While preparing to write my first blog, I was reminded of my time in college and how I would hope a lecture would be done earlier than the time allotted and not go over time. With that in mind, I want to keep the blog post concise but still provide you with all the necessary information on the subject. That said, let’s get to it.
What is a 529 Plan?
A 529 plan is an education savings account that provides you with the ability to contribute after-tax dollars with a tax-advantage (individual states allow a tax deduction for 529 contributions). These funds can be invested in the stock market and grow tax-free. All eligible, qualified higher education expenses are paid for tax-free. The funds can also cover tuition expenses for k-12 for up to $10,000 every year.
Some of our clients have opened and funded 529 accounts for their grandchildren, nieces or nephews. It’s a wonderful gift to help support a family member through college. That said, several items need to be considered when funding a 529 – today, we will focus on one of these considerations: the impact on financial aid when a grandparent or relative is the account owner.
The Impact of a 529 Plan on Financial Aid
It is essential to know the impact an account owner has on financial aid when a relative other than the parent of the beneficiary is the account owner.
When a parent or student owns a 529 plan these assets need to be included as a parental asset on the Free Application for Federal Student Aid (FAFSA) application. This, in turn, reduces eligibility for need-based aid by as much as 5.64% of the asset value, but any distributions from the 529 plan can be ignored and do not count as income.
Alternatively, when a grandparent or relative other than the parent owns a 529 plan, the plan is not included as an asset on the FAFSA application. This might sound great, but there’s a catch (there’s usually a catch when things sound too good to be true). Any distribution that comes out of the 529 (though tax-free) is considered untaxed income and will reduce need-based aid by 50% of the distribution amount.
To restate the above, if a parent or student owns the 529 plan, the account will be counted as an asset on FAFSA and will impact need-based financial aid by 5.64% versus 50% of the distribution if a grandparent/relative owns the account.
For example, suppose a parent or student-owned 529 plan has a balance of $10,000 which is included as an asset on the FAFSA application. In this case, it reduces aid eligibility by $564. If the grandparent or relative owns a 529 plan and makes a distribution of $10,000 to help pay for eligible college expenses, this reduces the student’s aid eligibility by as much as $5,000.
Therefore, whoever owns the 529 plan can have a significant impact on eligibility for need based financial aid.
Reducing the Impact on Financial Aid
The silver lining is that there are workarounds to lessen the impact of grandparent/relative-owned 529 plans on need-based financial aid.
- Be creative with funding strategies. If the 529 plan is needed at the start of college, consider changing account ownership from the grandparent(s) to the parent(s). Even though the balance in the 529 plan would need to be reported on the FAFSA, since the parent is the account owner, the impact is minimal as we saw in the example. If you don’t want to change ownership of the entire account simply rollover one year’s worth of tuition expenses to the parent-owned 529 plan. If these assets are rolled over after FAFSA is completed, the FAFSA will not include the 529 plan asset. Any distribution from the parent-owned 529 would not affect financial aid eligibility. It is important to note that the parent-owned 529 plan should be in the same state as the grandparent-owned 529 plan to bypass recapture rules.
- Defer distribution. The FAFSA application has to be filed every year for the year ahead. Since FAFSA looks at income from two-years prior, the grandparent/relative can make a distribution in January of the student’s sophomore year to avoid impacting financial aid if the student plans to graduate in 4 years. By doing this, the last time the student will be filing a FAFSA application will be their Junior year, which is for financial aid for their senior year, and the two-year look back will only be looking at their income from their freshman year. Therefore, the 529 plan distribution the grandparent made in the student’s sophomore year would not impact the financial aid for the student enrolled in a 4-year undergraduate program. If the student will graduate in 5 years, then the distribution should be taken in January of their Junior year.
- Use funds to pay down student loan debt. Instead of taking a distribution that would reduce a student’s financial aid package by up to 50% of the value of the distribution, the 529 plan could be used to pay off student loan debt if the student needed a loan to pay for college. Up to $10,000 of unused 529 plan funds can be used free from taxes and penalties to pay off student debt.
The workarounds can get complicated and rules continue to evolve, so consider talking to your financial advisor or tax advisor before moving forward. Another great resource is savingforcollege.com, which covers information including strategies shared in this blog post. Additionally, the information covered here is only referencing federal financial aid. Each college might have its own rules regarding 529 plans and those would need to be reviewed on a case-by-case basis.