College Financing Insights Newsletter
At first glance, this may seem puzzling, a nonevent even, but the truth is that this is actually very advantageous to the family. The financial aid season traditionally kicked off January 1st of the student’s senior year, with all the fan fair of The Olympic Opening Ceremonies. (Ok I exaggerate, a little) Colleges require an admission decision, Early Decision and Early Action aside, by May 1st. This used to give families as well as colleges a narrow window to: fill out the forms, get your taxes done, update the forms, receive your award letter, and make a decision…all before May 1st. This of course does not include any additional paperwork such as verification forms, the schools own forms, the infamous IDOC system imposed by the College Board and if you have a good College Financial Advisor, (patting myself on the back) negotiating for a better award package.
What moving the start date to October first will accomplish is enabling the family to make better informed decisions because they will have more time to evaluate offers and other factors that go into deciding on what college to attend. Yes, you will be applying for financial aid before you even know if you are accepted or not, which is the proper way of doing it even when the start date was January 1st. Another plus, although not as big as the mainstream media or other non-expert pundits would have you believe is that the financial data that will be required is termed “Prior-Prior” meaning the tax year they will be looking for is 2 prior years to the year of admission. So for the school year that you will be applying now, 2017-2018, you will be using 2015 tax info. This should already be filed with the IRS and you will be able to use a tool on the FAFSA called “IRS DATE RETRIEVAL.”
While others, as mentioned above, think that this is the greatest thing since sliced bread, I have personally completed, using this IRS DATA RETRIEVAL system over 1000 FAFSA’s, over 5,000 FAFSA’s in total, and I am here to tell you while it does ease the stain somewhat, it is not all that it is made out to be. First , it does not complete all the financial questions. Only the questions that are actually on your 2015 tax return can be transferred from the IRS to the FAFSA. These may cause more confusion for those that are not versed in finance and taxes. For example, the earned income of each parent is a required question. While wages is on line 7 of your 1040 tax form, if both parents work you have to bifurcate the wages and assign the correct amount to each. This information is found in box 1 of each of your parents W2s.
Additionally, if you rolled over a retirement plan, the entire amount will be listed under untaxed income on your FAFSA as the form cannot distinguish between rollovers and other distributions. Also, retirement plan contributions, asset values, and other questions will not be automatically transferred from the IRS to your FAFSA. This may cause more confusion than not by having to go back over the information and fill in the unanswered questions. One more addendum to the not so true notion that IRS DATA RETRIEVAL is the panacea to financial aid; many schools require additional forms that do not have the ability to auto transfer info from IRS to their forms. The CSS Profile is one of them and this is the form you need as much help as you can get with.
My experience also tells me, although I have no facts to back this up, but just common sense dictates that during the spring, BEFORE the final financial aid awards are handed out, the schools and most likely government (Fed and State) will want an update of your 2016 tax return.
Because the time frame seems to be very accommodating, some parents, as all humans do, will be tempted to procrastinate thinking that there is plenty of time. Remember, some schools will move up financial aid deadlines so please do not make this mistake. Some parents may be thinking that they should wait or they do not have to file right away. It is common knowledge that schools have a limited financial aid budget. By waiting, you take the chance that the schools funds will be depleted and your financial aid award could suffer. Also remember that students who apply earlier tend to receive more aid.
It is also important to apply for and get your FSA ID. You must get a FSA USER NAME and PASSWORD for each student applying for financial aid and at least one parent. Yes, a parent must get a FSA ID. You cannot file a FAFSA without one. In the name of privacy protection, the dept. of education now requires the use of this ID to manage federal student loans, the FAFSA or anything to do with Federal student aid. Each ID is password driven, meaning that each ID has to have a different e-mail address corresponding to that ID. So a parent will not be able to use his or e-mail for themselves as well as their student. The student must have a separate, different e-mail. The process to get this ID is a bit cumbersome, www.fsaid.ed.gov is where to start.
From my perspective, and I have been doing this since 1998, the new timeline is a nice step in the right direction. I realize that the families will be inconvenienced with this extra burden, but the extra time it will afford them of making a correct decision, not a hasty one based on half the story, will save them a lot of money in the end.
If you feel confused or overwhelmed by this process and want more information on how to get started, or if would like to discuss your specific situation, please do not hesitate to call or e-mail me at the numbers listed
If you hire your sons and/or daughters (This can also work for Grandparents!) to work in your business, where should they invest their earnings to get maximum financial benefits for college?
The answer is possibly a Roth or a traditional IRA, depending on the earnings of the child.
IRAs are a college-funding treasure for the working child, for six reasons:
1. The child may withdraw Roth or traditional IRA funds without penalty to pay qualified higher education expenses such as tuition, fees, books, supplies, and room and board.
2. The IRA might be ignored in measuring parent and student resources for purposes of college financial aid.
3. Monies in the IRA grow tax deferred.
4. The IRA tax deduction might eliminate some or all of the child’s existing investment income from the kiddie tax (child’s earnings taxed at the parents’ rates).
5. The IRA is a benefit even when the child’s earned income produces no income tax. The child puts the non-taxed earnings in a Roth IRA and grows that money tax deferred.
6. The working child who earns more than the standard deduction benefits from both a tax deduction for a contribution to a traditional IRA and that IRA’s inside buildup of tax-deferred earnings.
1. Penalty-Free Withdrawal for Qualified Higher Education
The 10 percent early-withdrawal tax does not apply to a distribution from an IRA, to the extent that the amount of the distribution does not exceed the qualified higher education expenses for the student. “Qualified higher education expenses” include tuition, fees, books, supplies, and equipment required for enrollment or attendance at an eligible educational institution. Qualified higher education expenses also include room and board if the student is enrolled at least half-time. An “eligible educational institution” is any college, university, vocational school, or other postsecondary educational institution. This category includes virtually all accredited public, nonprofit, and proprietary postsecondary institutions.
Example. Sally Little began working for her parents at age seven. She accumulates $77,651 in her traditional IRA at the beginning of her freshman year in 2010. She withdraws $27,651 to pay for her first year of college. She pays the regular federal income tax of $2,874 on the $27,651, but she pays no 10 percent penalty on this withdrawal.
2. The IRA and Financial Aid
The Federal Financial Aid formula does not assess, it ignores IRA’s. This means that you can have $1,000,000 in IRA’s and it will not count against you. It is not considered an asset available for educational purposes.6
However, the tricky part is withdrawing the money. When you withdraw the money from IRA’s or for that matter 529 plans, the FAFSA treats the IRA distribution as income in its financial aid calculations.8
Example. Jim Benson has $59,000 in his IRA when he applies for financial aid. The college uses the FAFSA application for financial aid and ignores Mr. Benson’s IRA. To supplement his financial aid in year 1, Mr. Benson takes a $6,000 distribution from the IRA. In year 2, the FAFSA application counts the $6,000 distribution as income in its financial aid computation.
To remedy this, it would be best, if possible to withdraw money from an IRA or a 529 plan after Jan 1st of your junior year in college. This will not be counted because it will be after the tax year income that will be assessed for your senior year. (Soph. Jan 1-Junior Dec 31st)
3. Monies in the IRA Grow Tax Deferred
Your child should invest in either a Roth or a Traditional IRA, depending on his or her taxable income. We all have read about the benefits of tax deferral, so in the interest of brevity I will not drone on about it. I, however, am not that enthralled with it because it is essentially a loan to the IRS. And many, many people are not prepared, or even aware of the tax ramifications of when they have to pay the piper! In my opinion the ROTH is a much better way to go. However, there are other factors to consider, such as kiddie tax elimination as we discuss below. Click Here to read about my Perfect Plan which eliminates all of these concerns and enables you to create a tax-free pension at any age
4. Using the IRA to Eliminate or Reduce the Kiddie Tax
If your son or daughter is subject to the kiddie tax, in which case his or her investment income is taxed at your tax rates, the hire-your-child strategy combined with a traditional IRA contribution can help. Here’s how:
John Smith, age 11, has dividend income of $5,000 that could be taxed under the kiddie tax rules at his parents’ federal rate of 33 percent for a total tax of $1,650. John eliminates this tax by first working for his mother in her proprietorship and earning $5,700 in wages for the year. Next, he makes a $5,000 tax-deductible contribution to a traditional IRA. His tax return looks like this:
Wages $ 5,700
Gross income 10,700
Less IRA deduction -5,000
Adjusted gross income 5,700
Less standard deduction -5,700
Taxable income 0
By working for his parents and using the IRA strategy, John’s $1,650 of income tax disappears.
5. The Roth IRA Strategy
When your child withdraws money from either the Roth or the traditional IRA, tax law imposes10 How Children Employed by Parents Can Use IRAs to Pay for College taxes on the monies withdrawn, but no 10 percent penalty when the withdrawal is used to pay qualified higher-education expenses. Contributions to the Roth IRA are not tax deductible. (Most people invest in Roth IRAs because withdrawals are tax free—but the Roth IRA strategy for a working child is different.)
Example. Jill Morgan, age seven, earns $5,000 working for her father in his proprietorship. The standard deduction of $6,300 eliminates any tax on her earned income.
Jill has $5,000 of non-taxable income. She contributes this $5,000 to a Roth IRA so that her investments can grow: tax deferred; without being subject to the kiddie tax; and without counting as assets when Jill applies for financial aid for college. Let’s say Jill socks away $5,000 every year for 12 years. That’s a total of $60,000 in her Roth IRA. That $60,000 is basis, and as such it is not taxable when she withdraws it for college. (The earnings are taxable, but not the basis. ROTH IRA is afforded the FIFO (First In First OUT) system for taxing withdrawals, meaning that your basis is withdrawn first before your earnings. So Jill can withdraw her entire contribution of $60,000 before she is taxed. Remember, Jill’s Roth IRA contributions are not deductible. Accordingly, she has basis equal to her contributions. The traditional IRA does not have basis, because you deduct the contributions.
6. The Traditional IRA Strategy
Jake Baker, age nine, earns $10,700 working for his mother in her proprietorship. The combination of the $6,300 standard deduction and the $5,000 contribution to a regular IRA eliminates the federal taxes on Jake’s earnings. Besides the tax deduction, Jake’s IRA grows tax deferred and without being subject to the kiddie tax. His investments that fall outside of the IRA protection will need tax planning to avoid the kiddie tax, such as investing in assets for long-term capital gains treatment rather than for interest or dividend income. By far the biggest advantage of using a Traditional IRA is the possible elimination of some or all of the Kiddie Tax.
When you hire your children to work in your business, you need to consider what’s best for those earnings. If your child is planning to save the money for college, then IRAs with good investment returns become important to the equation. The working child benefits from IRA investments because the monies grow tax deferred and the accumulations may be taken and used without penalty for qualified higher education. Your and your child’s planning may benefit from the fact that the IRA and other retirement assets are not counted as assets available for education on the FAFSA application for financial aid.
If you are planning on hiring your child, think young and annually. Your child’s IRA needs time to benefit from the time value of money. If your child has investment income that already triggers the kiddie tax, the hire-your-child strategy combined with the traditional IRA can eliminate some or all of the kiddie tax. The Roth IRA is the best choice if the child is earning less than the $6,300 standard deduction. When the working child has earned taxable income in excess of the standard deduction, the traditional IRA is the best choice. There are other choices, some may fit your needs and objectives better than either IRA option above. Before you decide which is best for you, consult a qualified professional who is versed in 1. College Financial Planning 2. Tax Planning 3. Investment Management. You need to combine all three or you most likely will not achieve your objectives.
For more information or to have a plan developed for your specific situation, send an e-mail or call.
Oct. 1st: The New College Financial Aid Timeline. What You Must Do RIGHT Now!
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