by Ryan W. Smith
The Free Application for Federal Student Aid (FAFSA) has become an annual rite for all college-bound students since its creation in 1992. The form, which parents fill out annually with income, debt and tax information in order to determine student qualifications for federal loans and grants, has its origins in the College Scholarship Service (CSS), started in 1954. Though several iterations existed between 1954 and 1992, the FAFSA’s most significant changes have occurred in the past year.
From 1992 until 2016, the FAFSA was filled out by parents after January 1 each year, based on the prior year’s tax forms and updated once taxes were filed. For example, the FAFSA due January 1, 2016 initially used tax data from calendar 2014, updated to include 2015 numbers in April when taxes were filed.
Changes to the FAFSA in 2016 ran in concert with reductions in the interest rates students are now charged for federal student loans. For the 2016-2017 academic year, interest rates fell about one-half percent (50 basis points) for each type of loan. For example, all federal loans issued after July 1, 2016 now carry a 3.76% interest rate for undergraduates, down from 4.29% in the 2015-2016 school year. For graduate students, the interest rates in 2016-2017 academic year are 5.31%, down from 5.84%. Likewise, PLUS loans, those loans obtained by graduate students or parents of undergraduate students on top of other federal loans, had an interest charge of 6.31% in 2016-2017, down from 6.84% the year prior.
These reductions in interest rates are notable because of the long-term aspect of debt repayment necessary for most students who obtain them. Taken into consideration with the changes to the FAFSA, how students and parents save and pay for college will undergo some significant changes in the coming years. Here are some of the ways that changes to the FAFSA will alter strategies regarding college loans, savings and expenditures:
1) Timing is Everything
While many students and parents will not qualify for federal aid, most colleges require a FAFSA be filled out before any student aid package could be awarded. Given the deadlines and information necessary, a cumbersome process of estimating unfiled taxes and then amending form when those taxes were filed can now be avoided.
Forms can now be filled out as soon as October 1 for the next academic year, meaning that students and financial aid offices would get nearly a full calendar year to determine best-fit aid packages.
Beginning with the 2017-2018 academic year, the FAFSA will use a two-year lookback. For example, 2016 and 2017 tax information would be used for the necessary portions of the 2017-2018 forms. This will prevent the amendments that were necessary in years past, which oftentimes would lead to significant aid package alterations making it somewhat difficult to plan ahead for many families.
2) Income Recognition
Now that amendments to the FAFSA are now eliminated for the vast majority of filers, the two-year lookback allows parents and students to make more clearly defined changes to their college savings plans. One of the primary ways this will occur for most families is to delay income, depending on student situation and grade-level.
For example, parents of future college students might want to delay income, if possible, until the tax year that ends during their child’s junior year of high school. For sophomores and seniors, parents who delay IRA distributions, as an example, until after January might see significantly different award packages since that income would not need to appear on the FAFSA until the following year.
3) 529 College Savings Plans
There are two main aspects of FAFSA and 529 College Savings Plans that are impacted by the FAFSA changes. The first deals with the Expected Family Contribution (EFC) amount derived from FAFSA information. The EFC’s calculations gives much more weight to student assets (20%) than parental assets (5.64%). The lower the EFC, the higher potential aid package can be.
The second aspect where FAFSA changes might alter how a 529 plan is utilized comes from distributions. Distributions from 529s owned by either parents or students are considered parental assets, but distributions from 529 plans owned by a grandparent are considered a student asset. Distributions from parent or student owned 529 plans during the first two years of college and distributions from grandparent owned 529s during the final two years would maximize potential aid packages for students because of the way EFC is calculated.
4) Maximum Gifts
The new FAFSA rules do not consider gifts as part aid eligibility for non-parents. This means that grandparents, and others, can help finance a student’s education without impacting an aid program for that student. These non-parents can give unlimited amounts of money directly to a college on behalf of the student without triggering a gift tax. They would also be able to reduce estate tax liability at the same time.
Another gifting option that doesn’t impact FAFSA aid packages when given by grandparents is giving appreciated assets to a student. This method does have tax implication on the capital gains. If the student receiving the appreciated assets sells them after age 24, uses the proceeds for educational purposes and their tax rate is 10% or 15%, there would be no capital gains taxes for that sale. If the student is less than 24 when the assets are sold, however, the gains would be subject to their parents’ income tax rate because of the “kiddie rule.”
5) Custodial Account Assets
Under the Uniform Gifts to Minors Act (UGMA), a custodial account in the name of a child is considered a student asset for FAFSA purposes. These UGMA accounts are weighted higher in FAFSA calculations than parental assets, so some families might want to begin spending down those assets two years before a student’s freshman year in college to minimize that impact. These assets can be spent on any product or service that benefit a child, like paying for a summer camp, a laptop or tutoring.
Some industry professionals suggest liquidating custodial accounts two years before a student reaches college, to trigger capital gains on appreciated assets before it would need to be entered on the FAFSA. These professionals then suggest using those proceeds to open a 529 plan, whose assets will be considered parental assets for FAFSA purposes, so that future distributions could be tax-free.
Changing interest rates on student loans and the alterations to the FAFSA process will have an outsized impact on how students and their families plan and pay for college expenses in the future. There are many options available, and many rules to go along with each option. However, a prudent financial advisor can help families well before a child is ready to leave for college by understanding these rules. As they develop a plan with clients and their families, technology can assist. Utilizing financial analysis programs like AdvisoryWorld’s SCANalytics program can help advisors manage client expectations as they plan for the future and deal with the myriad variables at play.