Q: “Is there any way I can ‘beat’ the FAFSA? Is there a smart way to organize my money so we can take advantage of the most federal aid that we can?” – Paula, Philadelphia
A: There are several approaches to maximizing your eligibility for federal student aid. But before you start manipulating your finances, play a few what-if games with an expected family contribution (EFC) calculator such as the one on FinAid.org to evaluate the trade-offs of each strategy. The EFC determines a student's aid eligibility so if a scenario has only a minimal impact on the EFC, it's not worth pursuing.
The federal need analysis formula is heavily weighted toward income, so manipulating your assets often has little or no effect on it. For example, unsecured debt is ignored by the federal need analysis formula, so paying off debt can reduce the assets reported on the Free Application for Federal Student Aid (FAFSA), but less than 4% of dependent students get any contribution from parent assets, so reducing those assets by paying off debt might not improve aid eligibility by much.
Every $10,000 increase in income reduces financial aid by about $2,000-$3,000, while every $10,000 increase in assets reduces financial aid by about $250. (Still, it is worthwhile to pay down debt from a financial planning perspective, since paying off a high interest credit card balance with money from a low interest savings account will save money by reducing your net interest expenses.)
The federal need analysis formula has important thresholds at $50,000 and $31,000 of income. When total income is less than $50,000 and the parents were eligible to file an IRS Form 1040A or 1040EZ (or satisfy certain other criteria), assets are disregarded entirely. This is known as the simplified needs test. If income is under $31,000 and the same criteria apply, the EFC is automatically zero. If you can control your income and live off of savings, you might be able to increase your eligibility for federal grants by artificially reducing your income.
For example, if you own a small business that is incorporated as a non-pass-through entity, such as a C corporation, you can reduce your income to increase student aid eligibility. The income is retained by the corporation, increasing the net worth of the corporation, but this doesn’t matter for need analysis purposes, since the simplified needs test and/or the small business exclusion cause the corporation’s value to be ignored on the FAFSA. This approach does increase your tax bill, however, perhaps by enough to wipe out the financial benefit from an increase in aid eligibility.