If you’ve got teenaged kids who aren’t cut out for life in the carnival, you’re probably starting to stress about funding their college education, particularly in light of the fact that the average four-year education at a private university will run you upwards of $120,000.
Hopefully, you started socking away money long ago, so your primary concern at this point is maximizing your eligibility for financial aid. If that’s the case, then it’s high time you start paying attention to your tax returns, as the information included on your Form 1040 will, in large part, determine just how much you’re entitled to in educational handouts.
William (don’t call me Billy) Baldwin over at Forbes has published a wonderful column detailing the numerous tricks a taxpayer can employ to “manage” their adjusted gross income for several different reasons, one of which is to maximize educational assistance. Your first order of business? Start thinking outside the typical “defer income/accelerate deductions” box:
Accelerate income.Most taxpayers would like to defer income and the tax bill that goes with it. But it makes sense to go the other way if your tax bracket is headed upward or if you will be filling out college aid forms two years from now or if you are planning a joint replacement next year. If your child is going to college in fall 2015 and you’re going to sell some appreciated stock to cover the costs, you should probably sell that stock now so that it doesn’t inflate the 2013 income shown on your financial aid application, says Barry Picker, a Brooklyn, N.Y. CPA.
As Baldwin points out, additional dollars of taxable income during your application years will cost you dearly:
Who’s the tax collector with the stiffest rate? For many middle-class families the ogre is a college bursar. Take home an extra $100 and the financial aid formula will snatch $37 away. That makes income planning a powerful idea for taxpayers with kids likely to qualify for tuition breaks. The idea is to shrink your income in the years that will show up on any aid application.
Carefully choosing your deductions can also mean more cash come college time. Baldwin explains:
Some things that lower your adjusted gross income also lower the income measured by aid formulas. One is the deduction (up to $7,250) for contributions to a health savings account. But some things that work fine with federal taxes don’t cut any ice with aid officers, warns Troy Onink, a FORBES contributor whose Strategee.com gives advice on financing education.
A deductible contribution to a 401(k), for example, reduces your AGI and thus your federal tax bill. But it gets added back in the income measure used by colleges. Perversely, colleges do count retirement assets going the other way. If you withdraw from a tax-deferred account or convert it into a Roth, the aid formula will treat the money as if it were lottery winnings.
What to do?
First, fund your retirement accounts to the max when your kids are young. Assets parked in retirement accounts are beyond the reach of aid officers.
Next, be careful about converting to a Roth if you have kids aged 16 to 21. It may cost you in reduced aid more than it saves over the years in federal taxes.
Finally, if you have a child in college and are contributing pretax money to a 401(k), think about switching to an aftertax (i.e., Roth) contribution. That will raise your 2012 taxes, lower your taxes in retirement and—surprise—increase the aid you get in 2013. That’s because aid formulas do deduct current tax bills in computing disposable income.
It is somewhat paradoxical that converting is bad, but electing a Roth for new money is good. Here’s the arithmetic. If you are in a combined 40% state and federal bracket, then converting $10,000 raises your tax bill by $4,000 and lowers your aid by $2,220. Switching from a $10,000 pretax to a $10,000 aftertax contribution raises your tax bill by $4,000 and raises your aid by $1,480.