Explain the rules of life insurance and the FAFSA

For families navigating the Free Application for Federal Student Aid (FAFSA), there are some questions that create more confusion about whether life insurance affects financial aid eligibility. As the costs of college rise, understanding how different assets are handled can make a meaningful difference in the amount of need-based aid a student receives.

The short answer: FAFSA He ignores The value of your life insurance policy but may be calculated Money paid From that policy, depending on the timing and how you handle it.

According to Federal Student Aid Guide issued by the U.S. Department of Education“the cash or equity value of a whole life insurance policy” is Not reported as an asset.

This exclusion applies whether the policy is term or permanent life insurance. Therefore, even if you accumulate a significant cash value under a whole life policy, that amount is not included on the FAFSA form.

This is one of several major asset exceptions. The FAFSA also ignores the value of your primary home, small family business, and retirement accounts — meaning some families with high net worth but low liquidity can still qualify for significant aid.

When a life insurance payout is counted as income

However, things change if your loved one receives a card Life insurance payout.

While the value of the policy itself is ignored, A life insurance settlement may be counted as income If it appears on your federal tax return for the “base year” used on your FAFSA. This is usually done two years before the school year in which you apply for aid (for example, your 2024 tax return for the 2026-27 FAFSA).

Here’s how it works:

• The FAFSA pulls your income statements directly from the IRS.
• If the return is taxable — such as interest dividends on a benefit or certain settlement structures — it will appear in your adjusted gross income (AGI) and therefore count as income on the FAFSA.
• If the return is not taxable (as is the case with most death benefits), it is no They appear on your AGI and are not reported as income.

In practice, this means that most families receiving life insurance death benefits will no We see that payment directly reduces their aid. However, if the return generated interest, or if part of it is taxable, that amount can count toward eligibility.

Financial aid officials stress that these events are taken into account One time and rare. If your FAFSA income temporarily increases due to the settlement, you can contact your college’s help desk to request assistance Review professional judgment. This allows the school to amend your FAFSA to exclude unusual income events (such as life insurance payouts) that do not reflect your ongoing financial situation.

Once you deposit money, it becomes an asset

Even if the return is not counted as income, it is He can It affects your FAFSA if it remains in your bank account when you file.

When life insurance proceeds are deposited into checking, savings, or investment accounts, the cash balance becomes a Reportable assets. The FAFSA requires families to disclose the total value of all cash, savings, and investments as of the day the form is filed regardless of the source of the funds.

This means:

• If you receive $100,000 in compensation and the funds are in your savings account when you file your FAFSA application in October, those funds will be treated like any other asset.
• If you receive the same return after filing your FAFSA, it will not be reported until you file the following school year (assuming it is still in a reportable account).

This timing issue can make a difference. The FAFSA rates up to 5.64% From parental assets and up 20% Student assets when calculating the Student Aid Index (SAI). So, if you have the ability to file the FAFSA before the settlement hits your accounts, that can be helpful (at least a year).

Once in your account, families sometimes spend a portion of the proceeds on non-reportable expenses, such as paying off debt, covering funeral costs, or contributing to qualified retirement accounts, before filing the FAFSA. This approach can legally reduce the impact of financial aid without misrepresenting assets.

The CSS Profile rules are different from the FAFSA

Families applying to private colleges using CSS profile (administered by the College Board) You should note that rules vary. Unlike the FAFSA, it may be a CSS profile Includes The cash value of life insurance as an asset. Some organizations consider all forms of financial assets, including pensions and insurance, when analyzing their needs.

If you’re applying to a combination of schools, some of which use only the FAFSA and some of which use the CSS profile, review each college’s financial aid documents carefully or speak directly with the financial aid office.

Strategies to reduce the impact of financial aid

Families cannot (and should not) hide assets, but there are legitimate steps to manage timing and organize requests for help strategically:

1. Find out what you can report. The cash value of the policy is excluded but the funds deposited are not.
2. Use your lump sums wisely. Spend on necessary expenses before filing the FAFSA if appropriate.
3. Seek professional judgment. Colleges can exclude one-time insurance payments when necessary.
4. Avoid “FAFSA shelters.” Products marketed as “financial aid-friendly” insurance often come with high fees and limited flexibility. Don’t fall for life insurance salespeople’s pitches on social media.
5. Coordinate with your financial advisor or tax preparer. Make sure the returns appear correctly (or are excluded) on your tax return.

Bottom line

Life insurance itself rarely hurts financial aid eligibility, but the timing of payments can. The cash value of the policy is not reported, and most death benefits are not taxable. However, if you have received proceeds that are now savings, they will be considered assets and could reduce the value of your aid.

Before filing for the FAFSA after receiving a life insurance payout, it’s a good idea to review how and where that money appears on your taxes. A brief conversation with your financial aid office or a qualified counselor can prevent a costly misunderstanding.

Don’t miss these other stories: