College is likely to be one of your most expensive investments, and you’re likely to need financial assistance. The FAFSA, Free Application for Federal Student Aid, is the first step to determine your eligibility for scholarships, grants, loans and work-study programs. The FAFSA bases your eligibility on your EFC (estimated family contribution), which changes annually with your financial situation. Some of these changes are within your control, but not every financial decision will affect your EFC. For example, you can decide how much to contribute to your 401(k), but that won’t lower your EFC.
401(k) accounts are retirement plans that allow you to reduce your taxable income by contributing part of your wages to the plan. These elective contributions cut an employee’s taxable income for federal income tax purposes. Though taxable income is a key component in determining your EFC on your FAFSA, taxable income for tax purposes isn’t the same as for FAFSA purposes.
The assets held in a qualified retirement plan, such as a 401(k), play no role in the EFC in a FAFSA. These assets are designated for your retirement, so they aren’t readily available for you or your family even if you need them to pay college expenses. Aside from behind held for retirement, the FAFSA formula recognizes that if you take an early distribution (before you’re age 59 ½) from your 401(k) account, you’ll face a 10 percent tax penalty. If, however, you’re getting retirement money, that will be considered income for FAFSA EFC purposes.
Involuntary 401(k) Contributions
Technically, there are no involuntary contributions forced on employees to their 401(k) plans. Employers may automatically enroll eligible employees and withdraw a certain salary percentage to contribute to the plan. Employees can always opt out of the plan. These contributions are treated the same as voluntary 401(k) contributions for FAFSA purposes.
Voluntary 401(k) Contributions
Basically, all of your contributions to your 401(k) plan will be voluntary. Unfortunately, they won’t lower your EFC. Instead, those voluntary contributions are treated as untaxed income for FAFSA purposes. Untaxed income will increase your FAFSA income, which in turn increases your EFC. The result for you is a smaller amount of financial aid.
- New York Times: The Choice, Part 4: Answers on the FAFSA, Free Application for Federal Student Aid
- FinAid: Student Aid Report (SAR) and Expected Family Contribution
- FinAid: Maximizing Your Aid Eligibility
- Adventures in Education: Understand the Role of the FAFSA
- IRS: Topic 424 – 401(k) Plans
- DOL: Automatic Enrollment 401(k) Plans for Small Businesses
Kay Lee began freelance writing for Answerbag and eHow in 2010. She is an attorney in Washington, DC, practicing since 2006. Lee specializes in employee benefits and executive compensation. She holds a Juris Doctor from the Columbus School of Law and a Master of Laws from Georgetown University Law Center.