How 401(k)s, 529s factor into the new FAFSA

This fall could be an unusually stressful time for families with children planning to start college next year.

The cause: Many will be guessing about how much they will have to pay or borrow for tuition.

Not only are they awaiting acceptance letters, but there's a two-month delay in Federal Student Aid applications as a result of a major overhaul in how the government is assessing eligibility. While the Free Application for Federal Student Aid (FAFSA) is typically published in October for the coming academic year, this year it has been delayed until December.

The new form is a result of legislation passed by Congress in 2021 that sought to simplify the financial aid application process, but a shorter list of questions (about 40 instead of 108) isn't the only difference that students and their families will see. There are some important changes to the application that will help or hurt financial aid eligibility.

One is that pretax contributions to employer-sponsored retirement plans won't count as income, which could make participating in 401(k)s beneficial for multiple reasons. And changes to the status of 529 accounts in grandparents’ names stand to benefit students.

But there is less relief than in the past for families with multiple children currently attending college. And small-business owners will have to report assets that had previously been exempt.

CAN'T GET A BREAK

“Families are going to go through a lot more stress now, because the FAFSA hasn’t been released yet … You’re going to have a longer period of time between knowing you got in and ‘What aid am I going to get?’” said Ross Riskin, chief learning officer at the Investments & Wealth Institute. “That will put some additional tension on families. Be prepared for those conversations and not knowing what [college] will cost for a little while longer.”

Some, but certainly not all, lower-income families will qualify for additional financial aid or Pell Grants that they wouldn’t have before, Riskin said. Those who own small businesses will be particularly impacted, as they will have to report assets that had been exempt since at least 2006, meaning they will be expected to shoulder a higher dollar amount of college costs. That affects farm owners and families who have significant income from rental properties, among others.

Another consequence of the new application is that families won’t get a break for having more than one kid in college at the same time. Previously, the portion of college expenses that they were expected to cover was reduced — for example, cut in half for each matriculant if two children were in college.

“There is no more adjustment for that,” Riskin said. “That’s going to be a big negative adjustment for families with more than one child enrolled at the same time.”

EVERYTHING IS AUTOMATIC

The new application will let most people port information from the IRS, and the contributions they have made to traditional 401(k)s and 403(b)s will not count toward their income. That is particularly significant, given that saving for retirement is often a competing priority with saving for children's college educations.

“Contributions to qualified retirement plans have historically and generally been categorized as untaxed income,” Paul Curley, associate director of 529 and ABLE solutions at ISS Market Intelligence, said in an email. “[B]ut the FAFSA Simplification Act will generally remove those types of contributions from the income calculation formulas going forward, which will encourage parents to continue to make contributions into their retirement accounts while their children are in college going forward.”

There is a big exception to that. Retirement account contributions exempt from income are only those that appear on W-2s, which means SEP IRA contributions will still be counted as income, Riskin said. That highlights a difference in the aid that would be available, for example, for a S corp owner versus an LLC member — the former may have an employer-sponsored retirement account while the latter more likely has a SEP IRA, he noted.

ALL IN THE FAMILY

One of the key changes that advisors should note is that 529 assets in grandparents’ or other family members’ accounts will no longer be reported on the FAFSA.

“This is a big change and has planning implications. A parent of a child can gift their 529 account to a grandparent and now that 529 won't count for student aid, where it would have if the parent still owned it,” Andrew Mastro, president of Wrought Advisors, said in an email.

In this case, grandparents can play an even more important role in college savings, said Kevin Shuller, founder of Cedar Peak Wealth Advisors.

“This means that in most instances, if people want to help pay for their grandchildren's college education, it makes a lot of sense for them to start their own 529s rather than give money directly to the student or the parents,” Shuller said in an email.

In addition to the changes for retirement account contributions, the changes “collectively, [on] the new FAFSA form will encourage positive money savings habits,” Curley said.

NEGOTIATING TACTICS

Colleges and universities are aware of the negative impacts that some of the changes will have for some students’ aid packages. It can pay families to reach out to financial-aid offices if the assistance they initially offer isn’t enough, Riskin said.

Some schools offer sibling discounts, for example, he said.

“Financial aid is always something in planning where advisors need to be talking with the clients as early as possible,” Riskin said.

While larger institutions that are in higher demand appear to be less flexible with financial aid, smaller liberal arts colleges can be more willing to work with families in order to boost enrollment, he said.

“Now more than ever it’s acceptable to appeal financial award letters,” he said. “There’s always a challenge with parents not knowing that … People sometimes become afraid to ask.”