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Eligibility for federal student financial aid is primarily based on income as reported for tax purposes. However, tax-exempt interest income can impact a student’s financial aid eligibility. Interest earned from municipal bonds is an example of this type of income. Although this income is not subject to federal income tax, it is included as part of the parents’ or student’s adjusted gross income (AGI) when completing the Free Application for Federal Student Aid (FAFSA). This means that higher tax-exempt interest earnings may reduce the amount of need-based aid a student qualifies for.
A financial advisor can help you use income and investment strategies to manage the impact of tax-exempt interest on FAFSA.
The Free Application for Federal Student Aid (FAFSA) determines a student’s eligibility for federal financial aid by assessing the applicant’s financial situation. The process starts with calculating the Student Aid Index (SAI) – formerly known as the Expected Family Contribution (EFC) – which estimates how much a family can contribute toward college costs.
FAFSA collects income and asset information from both the student and, if applicable, their parents. Key financial inputs include AGI, tax-exempt interest income, untaxed income and reportable assets. This data is used to generate the SAI, which schools then use to determine financial aid packages. A lower SAI generally means a student can receive more Pell Grants, Federal Work-Study, subsidized student loans and other need-based aid.
FAFSA doesn’t look only at income. The formula also considers household size, number of family members in college and cost of attendance (COA) at each school. It does not factor in liabilities like credit card debt or mortgage payments. Even though some forms of income, such as tax-exempt interest, do not increase taxable income, they still impact aid eligibility.
Tax-exempt interest income primarily comes from certain types of bonds and investment funds. The most common sources include:
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Municipal bonds: Issued by state and local governments to fund public projects, these bonds generate interest that is typically exempt from federal taxes and, in some cases, state and local taxes if the investor resides in the issuing state.
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U.S. Treasury securities: Some Treasury-issued savings bonds, such as Series EE and Series I bonds, may offer tax benefits when used for qualified education expenses. Although exempt from federal taxes under certain conditions, they are still included in FAFSA calculations.
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Tax-exempt bond funds: Mutual funds or exchange-traded funds (ETFs) that invest in municipal bonds can also provide tax-exempt interest income. While these funds offer diversification, their interest earnings remain reportable on FAFSA.
