Saving More in a 401(k) Can Now Boost Your College Financial Aid
Nov 03, 2023
How the
new Fafsa application changes the formula for financial aid
Faced with the gargantuan cost of higher education, Americans often
have to choose between securing their children’s future or their own. A new
rule change makes it slightly easier to do both.
Pretax contributions made to retirement accounts will no longer
count as income in the formula that measures a family’s ability to pay for
college, under changes
to this year’s Free Application for Federal Student Aid, or Fafsa. The
Education Department made the changes to simplify the form and ensure more aid
goes to those who need it most.
Some
families could save between $5,000 and more than $10,000 on the cost of college
each year, depending on their income.
Paying for
college and saving
for retirement are two of the biggest financial challenges Americans
face. The change encourages saving for retirement while making college more
affordable to middle-income Americans as high
inflation and interest
rates have stretched family budgets.
“It takes a
little bit of that guilt away,” said Aaron Cirksena, chief executive of MDRN
Capital, a retirement-planning and investment advisory firm. “For the people
that can even contribute small amounts to their 401(k), they now are able to do
that without it affecting the federal aid that their kids could get for
college.”
Under the
federal formula, the maximum families are expected to contribute to the cost of
college is capped at a range between 22% and 47% of their discretionary
income.
In the past,
the Fafsa asked families how much they contributed to their work-sponsored
retirement accounts. Retirement contributions were then factored back into
total income, raising the amount families are expected to contribute.
The new
Fafsa, which comes out in December, is shorter. Questions about untaxed
payments to tax-deferred pension and retirement-savings plans have been
removed. The changes are designed to simplify the process and help families in
greatest need of assistance by drawing more information directly from tax
documents.
This change will have the biggest impact on middle-income
households that make around $100,000 a year, financial advisers say, since
pretax contributions can lower their income below the threshold for additional
aid.
Among qualified retirement plans managed by Vanguard, nearly 60% of
participants with income of more than $150,000 contributed the maximum allowed
last year. Comparatively, 4% of participants with income between $75,000 and
$99,999 did so.
The Fafsa collects tax information from two years before the
application, so contributing more to retirement accounts this year won’t have
an impact on the financial-aid award for 2024-25, but will affect the amount
for the 2025-26 academic year.
Many families struggle with giving priority to saving for college
and retirement.
“They’ve got a limited amount of money they can set aside for
savings. Do they set it aside for their own retirement? Do they set it aside
for college?” said Shannon Vasconcelos, senior director of college finance for
Bright Horizons College Coach, a college-admissions advising firm. “There isn’t
a very clear right or wrong answer.”
Parents who put
college savings ahead of retirement savings might end up having to
play catch up once their kids graduate college, financial advisers say. By that
point, they are closer to retirement age and might need to save even more money
each year to meet their goals, stay in the workforce longer or adhere to a
stricter budget once they retire, said Chris Longworth, a certified
financial-education instructor at the Financial Education Group, an advisory
firm in Washington state.
“They literally sacrifice their future lives for the benefit of
their children,” Longworth said.
The change to the Fafsa affects federal aid and the institutional
aid granted by colleges that use the same formula. Some colleges and
universities use alternatives to Fafsa when considering how much institutional
aid they grant to students. Their formulas may still count retirement
contributions as income.
This new Fafsa formula could encourage parents to contribute more
toward their retirement earlier, college advisers say.
“This particular provision of Fafsa simplification allows you to
save more for retirement and it will help you a bit in terms of paying for
college as well,” Vasconcelos said.
Source: Wall Street Journal