Whether or not you think you'll qualify for any type of financial aid, unless you have enough saved to fully fund the entire cost without the need for loans, it's a good idea to know how financial aid packages are determined. Here's what you need to know.

First, file no matter what

Even if you don’t think you’ll qualify, it’s worth it to file. Families with significant savings can be offered aid, depending on circumstances. Plus, it's the only way to qualify for any type of federal student loans.

Because the rules changed to have the upcoming school year’s aid based on the tax situation almost two years prior (so fall 2020 aid is based on your 2018 tax return), any income planning you may be contemplating for middle school and early high school-aged kids, like maxing out retirement accounts in the years leading up (knowing that retirement account contributions made during the base year are added back for expected family contribution calculation purposes), needs to take place during your child’s freshman spring/sophomore fall year or earlier.

FAFSA base year

This change not only makes tax time less frantic, but in cases where grandparents or other non-parental family members wish to help out with costs, it’s especially favorable due to the fact that such gifts are considered income to the student, which has the most detrimental effect on aid calculations.

A student’s aid package can be reduced by up to 50% of the student’s income during the base year, so since there’s now an almost 2-year lag between income and aid, anything after your child’s sophomore year of college won’t affect the FAFSA (assuming your child is on the 4-year graduation plan). Besides income, the FAFSA asks about a variety of different savings and asset values.

Here’s how each affects the aid package that is offered to your student:

529 College Savings Plans and Coverdell ESAs

The value of 529 plans and ESAs are counted as parental assets if the parent is the owner. This is a good thing because only a single-digit percentage of a parent’s assets are considered available to spend on one student’s college. Investments or other savings in your child’s name count much higher at 20%! 529 accounts owned by grandparents or other non-immediate family members are not included as assets, but are treated as income to the student when distributions from these accounts are used to pay expenses.

That means you may want to wait until the second half of their sophomore year or later to use the non-parent owned 529 assets to pay expenses, if possible.

Retirement accounts

You do not have to list the value of any retirement accounts like your 401(k) and traditional or Roth IRAs, including those in the name of the student. However, if you take advantage of the Roth IRA’s penalty-free distribution feature to help pay for college, that amount will count as income on the FAFSA two years after. Consider waiting until the spring semester of sophomore year or later to exercise this option if needed, similar to using a 529 owned by a grandparent or other non-parent.

Savings in your child’s name

Custodial accounts, UGMA/UTMA accounts, and other accounts that are basically owned by your child etc. are pretty much assumed to be primarily for college so 20% of the value is expected to be contributed toward educational expenses each year. So for example, if you've been investing in a custodial brokerage account for your child that's worth $20,000, the FAFSA will assume that $4,000 will be spent each year toward college expenses.

If these assets are for college purposes anyway, consider transferring them into a 529 savings plan, where they will count as parental assets and have a less detrimental effect on aid offered (and you might receive a state income tax benefit as well). Of course, if you have large capital gains, you'll want to consider that as well – you'll have to liquidate any investments to fund the 529, so make sure you're aware of the kiddie tax rules in this situation.

Keep in mind that any interest, dividends or capital gains earned from accounts in your child’s name is considered your child’s income, of which 50% is expected to be contributed toward educational expenses. So in the above example, if the $20,000 brokerage account has an income of $1,500, $750 will be counted in addition to $4,000 of the principal.

Taxable investment accounts

Mutual funds and other brokerage assets held by parents are counted on the FAFSA. Dividends and capital gains earned in taxable brokerage accounts count as income. Distributions from a mutual fund or brokerage account to pay for college count as income.

Life insurance and annuities

Any cash value built up in insurance policies does not have to be included on the FAFSA. Before you move any of your child’s money into an annuity though, consider that if you have to use the funds to pay for college, the distribution will show up as income in future years. This is more detrimental than just holding the funds in savings or transferring to a 529 plan.

Other assets

Home equity

Home equity or the difference between what your home is worth and what you owe is NOT counted on the FAFSA. Keep in mind, however, that certain schools may still ask for this information when figuring eligibility for need-based aid from the school.

Small business

If more than 50% of a business is owned by your family and there are 100 or fewer full-time employees, you do not have to include the value of your small business.

Planning starts in middle school

The bottom line is that if you have middle school-aged kids, knowing which year is the first base year for the FAFSA may alter your family’s plans to do things like take capital gains or convert pre-tax retirement assets to Roth. Both are income-producing activities that can reduce the amount of aid offered to your child.

If you have a significant amount of cash savings that you don't wish to spend on college, one strategy would be to use that money to pay down your mortgage in the years before the Base Year. You may also wish to aggressively fund retirement accounts earlier so that you can pull back on that funding and redirect that money to paying for college, as the FAFSA calculates.

Additionally, if you have funds in your child’s name that you intend to use for college anyway, it may make sense to shift those into 529 plans simply to reduce their effect on aid offered.