wasn’t happening at the schools he wanted to attend but instead I’d be offered need-based aid. I didn’t expect it, so now I’m trying to understand how need-based aid works.
Is it a bad idea to max out my 401K for my retirement ($24K) and request aid? I guess I’m asking is need-based aid computed as a straight equation or is there subjectivity even at the initial offer? I would think if you appeal, then there’s subjectivity and contributing $24K would not be looked upon as needy.
@dadof1 Thanks for the response. So, do you agree that a ROTH would have been better given you experience? Can you share (no problem if you can’t) the contribution amount, the tax savings and the amount of aid that got cut?