posted: Jan. 2, 2009 @ 8:13a
I did my 2009 FAFSA today. One of my plans was to save up $20k in my 401k over the last 2 years to reduce my income and build up tax-sheltered savings to increase my expected financial aid. My big mistake was reading strategies online but not actually using a FAFSA calculator to see what would happen by changing some numbers around.
It was partially a waste of time and partially a success. The waste of time is that tax-deferred income does count towards your income. I was under the false impression that by reducing my AGI by $20,500 by maxing out my FSA and 401k, it would reduce my overall income. FAFSA does ask for tax-deferred income and counts it as regular income for purposes of Expected Family Contribution (EFC). In fact it INCREASES your EFC because it reduces your income tax paid. The higher the income tax you pay, the lower the EFC because the calculation subtracts that from your income. Tax-deferring the money reduces the income tax paid, and thus increases your EFC!
The success is now I have $20k in tax-shelters that I can use for tuition that is non-reportable on FAFSA. So I was able to reduce my EFC from $21k down to $17k by hiding that $20k in my 401k. I already posted my strategy a few weeks back, but basically I can rollover $10k of the $20k 401k into a Traditional IRA and use the one time $10k penalty free graduate school exclusion (and pay $1500 taxes on it) and then in year 2 (which I will be a full time student) convert the remaining $10k into my roth and "pay taxes" which will be $0 due to standard deduction/personal exemption and then take out a previous $10k from my Roth IRA penalty/tax free since they were prior contributions. My overall Roth value will be the same because I am putting in a new $10k and just taking out an old $10k.
Overall the plan was worthwhile because I am saving a few thousand dollars in taxes but was not as worthwhile on the FAFSA as I had expected. But then again maybe dropping from $21k EFC down to $17k will qualify me for a better interest rate loan, which I may float for a while if the tax-deductable interest payments are less than my post-tax gains from a CD at that point in time.
Another reason the plan is worthwhile is because if I get in on some really low interest rate loans starting August 2009 then I may not tap into the rollover/convert 401k money and instead keep the money tax sheltered and just pay off the loans over time depending on how good of a job I get. Thats $20k more money I can keep tax-sheltered and as I get older and make more money, its more difficult to keep all your money sheltered due to me getting a hire income and the 401k/IRA limits staying about the same.
For example if I take out $20k in loans instead of using the 401k money, and I net $60k my first year after grad school, then I can pay back the $20k my first year, max out $20k of 401k/IRA and live on the remaining $20k or so. I'll be living on under $20k as a graduate student so no need to increase my standard of living the first year I work. If I do this it will let me squeeze an extra $20k in tax shelters that would otherwise be unavailable.