FAFSA 401k/IRA "Trick" Results

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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.

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First off, young skywalker, this is not a "trick" and is well documented in pub 590 and discussed here and other sites. The take away lesson from other FW members is don't take the money out of your retirement instruments. It's easy to take out than to put back in.

I hope you realize as a graduate student your stafford loan rates are fixed at 6.8% and thus won't change next year, unlike your undergrad siblings. So don't expect anything different come next July 2009. The one time $10k limit does not apply to your school expenses. It is for first time home buyers.

PUB 590:
"Higher education expenses. Even if you are under age
591/2, if you paid expenses for higher education during the
year, part (or all) of any distribution may not be subject to
the 10% additional tax. The part not subject to the tax is
generally the amount that is not more than the qualified
higher education expenses (defined later) for the year for
education furnished at an eligible educational institution
(defined later). The education must be for you, your
spouse, or the children or grandchildren of you or your
spouse.
When determining the amount of the distribution that is
not subject to the 10% additional tax, include qualified
higher education expenses paid with any of the following
funds.
• Payment for services, such as wages.
• A loan.
• A gift.
• An inheritance given to either the student or the
individual making the withdrawal.
• A withdrawal from personal savings (including sav-
ings from a qualified tuition program).
Do not include expenses paid with any of the following
funds.
• Tax-free distributions from a Coverdell education
savings account.
• Tax-free part of scholarships and fellowships.
• Pell grants.
• Employer-provided educational assistance.
• Veterans’ educational assistance.
• Any other tax-free payment (other than a gift or in-
heritance) received as educational assistance.
Qualified higher education expenses. Qualified
higher education expenses are tuition, fees, books, sup-
plies, and equipment required for the enrollment or attend-
ance of a student at an eligible educational institution.
They also include expenses for special needs services
incurred by or for special needs students in connection
with their enrollment or attendance. In addition, if the indi-
vidual is at least a half-time student, room and board are
qualified higher education expenses.
Eligible educational institution. This is any college,
university, vocational school, or other postsecondary edu-
cational institution eligible to participate in the student aid
programs administered by the Department of Education. It
includes virtually all accredited, public, nonprofit, and pro-
prietary (privately owned profit-making) postsecondary in-
stitutions. The educational institution should be able to tell
you if it is an eligible educational institution."

ymarker said:
I hope you realize as a graduate student your stafford loan rates are fixed at 6.8% and thus won't change next year, unlike your undergrad siblings.

I didnt know that. Kind of sucks. But if I wind up in the 25% tax bracket then its 5% if I write off the interest. Does that student loan interest require itemization or can I take it with the standard deduction?

I guess provided I can get a tax deferred 10% gain in the stock market it would better to keep my 401k intact and pay the 5% interest. Its not a guaranteed 10% but over the next 30 years it hopefully will average out to that.

ymarker said:
The one time $10k limit does not apply to your school expenses. It is for first time home buyers.


I didn't know that. Thanks!

tripleB said: ymarker said:
I hope you realize as a graduate student your stafford loan rates are fixed at 6.8% and thus won't change next year, unlike your undergrad siblings.

I didnt know that. Kind of sucks. But if I wind up in the 25% tax bracket then its 5% if I write off the interest. Does that student loan interest require itemization or can I take it with the standard deduction?

I guess provided I can get a tax deferred 10% gain in the stock market it would better to keep my 401k intact and pay the 5% interest. Its not a guaranteed 10% but over the next 30 years it hopefully will average out to that.

ymarker said:
The one time $10k limit does not apply to your school expenses. It is for first time home buyers.


I didn't know that. Thanks!


The student loan interest deduction does not require you to itemize but it does get phased out based on your MAGI. The details are in IRS publication 970.

wraithtech said: The student loan interest deduction does not require you to itemize but it does get phased out based on your MAGI. The details are in IRS publication 970.

Yes. Thanks to the community here, I paid my student loan interest on my unsubs with CashBack I got from my Citi mtvU card. If you don't already have this card, I'd highly recommend it. You get 5% CashBack on eating out / books / movies. There is a thread on this forum if you want more details.



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