Monthly Archives: January 2014

Including 529 Plan Assets on the FAFSA

Are you still filling out the FAFSA? Is that because you have questions about it? One of the most frequently-asked questions about filling out the FAFSA is, “Do I need to include 529 Plan assets as an asset, and is the answer different if the account beneficiary is a child other than the one on whose behalf I’m filling out the FAFSA?” The answer is Yes and Yes, but there’s a qualifier.

First, 529 plans are parental assets, not student assets. That means that you report the value of all of 529 plan accounts for which you’re the owner, regardless of the beneficiary. What’s the qualifier? The FAFSA gives you an asset protection allowance. If the total balance of your non-retirement assets (checking, savings, 529 plans, brokerage accounts) is less than the asset protection allowance, then although you report them, none of the funds is considered an available asset.  (The asset protection allowance is determined by the age of the older parent and whether one or two parents are filling out the FAFSA. For a two-parent household the asset protection is around $30,000; for a one-parent household it’s about a quarter of the two-parent amount.)

Over-Funding a 529 Plan

What happens if you don’t use all the money in your 529 plan? This may happen for a variety of reasons: your child received a scholarship, chose a less expensive school than what you had budgeted for, or didn’t attend college after all. Maybe you had other family members contributing to the cost of college. Maybe you just put more money in than was needed. Is it lost? Fortunately, no. Unfortunately, though, you may need to pay taxes and/or penalties to withdraw the money. But you may not need to withdraw the money either.

The reason you didn’t spend the money will dictate whether there are penalties for a withdrawal. And the recipient of the withdrawal will determine the taxes.

First, though, should you withdraw funds that aren’t used? If you have another college-bound child, you can simply change the 529 account beneficiary to their name and use it tax- and penalty-free for their college expenses. Or you can hang onto the account in case your student attends graduate school, or make it available to the next generation if not. Assuming your grandchildren use the money for qualified educational expenses, it remains tax- and penalty-free. And after 25 or 30 years, even a small balance should grow substantially.

What if you do want to take the balance out, though? If your student got a scholarship or died or became disabled, then the withdrawal penalty is waived. In other cases, you’ll pay a 10% penalty on the earnings in the account.

Penalty or no, you’ll still pay income taxes on the earnings portion of the withdrawal, and may be subject to recapture of tax benefits you got for contributions. One way to mitigate the tax burden is to have the balance paid out to your college graduate so that it appears on their tax return, not yours. (Presumably a recent college graduate is in a lower income tax bracket than their parents.)

Earnings are the amount by which your account grew. Say, for example, that you contributed a total of $60,000 to a 529 account and it’s now worth $100,000. 60% of your account balance is contributions and 40% is earnings. Distributions are taken pro-rata from contributions and earnings, so any withdrawal will be 60% contributions and 40% earnings. In the above example, if you had $20,000 remaining in the account after your student completed college, $8,000 would be earnings subject to tax and penalty. (I chose these numbers for the easy math, not because they’re representative of anyone’s situation.)

Myth #2: We make too much money to qualify for financial aid

Many parents mistakenly believe that their income level means that they will be required to pay full fare for college for each of their children. The notion of $60,000 in annual costs x 4 years x 3 children keeps them up at night—understandably. As does the thought of limiting their children’s aspirations to in-state schools.

In fact, aid is available to most students. But to get it, you need to understand where aid comes from. There are two big pools of aid: need-based aid and merit-based aid.

Need-based aid is generally income-based and results from fairly strict analysis of your FAFSA and/or CSS PROFILE. It’s important to understand that need-based aid can come in the form of loans, work-study or grants.

Merit aid, on the other hand, is almost exclusively in the form of grants. Merit aid generally comes from a school’s own endowment funds, and it’s used to attract the students that the school most wants to attend. Who gets merit aid?

Contrary to popular belief, scholarships are not limited to students who play football or basketball or who have invented a cure for cancer in their spare time. Merit aid is most commonly used to improve the characteristics of the school’s student body profile. What does that mean? Look at the stats that are most commonly published about schools, especially in ranking guides like US News & World Report’s college rankings: median GPA, median SAT/ACT, number of high school valedictorians attending, percent of students in the top 10% of their high school class, etc. Merit aid comes down to this: Would your student’s attendance there make the student body look better? If so, they are likely to get some form of merit aid.

529 Plan Performance Rankings

Here is a 3-year performance ranking of all direct-sold 529 Savings Plans. (See my previous post for an explanation of the difference between Savings Plans and Prepaid Plans.) This ranking table does not account for tax benefits that some state plans provide on contributions. Because this isn’t comparing specific portfolios (i.e. the age-based option for 10-year-olds) but rather an aggregate of portfolios, you’ll do best to consider it a tool for evaluating the fund families each state’s plan offers rather than evaluating specific investment choices.

529 Plan Basics

There’s no such thing as a dumb question, but asking questions seems to make plenty of people– myself included– feel dumb, which then causes us not to do it. For those who find themselves wishing they had asked more about 529 plans, here is a “back to basics” guide. (As an aside, there is a veritable alphabet soup of college savings options including UGMA/UTMA accounts, Coverdell ESAs, and more. For most people, 529s are the best option so I’m talking about them first. I’ll cover the others later.)

First, a 529 plan is a tax-advantaged college savings plan operated by a state or educational institution. 529 refers to Section 529 of the IRS code which created these plans beginning in 1996.

529 plans offer several types of tax advantages:

  • Funds in the accounts grow tax-free
  • As long as they are withdrawn for qualified expenses– generally tuition, room, board and certain supplies– the withdrawals are also tax-free
  • Many states also offer their residents a tax deduction for investing in the state’s 529 plan. For example, Oregon offers a tax deduction for the first approximately $4,500 (married filing joint) or $2,250 (single filer) in contributions each year.

Beyond the tax benefits, there are some other benefits in financial aid equations. On the one hand, money in a 529 account is treated the same as a taxable brokerage account in the aid formulas– it’s assessed as a parental asset and, if the balance is greater than the asset protection allowance, it’s assessed at a rate of 5.65%. But there’s a big difference when you actually withdraw and spend the money: Besides the 529 plan’s growth not being taxable, withdrawals from 529 plans don’t count as income when you fill out next year’s aid forms. What does that mean? Let’s suppose you withdraw $20,000 from your brokerage account in 2013 to pay for freshman year, and that withdrawal included $5,000 in capital gains. That $5,000 will show up on your tax return, so you’ll pay taxes on it. Not only that, but the gain will also show up as income on your FAFSA or CSS PROFILE, which means it will be assessed at your highest income assessment rate, probably 47%, translating into an additional $2,350 in EFC. (Of course, if you had a loss in the brokerage account, it would have the opposite effect.)

Nearly every state offers a plan, and you can choose any state’s plan to invest in. Whichever plan you choose, you can use the funds at any qualified higher education institution. For example, you can live in Oregon, invest in Virginia’s plan, and send your student to college in California.

There are two types of 529 plans:

  • Savings Plans work a lot like an IRA or 401(k): you choose what to contribute and how to invest it. Your account balance will fluctuate based on your contributions and market performance.
  • Prepaid Plans let you prepay your state’s public school tuition, essentially locking in today’s tuition rates. Generally they also let you convert your savings to use at a private or out-of-state institution. Typically you purchase “units” of college tuition at today’s price (a “unit” might equal 1/100th of the cost of one year’s tuition); those units maintain their relative value as tuition increases.

Savings Plans are far more common than Prepaid Plans.

I’ve said “qualified” a few times here, and since you’re not a question-asker, I probably should tell you what that means too. With a 529 Savings Plan, “Qualified expenses” include tuition, mandatory fees, room and board, textbooks, supplies and other equipment that is required for enrollment. Prepaid plans cover a smaller list; check the plan’s document for details. One potentially significant expense that is not “qualified” is the cost of getting to and from school. Computers may or may not be qualified. Student loan payments and entertainment (sports tickets, fraternity/sorority dues, etc.) are also not qualified.

Qualified institutions are those for which you can withdraw funds tax- and penalty-free to pay for qualified expenses. A list is available here— and note, the list is not limited to US institutions.

Later we’ll get into the details of choosing a plan and opening an account.

College Savings Myth #1: The Aid Formulas Penalize You for Saving

While there’s a modicum of truth in this, the aid formulas really penalize you for not saving. Here’s why: Income is the biggest factor in every aid formula, and the aid formulas count more of your income than you’re likely to have available on an annual basis. Why? Because they assume that your income has been fairly consistent and linear for the years leading up to college, so you’ve been able to save on an ongoing basis.

Here’s a quick summary of the FAFSA’s Expected Family Contribution (EFC) calculation:

Up to 47% of your income above certain specific allowances is considered available to pay for college. Allowances might eat up half of your income, leaving up to 47% of the other half available for college.

How does that all play out? Let’s say you’re a family of 4 with household income of $100,000 and two students in college. Based on the formulas, your Available Income (what the FAFSA says you could spend for college) would be around $54,000.

Available Income is then assessed at various rates—much like tax brackets—up to a maximum rate of 47%. The average assessment rate for a household with $54,000 of available income is 35%, which translates to $18,900 available to pay for college. Each year. For four years. Obviously a family of four making $100,000 with two kids in college does not have $19,000 extra lying around each year. How can anyone possibly think this family could come up with that kind of money? They’re assuming you’ve been saving.

But wait—if they’ve been saving, then the formula is going to take that, too, right? Well sort of, and only some of it.

Just like with income, there is an “asset protection allowance.” If you have assets above the asset protection allowance, 12% of those are considered available to pay for college. The asset protection allowance depends on the age of the oldest parent, but the assessment rate is fixed. That 12% of assets figure is added to income and then assessed at the highest marginal rate (usually 47%) for the family’s income. So your savings are assessed at a maximum rate of 5.64% (12% x 47%), and only if they exceed the asset protection allowance.

What does that look like? Let’s assume our family of four, above, also has $50,000 in 529 plans, and based on the parents’ ages, the Asset Protection Allowance is $30,000.

                             $50,000             Assets in 529 plan

                           -$30,000             Asset protection allowance

                          =$20,000             Available assets

That $20,000 is multiplied by 12% (the parental asset assessment rate) to get $2,400. That amount is assessed at the highest income assessment rate (typically 47%) to get an amount available for pay for college, in this case 47% x $2,400 = $1,128.

So yes, your assets will be added into the calculation, but only a small fraction of them. In the above example, $100,000 of income generated an EFC of $18,900. $50,000 of assets only increased the EFC by $1,128. Looking at it another way, $1,000 in incremental income translates to $470 available to pay for college, but $1,000 in incremental assets is only another $56.50 available.

We rate “The formulas penalize you for saving” MYTH. But flip it around and it’s true: The formulas definitely penalize you for NOT saving.

When to file the FAFSA

Generally you want to file the FAFSA as soon as you can. That’s because some aid sources are available “until funds are depleted”—the early bird gets the worm, as the saying goes. However, keep in mind that your assets are calculated on the date you file. If you have assets in excess of the Asset Protection Allowance (approximately $30,000, depending on parents’ ages, and excluding funds in retirement accounts), you’ll want to make any large purchases you may be considering, and pay any large bills such as your mortgage payment and credit card bill, before filing. Every $1000 extra in your checking or savings account translates into approximately $65 more in EFC.  $65 may not seem like a big deal, but keep in mind you will be doing this every year that you have a student in college. Every dollar adds up!  

Acronyms, acronyms and more acronyms

Benjamin Franklin lived a long time ago. Had he lived in the early 21st century, his quote might have been, “In this world nothing can be said to be certain, except death, taxes and acronyms.” If you’re beginning to look at college costs, you may be overwhelmed by acronyms and jargon. Here are some common ones:

FAFSA: The Free Application for Federal Student Aid is the primary college financial aid application. All aid programs administered by Federal Student Aid (FSA) require the FAFSA. This includes not only Pell Grants, Stafford and PLUS loans but also campus-based programs including Federal Supplemental Educational Opportunity Grants, Federal Work-study programs, Perkins loans, and aid for military families. State agencies that provide financial aid generally also use the FAFSA, as do many schools and other organizations in determining eligibility for their own funds. Most families of college students will complete the FAFSA every year. The FAFSA’s aid formula is based primarily (in descending order) on income, number of dependents, family members attending college, and non-retirement assets. The FAFSA is available beginning January 1; different states and schools have different deadlines for its submission.

EFC: Your Expected Family Contribution is what the FAFSA or CSS PROFILE methodology indicates that your family should be able to pay each year towards college. Note that EFC is per family, not per student. So if your EFC is $20,000 and you have two college students, your per-student contribution is $10,000.

COA: The Cost of Attendance at a college. An important formula to remember: COA – EFC = Need. Need can be met in various ways; see FAFSA above for the different forms of aid available from Federal Student Aid.

SAR: After submitting the FAFSA, you will receive a Student Aid Report which gives you some basic information about your eligibility for various types of federal student aid, including your EFC. (If your FAFSA was incomplete, the SAR will not display an EFC.) The SAR is an opportunity for you to review your FAFSA information and make any corrections. Depending on how you submitted your FAFSA, it can take from 3 days to 3 weeks to receive your SAR.

CSS PROFILE The PROFILE form is an aid form administered by the College Scholarship Service, the financial aid arm of the College Board. Many private schools use it to determine eligibility for their own grants, loans and scholarships and other non-government aid. The CSS PROFILE uses a different methodology to calculate EFC and counts several types of assets that aren’t considered in the FAFSA. Generally the CSS PROFILE is submitted in the fall; like the FAFSA, it is re-submitted every year. And unlike the FAFSA, which is free, the CSS PROFILE charges a fee for each school or agency to which it’s sent.