Types of Income
There are two types of income to be considered on the financial aid application forms:
- assessable; and,
- non-assessable.
Financial aid income (assessable) is the sum of Adjusted Gross Income (AGI) plus “Other Untaxed Income and Benefits,” as described in this chapter.
Non-Assessable Financial Aid Income and Benefits
The following are the types of non-assessable income and benefits for financial aid purposes:
- Employer Provided Education Assistance
Employer provided education assistance benefits are regulated under IRC Sec. 127. The amount of the benefit is considered a “resource” and reduces the financial need of the student on a dollar-for-dollar basis.
- Loan Proceeds
Loan proceeds from any source are not assessed.
- “Rollover” Pensions
The portion of a pension withdrawal which is not “rolled over” is assessed; however, any rollover portion is not assessed.
- Food Stamps
Food stamps are not assessed.
- Gifts and Support
Gifts and support, other than money, received from friends or relatives are not assessed. Therefore, cash gifts are considered financial aid income and are assessed.
Note 1: Non-monetary gifts, such as stocks or automobiles, are not assessed.
Note 2: Gifts made directly to a college to pay for a student’s tuition are considered a “resource” and therefore reduce the financial need of the student on a dollar-for-dollar basis. Gifts given directly to a college (or private elementary or high school) for tuition do not reduce the donor’s annual $14,000 gift tax exclusion [IRC Sec. 2503(e)]. The gifts must be in cash.
Example 1: A grandparent wants to help his grandchild with upcoming college costs. The grandchild needs a car for college transportation. If the grandparent buys the car for $14,000 and then gifts it to the grandchild for Christmas, there are no financial aid ramifications for the grandchild. The non-monetary gift will not be considered “untaxed income” in the financial aid formula and since the car will be considered a personal asset of the grandchild, it is not assessed as a financial aid asset.
However, if the grandparent gifts the $14,000 to the grandchild for Christmas, with the understanding that the grandchild will use the money to buy a car for college, the $14,000 gift must be reported on the financial aid application form as “untaxed income.” This could lower the student’s financial aid eligibility by $7,000 ($14,000 monetary gift x 50% student income assessment rate). If the student delays buying the car until after the financial aid application form is filed, the $14,000 in the account further reduces the financial aid eligibility by $2,800 ($14,000 assessable cash asset x 20% student asset assessment rate).
Example 2: Grandpa did not like the financial aid consequences for the grandchild in the above example. Therefore, he consulted with his financial advisor, who was ignorant of the financial aid rules, and who told the grandparent that there was an alternative way to help the grandchild with college costs: He advised the grandparent to gift the $14,000 directly to the college for the tuition costs. The advisor explained this would eliminate the problem of the gift causing “untaxed income” to the grandchild and it would allow grandpa to reduce his estate by $14,000 without affecting his annual $14,000 gift exclusion. When the grandchild received the financial aid award letter from the college, the grandchild noticed that the dollar amount of the award offer was reduced dollar-for-dollar by the $14,000 gift made directly to the college for tuition. This disastrous consequence could have been avoided if the financial advisor had understood the financial aid rules.
Observation: A substantial portion of college expenses for students in the United States are being paid by grandparents. Most grandparents have a strong interest in seeing that their grandchildren receive a college education. They have the time to attend seminars regarding their grandchildren’s future college education, and more importantly, they have the money! Therefore, providing college funding seminars or materials to this group of grandparents may be a good way to increase a financial advisor’s business.
- Veterans’ Educational (VA) Benefits
Veterans’ educational (VA) benefits, including VA work-study, are not assessed. However, the amount of the benefit is considered a “resource” and reduces the financial need of the student on a dollar-for-dollar basis.
- State Payments
State payments for foster care and adoption assistance are not assessed.
- Flexible Spending Plans
Flexible Spending Plans are useful tools to increase a student’s financial aid eligibility as they reduce the parents’ AGI.
Example: Parents who contributed $8,000 to their flexible spending plans for dependent care and medical expenses reduced their AGI by the $8,000. This reduction increased their child’s financial aid eligibility because the parents’ AGI was reduced by this amount.
- Child-care Benefits
Child-care benefits provided by the Child Care Program and the Social Services Block Grant Programs should not be reported, as they are a form of in-kind income.
- Per Capita Payments
Per capita payments to Native Americans from the Per Capita Act or the Distribution of Judgment Funds Act are not assessed unless they exceed $2,000. Only the amount in excess of $2,000 should be reported on the financial aid application form.
- Low-income Home Energy Assistance
Income from any payments or allowances received under the Low-Income Home Energy Assistance Act (LIHEA) is not assessed.
- Disaster Funds
Federal and state disaster funds received by residents who live in a county that has been designated a federally declared natural disaster area are not assessed.
- Some Types of Insurance Proceeds
Some types of insurance proceeds are not assessed as income, depending on the situation. Reimbursements for loss of an asset, such as a stolen car, or reimbursement for medical bills are not reported. However, portions of insurance settlements received over and above these reimbursements are considered financial aid income and must be reported. If the insurance settlement income is not taxable, it should be included on the financial aid application as “untaxed income.“
- Foster Care Money
Foster care money received for foster children is not assessed, even though the foster child may be part of the household. Also, if the foster child is an applicant for financial aid, support payments made by the biological parent(s) to a court or to the foster parents are not reported as “untaxed income.”
- Student Financial Aid
Student financial aid received by the student is not assessed. This includes grants and scholarships, loans, and work-study.
- QTP Principal Withdrawal
A QTP withdrawal, including the earnings, is not assessed under the FM formula.
- Nonqualified Deferred Compensation Contribution
The contribution to a nonqualified deferred compensation plan is not assessed as “untaxed income and benefits.”
Observation: C Corporations are the entity of choice when it comes to financial aid planning. C corporation income is not assessed in the financial aid formulas. A client can remove business income from their personal tax return by transferring the business to a C corporation. In addition, the client can reduce their wages taken from the C corporation during college years, and thus increase eligibility for financial aid. However, before suggesting that a client establish a C corporation, the client’s tax advisor must be consulted to determine the income tax consequences of establishing a C corporation. Because of the double taxation potential for C corporation income, the tax negatives must be weighed against the financial aid benefits of a C corporation.
Assessable Financial Aid Income and Benefits
Assessable financial aid income is the sum of Adjusted Gross Income (AGI) plus “Other Untaxed Income and Benefits”. There are numerous “Untaxed Income and Benefits” which are considered financial aid income. They are as follows:
- Current Year Retirement Contributions
Deductible IRA, SIMPLE IRA, SEP or Keogh contributions for the current year are assessed. In addition, payments to tax-deferred pension and savings plans (paid directly or withheld from earnings) as reported on the W-2 Form (Box 12, codes D, E, F, G, H, & S) are assessed. This includes the untaxed portions of 401(k) and 403(b) plans.
Example: A student’s parent made a $5,500 tax deductible contribution to a regular IRA. The $5,500 is considered an “untaxed benefit” and is added back to AGI in the EFC computations.
Note: An employer’s contribution to a retirement plan, such as a corporate profit-sharing plan or a defined benefit plan [IRC Sec. 412 or 412(i)], will not be considered an “untaxed benefit” of the employee.
- Untaxed Portion of Retirement Withdrawal
Untaxed portions of retirement, pension, annuities, or life insurance withdrawals or benefits (excluding rollovers) are assessed. This includes distributions from Roth IRAs, whether taxable or non-taxable.
Note: The taxable conversion of a regular IRA to a Roth IRA causes an increase in AGI. Therefore, clients need to consider the financial aid effect that this conversion has on their children who will be attending college during one of the conversion years.
- Tax-exempt Interest
Tax-exempt interest (e.g., municipal bond interest) is assessed.
- Worker’s Compensation
Workers’ Compensation benefits are assessed.
- Veteran’s Non-educational Benefits
Veterans noneducation benefits, such as death, pension, Dependency & Indemnity Compensation (DIC), etc., are assessed.
- Living Allowance
Housing, food, and other living allowances (excluding members of the military) paid to members of the military, clergy, and others (including cash payments and cash value benefits) as compensation for their jobs are assessed (e.g., If a client receives the tax-free use of an apartment, the rental value of the apartment would be reported.). Housing allowances excludes rent subsidies for low-income housing.
Example: Room and board provided as a non-taxable fringe benefit by a corporation for its employees would be considered an “untaxed benefit.”
- Money Paid on a Student’s Behalf
Cash or any money paid on the student’s behalf by persons other than the student’s parents is assessed.
Example: If a relative of the student pays the student’s rent or utility bill, the student must report those payments as untaxed income on the FAFSA. If the relative provided an apartment free of charge, it would not be considered an “untaxed benefit.”
Note: Money received by a dependent student from the non-custodial parent when the parents are divorced or separated is included as “untaxed income” of the student. If the non-custodial parent pays a monetary obligation of the student, such as college tuition, the amount paid is reported as “untaxed income” of the student. Note that in the latter situation, the parent makes payment directly to the student or the college.
- Child Support
Child support received for all the parents’ or student’s children is assessed.
A divorce or separation could be structured to give the custodial parent more assets and less child support payments. The custodial parent’s assets would be assessed at 5.6% versus the financial aid income assessment rate of 47%.
The timing of child support (and alimony) payments to the custodial parent should be considered. These payments could either be prepaid or deferred in order not to be included in “untaxed income” during college years.
- U.S. Series EE Savings Bond Interest
The interest from EE bond redemptions used to pay for qualified education expenses is tax-free. This tax-free income is assessed in determining financial aid income. The bond principal is not assessed.
- Income Exclusions
Income exclusions, such as the exclusion of the gain on the sale of a personal residence, are assessed. Even though these items are not taxable, they must be reported as “untaxed income,” as they represent additional financial funds available to the family.
Example: A student’s parents sold their house because of a job change. The parents had a $100,000 gain on the house. Because of the provisions of IRC Sec. 121, this gain was excluded from their taxable income. However, when the student fills out the financial aid application for the upcoming college year, the student must report the $100,000 as “untaxed income” of the parents on the application.
- Other Untaxed Income and Benefits
Any other untaxed income and benefits, such as Black Lung Benefits, Refugee Assistance, untaxed portions of Railroad Retirement Benefits, or VA Educational Work-Study allowances are assessed. Tuition benefits a parent receives for a dependent (e.g., from the parent’s employer) are not included as untaxed income but as a financial aid resource (such as a private scholarship). The amount of the benefit will reduce the student’s financial need on a dollar-for-dollar basis.
Deductions from Financial Aid Income
There are certain items that are deducted from financial aid income. These items are as follows:
- Child Support Paid
Child support paid by the parents or student is a deduction. The timing of payment of child support could increase the financial aid eligibility of a student whose parents are making these payments.
- Need-based Work Programs
Federal work-study or other need-based work programs can be deducted if they were included in adjusted gross income.
Observation: This deduction is often missed by financial advisors and families. Work study can often be identified on a W-2 issued to the student by the college or university because it is exempt from FICA.
- Taxable Grants and Scholarships
Taxable grant and scholarship aid, in excess of tuition, fees, books, and required supplies, that is included in the student’s AGI is a deduction.
Note: Students who are attending school with scholarship aid may be hit with an unexpected tax bill. Under current tax law, scholarships are tax-free only to the extent that they are used for tuition, fees, books, course material, supplies and other items that are directly connected to education. Any amount given for room, board and personal expenses are taxable. For students who aren’t candidates for college degrees, all scholarships and fellowships are fully taxable.
Students should keep records and receipts for all money spent on tuition, fees, books, school supplies and the like. It is up to the student to prove how much of the scholarship went for these purposes and how much, if any, went for personal living expenses.
If the student is required to perform any services (teaching, for instance) as a condition of receiving the scholarship, some or all of the grant will be regarded as taxable compensation.
Observation: Prior to the 1997 Taxpayer Relief Act, very few students reported the taxable portion of their grants or scholarships. Because of new tax reporting requirements and the interaction of grants and scholarships with the American Opportunity Credit and Lifetime Learning Credit, there will be a dramatic increase in the amount of taxable grants and scholarships being reported by students.
- Americorps Awards
Allowances and benefits received under the National and Community Service Act of 1993 (Americorps awards), included in adjusted gross income, are a deduction.
Note: These benefits are considered a “resource” of the student and will reduce financial aid eligibility on a dollar-for-dollar basis.
- Federal Income Tax
Federal income tax paid (actual tax paid, not the amount withheld) is a deduction. This does not include social security tax on tips, 10% penalty on early withdrawals from retirement accounts, advance earned income credits, or household employment taxes.
Note: The American Opportunity Credit and Lifetime Learning Credit reduce the amount of federal income tax paid. However, the FAFSA has a line that can be used to deduct the amount of these credits that reduced the federal income tax paid. Therefore, these credits will not affect a student’s financial aid eligibility under the Federal Methodology. However, unless the FAO uses professional judgment, the PROFILE and Institutional Methodology will assess these credits as untaxed income thus lower the student’s financial aid eligibility.
- State Tax Allowance
An allowance for state tax is a deduction. This is automatically calculated in the financial aid formula, based on the state of residency.
- Social Security Tax
Social security tax is a deduction. This is automatically calculated based on the amount of earned income, including payments in kind, shown on the Form W-2 and Schedule SE.
Note 1: For purposes of this deduction and the Employment Expense Allowance (defined later in this section), the amount shown in the “Medicare Wages” (box 5) of the person’s Form W-2 is the correct amount to be reported as the person’s earned income. The instructions for the financial aid applications state to use the amount from line 7 of the 1040. These instructions are wrong!
Note 2: For the purposes of this deduction and the Employment Expense Allowance, a loss on Schedule SE should not be netted against that person’s Form W-2 Medicare wages. A loss on Schedule SE does not cause a refund in the social security or Medicare tax paid on a person’s W-2 earnings.
Income Protection Allowance
In the parents’ case, this is automatically calculated in the financial aid formula based on the number of household members and the number of household members enrolled in college.
TABLE A3: (2018-2019)
INCOME PROTECTION ALLOWANCE
Number in parents’ household, including student vs. Number of college students in household
1 2 3 4 5
2 $18,320 $15,180 ———- ———- ———-
3 $22,810 $19,690 $16,560 ———- ———-
4 $28,170 $25,040 $21,920 $18,790 ———-
5 $33,240 $30,100 $26,990 $23,850 $20,740
6 $38,880 $35,740 $32,630 $29,490 $26,380
In the student’s case, this is a fixed standard allowance. For the college year 2018-2019, the allowance is $6,570 for the Federal Methodology EFC formula. The Institutional Methodology EFC formula does not have an Income Protection Allowance against the student’s income.
- Employment Expense Allowance
This is automatically calculated by multiplying the lesser of the earned income of the father or mother times 35%. The definition of “earned income” for the purposes of this allowance is the same as the definition of earned income for the social security tax deduction. The maximum allowance for 2018-2019 is $4,000.
Example: A family owned a closely-held corporation. The father received $60,000 in wages per year from the corporation. Historically, even though the mother had worked for the corporation, she had not received any wages from the corporation. During their children’s college years, the parents followed the advice of their college financial planning advisor and had the corporation pay the father only $50,000 and pay the mother $10,000. The earned income shown by mother made the parents eligible for the maximum $4,000 Employment Expense Allowance. Since this allowance reduced their financial aid income, it increased their children’s financial aid eligibility.
- Unreimbursed Medical Expenses
Unreimbursed medical expenses in excess of 3.5% of total financial aid income are a deduction from income (Institutional Methodology formula only).