How Obama's new FAFSA rules will change college savings

http://www.savingforcollege.com/articles/how-obama-s-new-fafsa-rules-will-change-college-savings-844

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Back in January, President Obama proposed the idea of ending the federal tax benefits offered by 529 college savings plans, but soon retracted the plan after receiving harsh backlash from American families and the media. Since then, the President continues to support 529s. In fact, at a recent town-hall style meeting in Des Moines, Iowa, he directed a 529 plan question to Education Secretary Arnie Duncan. Duncan, standing right beside Obama, uses 529 plans for his own children and suggested the federal government provide more support to families saving for college.

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The President has also recently made changes to the FAFSA which could make saving for college easier for some families. The U.S. Department of Education recently announced that beginning with the 2017-18 school year, students will be able to submit their FASFA forms in October 2016, rather than having to wait until January 2017. What’s more, the student’s financial aid eligibility for 2017-18 will be based on 2015 tax returns. This new method of using prior-prior year income will impact some of the more popular ways families save for college, since income increases a student’s Expected Family Contribution (EFC) and can reduce financial aid eligibility.

Here are four common examples of how assets used to save for college can affect financial aid. With the new method, a family can wait to use these funds until January of the student's sophomore year (after he's filed his last FAFSA) so that the income will not affect his financial aid eligibility.

Related: How 7 different assets affect financial aid eligibility

1. Distributions from a Roth IRA

There are some benefits to using a Roth IRA to save for college. Assets in a Roth are not counted on the FAFSA when determining a family’s (EFC), and the principal portion of the account can be withdrawn at any time, for any reason.

But parents who save with a Roth IRA need to be aware that when they withdraw from their Roth IRA to pay for college it will be counted as student income on their child’s FAFSA. So if both parents each saved the maximum $5,000 per year per person in a Roth IRA from the time their baby was born and withdrew the $180,000 in contributions during the child’s senior year of high school in 2015, the student’s aid package for their sophomore year (2017-18) will be reduced by up to $90,000.

2. Proceeds from a mutual fund

On top of having to pay income and capital gains taxes, families who use mutual funds to pay for college will have to report both their assets and any unearned income on their child’s FAFSA. The value of a mutual fund will be counted as a parent asset, which means up to 5.64% will be considered available funds to pay for college.

Let’s say a parent sells their mutual fund with a value of $80,000 and an unrealized gain of $5,000. The parents’ capital gains tax rate is 15%, so after taxes they are left with $4,250 of unearned income. That means the student’s EFC will increase by as much as half that amount - $2,125. If the student owns the mutual fund (and no other investments), the amount of the gain will be covered by the income protection allowance ($6,310 for the 2015-16 school year) and will not have to be reported.

RELATED: 7 reasons why mutual funds don’t work so well for college

3. Earnings from a student’s job

Many families require their teens to work part-time or during the summer months to help pay for college. But what they might not realize is that any income the student earns above the income protection allowance will count as student income on the FASFA. The current allowance is $6,310, which means up to 50% of earnings above this amount may be counted as available funds to pay for college. One exception is work-study programs, which are excluded from this formula.

4. Withdrawals from a 529 plan owned by a grandparent or other relative

Unlike parent or student owned 529 plans, the value of a distribution from any other person’s 529 plan used to help pay for college is counted as student income on the FAFSA. This sometimes comes as a surprise to grandparents who want to help pay for their grandchildren’s college education. To get around this trap, grandparents are often advised to wait to help pay for college until the child files his last FAFSA, but with the new method they’re able to help pay for an additional year.

With this strategy, help from grandparents will have zero effect on financial aid eligibility, since there is no income to report, and assets owned by anyone other than the student or their parents do not have to be reported.

RELATED: Avoiding the financial aid trap with grandparent-owned 529 plans