Self-employed parents have unique considerations when sending their children to college. If you own your own business, there are several ways to optimize your financial situation as you prepare for your child to go to college. Keep these tips in mind.
Request a financial aid appeal to smooth out income
Self-employed people often earn significantly different incomes from year to year. If you submit the Free Application for Federal Student Aid (FAFSA) during a year when you earned a lot of money, your child may not qualify for enough financial aid. Most schools, however, are willing to take a second look at the situation of self-employed parents.
Depending on the school, this may be called a professional judgment review, a special circumstances appeal, or a financial aid appeal. Generally, if you request a review, the school will average your last three to five years of income when creating a financial aid package.
Leverage low-earning years to increase financial aid
On the flip side, if you apply for financial aid during a year when your self-employment income is lower than normal, your child may qualify for more aid. In these cases, you don't want to request a review. If possible, you may even want to actively pursue strategies that reduce your income on paper during the years your child is in college.
Understand FAFSA loopholes
There are a few loopholes that come into play when self-employed people fill out the FAFSA. You may be able to use depreciation to reduce your self-employment income on paper. That must happen when you file your tax return, not when you fill out the FAFSA1.
When listing your assets on this form, realize that the government does not count the value of small businesses. If your business has fewer than 100 employees, you generally can exclude its value.
You can also use retirement account contributions to reduce taxable income on your tax return. But unfortunately, if you make large retirement contributions the year you fill out a FAFSA, the review committee will add those amounts back in. Say you earn $100,000 and contribute $50,000 to a retirement account, your income will be considered $100,000 for the purposes of FAFSA.
Compare student loan interest rates with the return on your investments
Most families have two major long-term financial goals — funding college for children and paying for retirement for parents. To balance both goals, compare the cost of loans with the returns on your investments.
For example, if retirement accounts offer a theoretical 6% return annually, but student loans charge 7% interest, it's more cost-effective to pay for college in cash than save for retirement. However, if the interest rate on the loans is 3% and investments are returning 20%, you're better off investing.
Employ your children
If you hire your children, you can pay them up to the standard deduction without creating a tax bill for them. As of 2022, that is $12,950. At the same time, you also can deduct their pay from self-employment income.1
With this strategy, you reduce your income on paper, increasing the chance your child can qualify for student aid. But you also transfer money to your child. If you do this for years before they start college, they can invest their income to save for their future college expenses.
Reimburse your child-employee for tuition expenses
You can reimburse employees up to $5,250 per year for educational expenses. You can claim this as a deduction, which reduces your income on paper, helping your child qualify for more aid packages. But your child doesn't have to report the funds as income.
Invest in college savings plans
You should also find ways to save for your child's college tuition. With 529 and Coverdell plans, you contribute pre-tax dollars, but the earnings and withdrawals are tax-free.
To learn more about saving for college when you're self-employed, consider consulting with a financial professional experienced with college planning. They can answer questions and plot the best path forward.
The opinions voiced in this material are for general information only and are not intended to provide specific advice or recommendations for any individual.
Investing involves risks including possible loss of principal.
Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.
This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
All information is believed to be from reliable sources; however LPL Financial makes no representation as to its completeness or accuracy.
This article was prepared by WriterAccess.
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1. Paying for College: Own a Business, Forbes, https://www.forbes.com/sites/baldwin/2013/02/28/how-business-owners-save-on-college-costs/?sh=11d0c0d32b5c