Last year, dozens of families in Lake County, Illinois made headlines by going to extreme lengths in order to maximize their college-bound students’ financial aid. Guided by a college consultant, they went to court to give up guardianship of their children to a friend or relative in order to qualify for a loophole in the financial aid system. By voluntarily severing legal ties, the students qualified as financially independent from their families. Therefore, the families’ incomes and assets were excluded from the financial aid formula.¹

These families went to outrageous lengths to exploit the system and they were widely condemned. However, with college costs now largely unaffordable for all but the wealthiest and limited financial aid funds being understandably prioritized for the neediest students, many middle-income families can sympathize with the temptation to go to questionable lengths to pay for their children’s educations. Fortunately, there are steps that families can take to optimize their FAFSA application without going to such extremes. (Detailed instructions on calculating financial aid can be found in the EFC Handbook here.)

Planning ahead is crucial to optimizing the FAFSA application. The application considers all income and most assets of both parents and students.² The formula uses financial information from tax returns that report income two years before the start of the school year. The table below shows the relevant tax year for each year of a four-year college degree beginning in fall 2020.

There is also a benefit to having more children in college at the same time. The aid formula calculates a number that a family can pay for college expenses and divides it among all family members attending college that year. It may be beneficial to encourage an older child to take a gap year or two in order to delay college if there is a younger sibling close in age so they can attend school at the same time. If a parent is planning on going back to school, a good time to do so is while a child is also attending college.

It is beneficial to keep the relevant tax years in mind when planning for gifts to the student. For example, a distribution from a 529 college savings account owned by a grandparent will be counted as student income in the year of distribution. If the grandparent is planning on paying for two years of college for a student beginning this fall, they should wait until 2022 to distribute the money for junior and senior year. This prevents the income from ever being counted in the financial aid formula, assuming the child does not attend graduate school.  The timing of other income has a substantial impact on financial aid as well.

50% of net student income above $6,840 (for 2020-2021) and no more than 47% of all net parental income is considered available for college expenses (less a few minor deductions). Whenever possible, avoid generating income during the four reportable years. For example, parents should delay realizing capital gains, executing stock options or taking a distribution from a pre-tax retirement account.

Business owners often have more flexibility in reducing income for financial aid purposes than employees. For example, in a method known as "retained income", an employee's salary is paid by a C corporation in which she owns a controlling interest. During the four reportable years, the employee has the corporation reduce his income, and the corporation retains the income until after the child graduates. The income is shown on the FAFSA as an asset, since the corporation is treated as an investment or business asset. This benefits the family since assets are assessed at a lower rate than income by the need analysis formula. This loophole does not work with S corporations or partnerships, since their retained earnings pass through to the tax returns of the shareholders.³

There are several common misconceptions regarding income on the FAFSA. Pre-tax deductions like 401(k) contributions are not sheltered from the FAFSA calculation despite being excluded from the tax return. Pre-tax deductions and other nontaxable income like child support must be added back in. Financial aid administrators also have discretion to add in unrealized income like deferred compensation or future installment contract income from the sale of an asset. In that case, the administrator looks back at more years of tax returns to make a judgement.

Keeping income low provides a valuable additional advantage. If adjusted gross income is below $50,000, the family qualifies for the Simplified Needs Test which disregards the value of the family’s assets entirely.⁴ For everyone else, a portion of many assets is considered available to spend on college expenses.

The financial aid formula assumes that 12% of included parental assets and 20% of included student assets will be available to spend on college costs. Cash, brokerage accounts, and college saving accounts are included assets. A college savings account owned by a parent beneficiary counts as an asset of the parent no matter the beneficiary of the account.

Several types of assets are excluded from the formula including retirement accounts (e.g. 401(k), IRA, Roth IRA) and home equity of the family’s primary residence. Prior to FAFSA tax years, it is more efficient for financial aid reasons to use cash flow to maximize retirement accounts instead of putting the cash into a college savings, brokerage or bank account. Cash and funds from a brokerage account can be sheltered from the financial aid formula by paying down a mortgage on the family’s primary residence prior to the reportable years. It could also be spent on making improvements to the primary residence that improve the asset’s value. Sheltering assets from the financial aid formula should not be the only consideration in determining where to direct cash flow. Potential financial aid should be weighed against other risks and tax implications.

If the student has reportable cash and brokerage accounts, they could also make a Roth IRA or IRA contribution as long as there is enough earned income. They could give each parent up to $15,000 per year so the cash is counted at the parent’s lower rate. This must be done before the reporting years.

The financial aid formula considers almost all financial resources and assumes that most of these resources will be spent on college expenses. Optimizing the formula requires painstaking planning and meticulous forward thinking. A family that can actually afford to pay for college would have to go to extraordinary lengths like the Lake County parents in order to receive need-based financial aid. Ultimately, the best financial aid “hack” is to start saving early and not need it.

¹ https://www.propublica.org/article/college-financial-aid-guardianship-loophole-higher-education-illinois-families

² Some students are considered “independent” of their parents, so they do not provide their parents financial info. The EFC Handbook outlines the situations a student can be considered “independent”.

³ https://www.finaid.org/educators/pj/unrealizedincome.phtml

⁴ The family also must not report any adjustment on Form 1040 Schedule 1 except capital gains, unemployment compensation, Alaska Permanent Fund dividends, educator expenses, IRA deductions, or student loan interest deductions.