Hiking 401k Contributions Can Now Boost College Aid, Thanks To FAFSA Change

Thanks to new federal rules, boosting your pre-tax contributions to 401(k) and similar retirement plans may now increase your child's access to federal financial aid. Another change makes grandparent-owned 529 plans more beneficial. 

Pre-tax contributions are ones that aren't exposed to current-year federal income taxation, but instead are taxed when withdrawn. They differ from Roth contributions, which are taxed in the current year but can be withdrawn tax-free in your retirement. 

Until now, the Free Application for Federal Student Aid (FAFSA) asked parents to input their pre-tax retirement-plan contributions. The calculations then added that money back to arrive at the parents' total income, which in turn increased the amount those parents were assumed to have available to pay for college, and thus reduced the child's eligibility for aid.  

The revised FAFSA form, which is geared toward simpler calculations driven by data on income tax returns, won't ask you about those retirement contributions, which means the more pre-tax money you add to your 401(k) or similar account, the higher your child's chance of qualifying for federal handouts. 

For 2023, the 401(k) maximum is annual contribution $22,500, or $30,000 if you're 50 or older at the end of the calendar year. Note the FAFSA uses data from two years before the academic year you're seeking aid for. Thus, 401(k) contributions you make in 2023 will effect the FAFSA math for the 2025-26 school year. 

Debuting in December the new form will no longer use the term Expected Family Contribution, which caused confusion about its meaning. Instead, the key number will be a formula-driven Student Aid Index. 

Because there are other numbers at play in the aid calculation, jacking up your contributions doesn't guarantee you'll get a FAFSA benefit. "This change will have the biggest impact on middle-income households that make around $100,000 a year," reports the Wall Street Journal's Oyin Adedoyin, citing financial advisors. 

In another wrinkle, 529 plans owned by someone other than a student or the student's parent won't be included in the asset calculations, even if the student is the beneficiary. That puts generous grandparents and other relatives in a better position to help out.

You can even add your own money to that 529 -- but you better have high confidence in the account owner's intentions. You should also ponder a scenario where that third-party 529 owner predeceases your college student. If no successor owner is named, the account might go through probate and end up in the hands of someone who'd prefer using the money to buy a new car.  

Not all the FAFSA changes will make receiving aid easier:

• The "sibling discount" -- which previously cut applicants a break in situations where two kids are in college simultaneously -- is vanishing. 
• Parents will have to start reporting the value of small businesses they own.