If you’ve been reluctant to fund a 529 college savings account because you heard it hurts you in the financial aid formula, here’s the real truth: 529s are a powerhouse when it comes to financial aid.
Yes, your student’s 529 is an asset that is reported on the FAFSA and CSS Profile. This means that about 5% of its value is added to your Student Aid Index or Expected Family Contribution– the same as your savings account, brokerage account and any other non-retirement financial account. In English that means that every $1,000 in your 529 (or other account) will reduce your financial aid eligibility by about $50. So you come out ahead by about $950. But after that, 529s are light years ahead of any alternative savings vehicle when it comes to financial aid.
529s have loads of well-publicized benefits: tax-free growth and distributions for qualified expenses, state tax benefits for contributions, gifting pages, and much more. But the unsung benefit of 529s is their preferential treatment in financial aid formulas. How is that?
First, the new simplified FAFSA only has you report the student’s 529 balance as an asset, not the student’s siblings’ accounts. If you are a parent of three and you’re trying to decide whether to put money into 529s for each child or just use a taxable account for simplicity’s sake, know that dividing that money among the 529s will reduce its value on each child’s FAFSA by 2/3 as compared with the taxable account. (The CSS Profile does still ask for all 529s.) If each student had $20,000 in their 529, then each student’s Student Aid Index would increase by 5.64% of $20,000 or $1,128. If the total $60,000 were in a taxable account, then each student’s Student Aid Index would increase by 5.64% of $60,000 or $3,384.
Second, since distributions from the 529 are tax-free as long as they’re used for qualified education expenses, they don’t generate income on your tax return. Taking money from a taxable brokerage account or a Roth IRA generates income which is reported on your tax return and then flows through to the FAFSA, which in turn increases your Student Aid Index. And yes, even though Roth IRA distributions are tax-free, they are reported on your tax return and the FAFSA includes untaxed income from your tax return. Suppose you contributed $10,000 to each student’s 529 and now it’s worth $20,000. When you withdraw that $20,000, you get $20,000 because no taxes are due, and nothing is added to your SAI. Suppose you put the same $10,000 into a taxable account and now it’s worth $20,000. Withdrawing that $20,000 would result in $10,000 of income– which would raise SAI by $4,700– and a capital gains tax bill on the $10,000 gain. Withdrawing it from a Roth IRA would add $20,000 of income to the FAFSA, raising SAI by $9,400. And of course if you’re withdrawing for multiple students in the same year, that income would flow through to multiple FAFSAs.
One of my personal favorite reasons to use 529s isn’t about the FAFSA at all. It’s this: having dedicated dollars available for college makes it a whole lot easier to have a budget for college and to guide your student towards financial choices that work for your family.
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My hesitation in fully funding annual 529 contributions is: what if the child does qualify for a good level of scholarship $; what happens to the now-unnecessary-for-college extra 529 built up $? Some can go to a Roth conversion, but this is limited…?
That’s a common hesitation. The Roth part is easy: current regs allow you to convert up to $35,000 from 529 to Roth. If you set up 2 529s, one with the student as beneficiary and the other with the parent, then each could convert $35,000 to Roth. And if the $$ were needed for college, the parent could simply change the beneficiary from themselves to the student. As for scholarships: about 1% of students get full ride scholarships including tuition, fees, room, board and books. The rest need additional money. The vast majority of scholarships are tuition only. There are lots of options for extra 529 $$– changing the beneficiary to a sibling or other family member, saving for grad school, using for career expenses (now continuing education and certification programs are qualified 529 expenses). Or just take a distribution and pay the taxes– the student’s tax rate is likely pretty low.
What happens when grandparent opened a 529 many years ago for his child. His child now has his own children going to college. How does this effect assistance if the grandparent uses the 529 for his grandchildren even though the 529 is in the name of his son?
The grandparent would have to change the beneficiary from the child to the grandchild, first of all. Grandparent-owned 529s are not reported on financial aid forms so this would not hurt the student in the aid formula.
When should a grandparent confirm to a grandchild that there is a 529 in their name for their use?
I think it depends on the size of the 529. Will it change the student’s range of choices? Will it change the parents’ savings plans? Grandparents who are saving a lot for their grandchildren’s college should be discussing this with the parents to ensure there’s some coordination and not an excess of funds, for example. If grandparents are superfunding then the earlier, the better. If it’s an amount that might change the student’s college choice, then the student should know about it before they begin their college search process. This might be earlier than you think– for example, if the student has friends with older siblings, they’re likely to start hearing about colleges much earlier. If it’s an amount that is maybe the difference between a student loan or not, then you have a lot more leeway.
I am a retired military officer receiving military pension (fully taxable) and VA disability (non-taxable). Do you know if my VA disability pay is computed in the FAFSA, or is it shielded since it’s not taxed?
It is not one of the untaxed income categories that is added back so it should be shielded. The form only requires you to add back untaxed retirement contributions and distributions. However, the CSS Profile may request that info. (“May request” = “I don’t know whether or not they do.”)