Why putting more into a 401(k) can now increase your college financial aid

The Free Application for Federal Student Aid (FAFSA) determines your eligibility for need-based financial aid for college. In previous years, the FAFSA asked families about the amount they contributed each year to employer-sponsored retirement accounts, like 401(k)s, and factored it into overall annual income households, thereby reducing their eligibility for assistance based on their needs.

That’s changing: Under a new rule for the FAFSA form, pre-tax contributions to workplace retirement plans will no longer count as income, meaning the possibility of more financial aid. Here’s how families can use this change to prioritize both their retirement savings and college budgeting.

How the new FAFSA rule will impact your retirement planning

In previous years, the FAFSA required families to report their retirement contributions, which would be counted toward their total income. This meant those dollars would reduce their chances of getting need-based aid. That’s all about to change with a redesigned FAFSA, in which questions about tax-free payments to tax-deferred retirement and retirement savings plans have been removed. These changes are part of the FAFSA Simplification Act transmitted in 2020.

This change means that with proper planning, a 401(k) can now provide both retirement security And help increase your financial aid eligibility because saving pre-tax through your employer will be a viable way to reduce your total income as reported on the FAFSA. In other words, you may no longer be faced with the stark decision of whether to invest in your child’s college education or your retirement plan. Although some colleges and universities use alternatives to the FAFSA, this change will open up more options for many families hoping to strategically leverage their retirement savings.

One way to simplify the FAFSA process is to extract more information directly from tax documents. However, the FAFSA collects this tax information from two years prior to application, so contributing more to retirement accounts this year will not impact financial aid awarded for the 2024-25 school year, but it will for the 2025-26 school year.

The redesigned FAFSA is launch planned for December 2023 for the 2024-25 academic year. Here’s how you can start getting ready now apply for federal student aid in December.