Journal of Financial Planning: February 2019
Mark Kantrowitz is publisher and vice president of research at SavingForCollege.com. A leading expert on student financial aid, scholarships, and student loans, he has been widely quoted in national newspapers and magazines about college admissions and financial aid, and has written for the New York Times, Wall Street Journal, Washington Post, and Reuters, among others. He is the author of four bestselling books about scholarships and financial aid, and he serves on the editorial board of the Journal of Student Financial Aid, the editorial advisory board of Bottom Line/Personal, and is a member of the board of trustees of the Center for Excellence in Education.
A few important issues are frequently faced by financial planners who help their clients fill out the Free Application for Federal Student Aid (FAFSA). Most of these issues center on conflicts between tax and financial aid optimization of a family’s finances. Examples include the treatment of divorced and separated parents, and the treatment of grandparent-owned 529 college savings plans. This article will explore these topics and provide financial planners tips for ensuring the FAFSA is completed correctly.
Treatment of Divorced and Separated Parents
When a dependent student’s parents are divorced or separated, only one parent is responsible for completing the FAFSA. The FAFSA treats legal and informal separation the same as divorce.
This parent, often referred to as the custodial parent, is not necessarily the parent who has legal custody of the student. Rather, it is the parent with whom the student lived the most during the 12 months ending on the date the FAFSA is filed.
One must count the nights the student spent with each parent, and this usually should be consistent with the child custody agreement. If the parents have varied from the agreement, they should go back to court to have the child custody agreement changed to match the actual living arrangements.
Usually, the living arrangements are definitive, since there are an odd number of days in the year. But, sometimes the student has lived with both parents equally. This can occur in a leap year or in a recent divorce or separation. In that case, the custodial parent is whichever parent provided more financial support to the student.
Multiple support agreements are irrelevant, and it does not matter which parent claims the student as an exemption on their federal income tax return. Eligibility for federal student aid is controlled by the Higher Education Act of 1965, while tax law is based on the Internal Revenue Code of 1986. An informal separation counts the same as a legal separation on the FAFSA, even though the IRS treats it differently.
Parents who have an informal separation cannot live together. And if divorced or separated parents live together, they are treated as though they are married on the FAFSA. The FAFSA depends on the student’s relationship with his or her parents, as opposed to the parents’ relationship with each other.
Because the FAFSA bases income and tax information on the prior-prior year, this may require splitting the custodial parent’s financial information from the ex-spouse’s financial information if they were married at the time and filed a joint return. If the custodial parent has remarried as of the date the FAFSA is filed, the stepparent’s income and assets must be reported on the FAFSA, regardless of any prenuptial agreements and even if they weren’t married during the prior-prior year. This is a matter of federal law (specifically, 20 USC 1087oo(f)(3)).
If the stepparent has children from a previous marriage, they are counted in household size on the FAFSA if the stepparent and custodial parent provide more than half of their financial support, even if they don’t live with the stepparent and custodial parent.
If any of these children are enrolled in college on at least a half-time basis, they can also be counted in the number of children in college, which can have a big impact on the student’s eligibility for need-based financial aid. The parent contribution portion of the Expected Family Contribution (EFC) is divided by the number of children in college. Increasing the number in college from one to two is almost like dividing the parents’ income in half.
The non-custodial parent’s income and assets are not reported on the FAFSA. (This is in contrast with the CSS Profile, which is used by fewer than 200 mostly private colleges for awarding their own financial aid funds. The CSS Profile counts the income and assets of both biological/adoptive parents, as well as any stepparents.)
Alimony may present a tricky issue. The Tax Cuts and Jobs Act of 2017 changed the tax treatment of alimony, starting in 2019. The IRS will no longer allow an exclusion from income for the spouse who pays alimony. However, the FAFSA assumes that alimony will be included in the adjusted gross income (AGI) of the recipient. Congress will need to amend the Higher Education Act of 1965 to accommodate this change. Because the FAFSA is based on prior-prior year income, Congress has two years to fix this problem. However, it may be an issue in professional judgment reviews when a family appeals for more financial aid due to a change in income.
Head of Household Status
When married parents claim head of household status on their federal tax returns, it is almost always incorrect. The IRS might not enforce it, but college financial aid administrators will. The financial aid administrator (FAA) is within their legal authority to require the family to file amended federal income tax returns. If the family refuses, they will not get any financial aid. College financial aid administrators are prohibited from disbursing student financial aid if there is any unresolved, conflicting information.
The U.S. Department of Education has highlighted head of household status as an example of conflicting information. The Application and Verification Guide, a source of sub-regulatory guidance published by the U.S. Department of Education available at ifap.ed.gov/ifap, states that “an FAA who notices that a dependent student’s married parents have each filed as ‘head of household’ (which offers a greater tax deduction than filing as single or married) must question whether that is the correct filing status.”
Financial planners should reread IRS Publication 17 (available at irs.gov/forms-pubs/about-publication-17) to refresh their recollection of the rules concerning head of household status. In particular, only one parent can provide more than half the cost of upkeep of the home, a child can count as a qualifying person for only one parent, and the parents must be considered unmarried. To be considered unmarried, the parents must be divorced, have a legal separation, or the non-custodial parent must not have lived in the home for the last six months of the year. Temporary absences for school, work, vacation, military service, incarceration, or hospitalization do not count. If the non-custodial parent is expected to return to the home after the temporary absence, the parents are not considered unmarried.
Ownership of 529 College Savings Plans
529 college savings plans have an account owner and a beneficiary. The beneficiary is usually the student. The account owner may be a parent, the student (a custodial 529 plan), or someone else, such as a grandparent. The account owner can change the 529 plan’s beneficiary, except for a custodial 529 plan.
If a 529 plan is owned by a dependent student or the student’s parent (custodial parent if the parents are divorced), the 529 plan is reported as a parent asset on the FAFSA and qualified distributions are ignored. If the 529 plan is owned by anybody else—such as a grandparent, aunt, uncle, or non-custodial parent—the 529 plan is not reported as an asset on the FAFSA, but qualified distributions count as untaxed income to the beneficiary. (In all cases, the earnings portion of a non-qualified distribution is included in adjusted gross income.)
Parent assets are assessed on a bracketed scale on the FAFSA, with a top bracket of 5.64 percent. This compares with a 20 percent rate for student assets, such as UGMA or UTMA bank and brokerage accounts or other custodial accounts. (The difference in financial aid treatment of student assets versus parent assets eliminates any benefit of the so-called Kiddie Tax, if the student will qualify for need-based financial aid.) Money in a custodial 529 plan account is treated as a parent asset, not a student asset, on the FAFSA.
Income to the beneficiary—whether taxed or untaxed—will reduce eligibility for need-based financial aid by as much as half of the distribution amount on a subsequent year’s FAFSA.
For example, suppose there is $10,000 in a 529 plan that is distributed to the beneficiary. If the 529 plan is owned by the student or custodial parent, it reduces aid eligibility by at most $564. If the 529 plan is owned by the non-custodial parent or grandparent, however, it reduces aid eligibility by as much as $5,000.
Some grandparents open 529 plans with themselves as the account owner for tax reasons. More than two-thirds of states offer a state income tax deduction or tax credit based on contributions to the state 529 plan. Of these, 10 require the taxpayer to be the account owner.
Others open a 529 plan in their own name to retain control over the account. Perhaps they don’t trust the parents to not take a non-qualified distribution to buy a big-screen TV or to pay for groceries when money is tight. Perhaps they want to keep the 529 plan a secret from the family until the student is ready to enroll in college. Some grandparents will open a custodial 529 plan account with themselves as the custodian to retain control without hurting the student’s eligibility for need-based financial aid.
It is usually better for the grandparent to contribute to a parent-owned 529 plan. There are, however, a few workarounds for a grandparent-owned 529 plan:
The grandparent can change the account owner to be the student or the parent.
The grandparent can rollover a year’s worth of funds from the grandparent-owned 529 plan to a parent-owned 529 plan. It is best for this to occur after the FAFSA is filed, so the money does not need to be reported as a parent asset on the FAFSA. Note that the parent-owned and grandparent-owned 529 plans should be in the same state to avoid state recapture rules. Some states treat a rollover to an out-of-state 529 plan to be a non-qualified distribution subject to state income taxes and recapture of any state tax benefits previously received.
Wait until after January 1 of the student’s sophomore year in college to take a qualified distribution. If the student will be graduating from college in four years, there will be no subsequent year’s FAFSA to be affected. If the student will need five years to graduate, wait until after January 1 of the junior year in college. Or, wait until the student has graduated to take a non-qualified distribution to pay down student loan debt. (Note that the earnings portion of a non-qualified distribution is subject to income tax at the beneficiary’s rate, plus a 10 percent tax penalty, as well as recapture of any state income tax benefits previously received.)
Outside of a 529 plan, if grandparents want to help pay for college costs while the student is in college, they should give the money to the parents, not to the student. Gifts to the student count as untaxed income on the FAFSA, while gifts to the parents are not reported as untaxed income on the FAFSA.
No Double-Dipping
Most education tax benefits are based on the taxpayer paying for certain qualified higher education expenses. IRS rules, called coordination restrictions, ban double-dipping. You cannot use the same qualified expenses to justify two different tax benefits. For example, you cannot use the same expenses to qualify for both a tax-free distribution from a 529 plan and the American Opportunity Tax Credit (AOTC).
Since the AOTC is worth more, per dollar of qualified expenses, than a tax-free distribution from a 529 plan, even considering the 10 percent tax penalty on non-qualified 529 plan distributions, it is often best to maximize the AOTC before taking a qualified distribution from a 529 plan.
Thus, families should carve out $4,000 in college tuition and textbook expenses to qualify for the maximum AOTC before using 529 plan money to pay for the remaining qualified expenses. It helps that 529 plans have a broader set of qualified expenses, including room and board, if the student is enrolled on at least a half-time basis.
Income Too High for Financial Aid
Some parents wonder whether it is worthwhile to apply for need-based financial aid if they earn a high income; and parents tend to underestimate eligibility for need-based financial aid and to overestimate eligibility for merit-based aid.
Families should file the FAFSA every year, even if they received nothing other than loans the prior year. Several subtle factors can influence eligibility for need-based financial aid. Wealthy students may qualify for aid at higher-cost colleges or when multiple children are enrolled in college at the same time.
The FAFSA is a prerequisite for unsubsidized federal Direct Stafford and federal PLUS loans. These loans are available without regard to demonstrated financial need. The federal Direct Stafford loan is a reasonable way for a student to have skin in the game, since a student is unlikely to graduate with excessive debt if they borrow using only federal Direct Stafford loans.
Unless the parents earn more than $350,000 a year, have more than $1 million in reportable assets, and have only one child in college and that child is enrolled at an in-state public college, they should still file the FAFSA annually. Not doing so could leave money on the table.
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