Tax-advantaged 529 college-savings plans have been a huge help for many students and their families as the costs of higher education have soared. But if you’re applying for financial aid (and who isn‘t?) you need to know how these accounts will affect your bottom line.
The basic problem: Not all 529 accounts are treated equally, so two different students with the same basic profile could get different aid offers, based on who actually owns their 529 plan.
That can come as a shock to middle-class families under the impression that 529 accounts, especially those of grandparents or non-custodial divorced parents, would not count against their aid offers.
Assets in a 529 plan owned by the student or her parents count again need-based aid, while those in a plan owned by anyone else (including grandma) don‘t. But once grandparents or other relatives start taking money out of a plan to help pay those bills, the reverse is true. The withdrawals can ding you pretty hard in the following year’s financial aid package.
Grandparents, who may have started 529 plans for their grandkids thinking it will help out when the time came to pay tuition, are particularly dismayed.
“They say, ‘You’ve got to be kidding me. I did all these nice things, and it penalized my grandchild,’” says Douglas Rothermich, vice president of wealth planning strategies at TIAA-CREF, who counts a number of such grandparents among his clients. “It is an awakening.”
DOING THE MATH
The issue is that the federal financial aid formula treats assets and income differently, and also treats the student’s money different from that of other relatives.
The differences show up starkly on the Free Application for Federal Student Aid (FAFSA), which all students seeking aid must fill out. The 529 plans owned by college students or their parents count as assets and reduce need-based aid by a maximum of 5.64 percent of the asset’s value. That means if you have $20,000 in a college-savings plan for your daughter, her aid would be reduced by roughly $1,100. For financially independent students who hold their own 529 plans, the assessment is a far larger 20 percent, but that’s not typical.
However, if the 529 plans are held by grandma and grandpa, they won’t appear on the FAFSA as assets. Instead, as the money is withdrawn to pay for tuition or other educational expenses, that amount must be reported on the next year’s financial aid forms as untaxed income to the student, and it can reduce the amount of aid by 50 percent.
So if that same $20,000 college-savings plan was owned by the grandparents, and the student withdrew $5,000 from it one year, that withdrawal could increase the amount the family is expected to pay for college (and reduce the aid) for next year by about $2,500.
For divorced parents, it’s more complicated. Only the custodial parent’s income and assets are reported on the FAFSA for a dependent student. However, withdrawals from a 529 plan held by the non-custodial parent will be assessed as income against financial aid, just like those held by grandparents.
And that’s just the federal rules. Hundreds of private universities make their financial aid awards based on the College Board’s CSS Profile form, which asks for more detailed financial information than does the FAFSA and treats all 529 plans as assets.
Schools may set their own rules on how to award need-based aid, so the reduction in aid for 529 plans varies, but could be as much as 25 percent of the value of the asset.
“There are lots of questions from families and financial planners,” says Joe Hurley, founder of SavingforCollege.com. “It’s a concern to a lot of families, and the rules are (quirky) enough that it’s hard to get a good grasp on them.”
To avoid complications down the road, one route is to set up all the college-savings plans in one name to be owned by the student or the parents. That way, they’d all be covered by the same, generally, less onerous, rules. If grandparents or other relatives have 529 plans, they could transfer that ownership before college if such transfers are allowed by your state. Of course, the assets still would count as student assets, but not as income, so they would have a smaller impact on the aid calculation.
Unfortunately, about a half-dozen states, including New York, restrict such ownership transfers of 529 plans.
Also, you can wait to spend down the grandparents’ 529 plans until the last year of college. Since the financial aid forms are based on the previous year’s income and assets, this type of backloading would avoid any impact from the withdrawals.
“The theory becomes, let’s use that account to fund the last year’s expenses when there won’t be a next year,” Rothermich says.
An added benefit: If both the parents and the grandparents own 529 plans for the benefit of the same student, by spending down the parents’ plans first you might be able to reduce the assets you report on subsequent years’ FAFSAs.
Depending on a family’s situation with financial aid, it could make sense to delay the spend-down of the 529 plans – perhaps using withdrawals to pay down student loans later – though it could, ironically, mean forgoing the tax benefits of the distribution.
“That’s a difficult decision,” Hurley says. “Most people would never think of that, but depending on the financial aid package, the financial aid penalty may be worse than the tax penalty.”