Is There Any Way to Shelter Retirement Plan Distributions on the FAFSA?

Is There Any Way to Shelter Retirement Plan Distributions on the FAFSA?

My question is simple: is there a way to withdraw money from my

401(K), at age 59 1/2, that will not be counted as income for FAFSA

purposes? Although I receive an annual pension of $34,500, I fall

short by about $20,000 to meet my annual expenses. Should I withdraw

what I need for next year this year, so it doesn’t show in next year’s

income, plus withdraw enough to pay off my car, so I can reduce my

expenses for next year and require a smaller withdrawal that year,

too? Obviously I wouldn’t withdraw any money if I didn’t need it. But

the FAFSA will just see it as income and not take into consideration

the expenses I’m paying off.

— Myra C.

Even simple questions can have complicated answers, especially if they

concern taxes and the Free Application for Federal Student Aid (FAFSA).

Retirees may begin taking distributions from a 401(k) without

paying a 10% tax penalty starting at age 59 1/2. In some cases they

may be able to take penalty-free distributions as early as age 55.

Distributions from an IRA to pay for higher education

expenses before age 59 1/2 are also not subject to the 10% tax penalty.

Even if the distribution is not subject to the 10% tax penalty, the

amount of the distribution is still subject to ordinary income taxes.

Although the FAFSA ignores assets in qualified retirement plans, it

does not provide special treatment for retirement

income. Distributions from retirement plans count as income on the

FAFSA. The FAFSA bases the calculation of the expected family

contribution (EFC) on total income, which is the sum of taxable and

untaxed income. Taxable income is based on the adjusted gross income

(AGI) reported on the taxpayer’s federal income tax returns. AGI

includes taxable distributions from retirement plans. Untaxed income

includes tax-free distributions from retirement plans, such as a

tax-free return of contributions from a Roth IRA, as well as voluntary

tax-free contributions to retirement plans.

Since the EFC depends heavily on income, retirement plan distributions

can significantly increase the EFC and reduce eligibility for

need-based financial aid.

There are no loopholes that can be exploited to shelter retirement

plan distributions made during the prior tax year on the FAFSA. There is

one exception, which relates to the taxable income that is realized

from converting a traditional IRA to a Roth IRA.

Dear

Colleage Letter GEN-99-10 allows college financial aid

administrators to adjust income to exclude the income attributable to

a Roth IRA conversion. But any distributions in excess of the

conversion will still be treated as taxable income.

One workaround is to take the retirement plan distributions before the

years during which the distributions will be counted on the FAFSA. The

FAFSA is filed on or after January 1 because it is based on income

from the prior year (PY). Income from the year before that —

often called the prior prior year (PPY) — is not reported on the

FAFSA. Timing the distributions to occur at least two years prior to

enrollment can help avoid artificially inflating income when it will

hurt eligibility for need-based aid.

If the child is already enrolled in college, some families will take a

higher distribution one year in order to avoid taking a distribution

the next year. This seesawing of the distributions can increase

eligibility for need-based aid, especially if the family income is

close to the $50,000 threshold for the simplified needs test or the

$23,000 threshold for auto-zero-EFC. The simplified needs test

disregards all assets and the auto-zero-EFC sets the EFC to zero if

the family also satisfies certain other criteria, such as being

eligible to file an IRS Form 1040A or IRS Form 1040EZ.

However, the family’s ability to manipulate the distributions may

depend on the taxpayer’s age. Taxpayers who retire at age 55 instead

of age 59 1/2 must make substantially equal periodic payments in order

to avoid the 10% tax penalty. This usually results in an increase in

income throughout the child’s college education.

A better approach may involve tapping into savings and investments in

taxable accounts to pay for living expenses until the child’s senior

year in college. Spending down non-retirement savings doesn’t count as

income on the FAFSA. It also reduces the amount of reportable assets

on the FAFSA.

As a general rule, all debts, including auto loans, mortgages, credit

cards and student loans, should be paid off by the time one

retires. There is no new income during retirement, just savings. It

does not make sense to be paying a higher interest rate on debt than

one is earning on savings. Paying off the debt will save the retiree

some money.

Source: Fastweb

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