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Income Earned from Work

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The instructions on the FAFSA concerning income earned from work (also referred to as earned income) are incomplete and incorrect. This page discusses the purpose of the income earned from work question, the problems with the current FAFSA instructions, and suggestions for a more accurate set of instructions.

Purpose of the Question

The income earned from work questions on the FAFSA is used in the federal need analysis methodology in three ways:

  • It triggers the calculation of an allowance for FICA taxes (Social Security Taxes and Medicare Taxes).
  • It triggers the calculation of the Employment Expense Allowance when both parents work (or when the applicant and the applicant's spouse both work).
  • It is used as a proxy for AGI when AGI is zero, such as occurs when the individual is not required to file an income tax return (e.g., when income is below the filing thresholds).

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Problems with the Current Instructions

Clearly, if an incorrect figure is reported for income earned from work, it will lead to an incorrect calculation of the allowances. If the income earned from work is too low, this will yield lower allowances and a higher EFC. (Total income is usually based on the adjusted gross income, not earned income. The tax allowances, which are based on earned income, are subtracted from total income to yield available income. When the income earned from work figure on the FAFSA is lower than the actual income upon which the taxes are based, it yields lower tax allowances and hence a higher available income, which ultimately leads to a higher EFC.)

The 2009-2010 FAFSA tells applicants to use the sum of lines 7 (wages, tips and other compensation), 12 (sole proprietorship business income and losses) and 18 (farm income) from IRS Form 1040 when completing the questions concerning income earned from work. Ever since the 2007-2008 FAFSA the instructions have also said to include Box 14 of Schedule K-1 (Form 1065), which is a marginal improvement but still doesn't fully address the problem. The 2010-11 FAFSA adds the sentence "if any individual earning item is negative, do not include that item in your calculation" which still doesn't fully address the problem.

There are several problems with these instructions that will almost always yield an incorrect value (usually a value that is too low):

  • Omits Partnership Income. Partnership income is usually reported on line 17 of IRS Form 1040. As a result the partnership income will not be counted as part of income earned from work even though the taxpayer paid FICA taxes on that income.

  • Includes Taxable Scholarships and Fellowships. Taxable scholarships and fellowships are reported on line 7 of IRS Form 1040. Taxable scholarships and fellowships are not subject to FICA taxes unless the payment was a fee for services. Accordingly, in most cases this will result in the scholarships and fellowships being incorrectly included in income earned from work.

  • Negative Income. Negative income included on lines 12 and 18 will offset income earned from work, even though negative income does not offset the FICA tax liability.

    The 2006-2007 Application and Verification Guide tells financial aid administrators to treat negative values on lines 12 and 18 as zero when verifying an application. (The 2007-2008 Application and Verification Guide includes similar advice on page AVG-12, adding in box 14 of Schedule K-1 (Form 1065).) But the FAFSA instructions do not give similar advice to applicants, meaning that applicants who are not selected for verification will be at a disadvantage. Moreover, the verification guide does not contemplate the possibility that negative income from one partnership may offset positive income from a sole proprietorship.

  • Exclusion of Retirement Plan Contributions. Line 7 of IRS Form 1040 is based on Box 1 of IRS Form W-2. The Social Security wage tax, however, is based on Box 3 of the W-2 and Medicare tax on Box 5 of the W-2.

    Box 1 is computed by subtracting certain before-tax deductions from gross pay, such as the employee's share of medical, dental, disability and flexible spending account benefits and 401(k), 403(b) and 457 plan deductions. Certain employer paid expenses are then added back in, such as employer-paid group term life above $50,000 in coverage.

    Box 5 is computed in a similar fashion, except the set of allowable before-tax deductions is different. In particular, 401(k), 403(b) and 457 Plan deductions are not included in the set of before-tax deductions. This usually leads to a higher income figure in Box 5.

    Box 3 is similar to Box 5, except that the income is capped at the Social Security wage limit ($97,500 in 2007). Income above this limit is not subjected to Social Security Taxes, but is subjected to Medicare.

    Assuming that the federal need analysis methodology is smart enough to apply the Social Security wage limit when calculating Social Security taxes, one should use Box 5 of the W-2 instead of Box 1. Thus line 7 of IRS Form 1040 uses an income figure that is often too low. (The FAFSA instructions refer to line 7 of the 1040 instead of box 5 of the W-2 in part because of a reluctance to base the FAFSA on W-2 statements.)

    (A potential complication of using Box 5 from the W-2 arises when AGI is zero. The federal processor assumes that an error was made when AGI is zero but income earned from work is nonzero, and sets AGI equal to income earned from work. If Box 5 from the W-2 was used, this means that retirement plan contributions will be double-counted, once as part of AGI derived from income earned from work and once from Worksheet B. The financial aid administrator at the school will need to use an assumption override to prevent this 'correction' by the federal processor.)

  • Incomplete Instructions. The FAFSA instructions also state that "this information may be on your W-2 forms" but does not specify which box to use from IRS Form W-2. As noted above, Box 5 should be used.

  • Counts Employer Contribution. Schedule SE of IRS Form 1040 reduces net earnings to 92.35%, effectively subtracting the employer's contribution of 7.65%, before calculating FICA taxes. The figures reported on lines 12 and 18 of IRS Form 1040 do not reflect this reduction. Line 27 does reduce AGI by one half of self-employment tax, corresponding to the employer's share of self-employment taxes. But that does not affect the earned income figures used from lines 12 and 18, only the AGI.

Workaround

To correctly calculate income earned from work, add Box 5 of the W-2 statements to line A.4 or B.6 of Schedule SE.

Note that Schedule SE includes partnership income from Schedule K-1 (Form 1065 box 14 code A, self-employment income, or Form 1065-B box 9), so there is no need for a separate treatment of partnership income.

 

 
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