With the start of tax season, families with college students are working on a key document used in granting financial aid to their young scholars: the tax return. Things have changed recently and aid experts have a number of tips for getting the biggest aid package possible, and using college savings wisely.
The heart of the aid process is the Free Application for Federal Student Aid (FAFSA), which relies heavily on figures from the family's federal tax return and is due by June 1. In the past, this has produced a lot of hassles this time of year as parents raced to complete the return in time, but that shouldn't be so any longer.
"Families may not be aware that the base year is no longer the prior year's tax return but the year prior to that year -- so for [fall of] 2017, using 2015 rather than 2016 as the base year for reporting income," says James W.C. Canup, chairman of the tax practice at Hirschler Fleischer law firm in Richmond, Virginia.
Another big change, he says: "The FAFSA can now be filed out [as early as] October rather than waiting until January, which means you may have a better sense of what your financial aid package will look like at each school prior to making a decision as to which school to attend."
"There seems to be no more do-si-do about estimating your 2016 return, submitting FAFSA, and then returning to amend FAFSA once you have 2016 return done," says Robert Reed, a partner at Partnership Financial in Columbus, Ohio.
Plan ahead -- way ahead. The 2016 return due in April will be used for aid applications for the 2018-2019 academic year, says Joseph DePaulo, CEO and co-founder of College Ave Student Loans, a nationwide lender.
"In other words, if you have a junior in high school who's planning to start college in fall 2018, you're filing the tax return that will impact your estimated family contribution for their first year in college now," he says.
While it's too late to change the 2015 return for aid next fall, it does make sense to think about how the 2016 return and those that follow can affect aid eligibility, Canup says, noting that the basic concepts should be familiar to anyone who's looked for ways to minimize taxes: "postpone receipt of income to future years, accelerate deductions in the current year, maximize contributions to retirement vehicles such as 401(k)s, IRAs and the like."
The idea is to show the smallest income and assets possible.
For FAFSA purposes, contributions to 401(k)s and similar plans do not reduce annual income, but do shift assets into an account that isn't included in the tally of parents' assets, says Mark Kantrowitz, publisher and vice president of strategy at Chicago-based Cappex, a college advisory service.
Who owns what. Families should also keep in mind that the FAFSA formula assumes that 20 percent of the student's assets can be used for college each year, compared to 5.6 percent or less of the parents' assets Canup says. That means it's best to keep college savings in the parents' names.
Also, funds kept in a custodial account for the child come under the child's control when he or she becomes an adult (generally at 18), so keeping this money under the parents' control avoids the risk of something foolish happening to those savings.
"Custodial accounts ... are terrible for financial aid," says Patrick Stark, director of Financial Planning for RS Crum, a wealth management firm in Newport Beach, California. "It's considered an asset owned by the student and as such is assessed unfavorably in financial aid formulas. It's much better for assets to be owned by the parent. A parent-owned 529 account is ideal."
529 Plans. State-sponsored Section 529 plans are especially valuable for college savings, since gains withdrawn for tuition and other approved purposes are tax-free, Canup says.
Also, these accounts are generally considered parental assets and thus do minimal damage to the aid application. (529s in the grandparents' names are neither the child's nor the parents' assets for the first aid application, but 50 percent of withdrawals for college bills can be counted as student assets, so Canup urges grandparents to transfer these accounts to the parents before withdrawals begin, or postpone withdrawals until the last two years of college -- too late to appear on a FAFSA application.)
Examine holdings. Canup says families that have used target-date funds for college savings should look closely at their statements just before and during the college years to be sure they are comfortable with the mix of stocks, bonds and cash.
These funds typically are heavy on stocks to emphasize growth while the beneficiary is young, and gradually shift toward bonds and cash for safety as the child ages. However, providers use different "glide paths" and the final mix may be too risky or too conservative for some families.
If the fund is in a 529 plan, it's possible to make a tax-free transfer to another investment.
Use accounts in order. Of course, it's generally wise to use 529 assets for college because they can be taxed and penalized if used for non-approved purposes, a problem if money is left over. So it usually makes sense to use these funds before tapping taxable accounts that can be used after college with no penalty or additional tax, regardless of how the money is spent.
"If a family has 529s and taxable college savings, they should use funds from the 529 plan first," says Ann Summerson, a planner with Wise Investor Group in Reston, Virginia.
"Since 529 plans can only be used for qualifying expenses, you do not want to have money left over after the student has graduated," she says. "For many families, it makes sense to use funds from a parent's or student's 529 plan first, then money from other relatives' 529 plans and then use any taxable college savings."
Jeff Brown spent nearly 40 years as a newspaper reporter, columnist and editor, including 20 years writing about investing, personal finance, the economy and financial markets. He spent 20 years at The Philadelphia Inquirer and has been freelancing since 2007.