How will a 529 plan affect my child's chances to qualify for financial aid?
Guidance from the U.S. Department of Education says that your 529 savings account is treated as an asset of the parent or other account owner in determining eligibility for federal financial aid. This means that your expected contribution toward your child's college costs will include 5.6 percent, or less, of the value of your account for each academic year. This is much better than the 35 percent assessment against assets owned in your child's name or in a custodial account.
However, any distributions from a 529 plan this year may impact a student's financial aid eligibility next year. Student income is assessed at a 50 percent rate in calculating expected family contribution (after certain allowances). Does a tax-free 529 distribution have to be added as "untaxed income" for federal aid purposes? While logic might say "yes" (at least for the earnings portion of the distribution), the latest word from Washington (November 2002) suggests otherwise. The Department of Education has informally indicated that there are no rules requiring that tax-free 529 distributions be treated as financial aid income or as any other type of adjustment to the student's financial aid eligibility. This position may change, so be careful.
Example: You file the FAFSA aid application when your child is a senior in high school. Let's say you have a 529 savings account with $20,000 in it, of which $10,000 represents your original contribution and $10,000 is earnings. Your eligibility for federal financial aid this year will decrease by as much as 5.6 percent of the account value, or $1,120. Assume there is no further appreciation in the account and you withdraw $5,000 in the fall to pay for the first-semester college bills. If you have $15,000 left in the account when you apply for aid for sophomore year, you will again be assessed up to 5.6 percent, or $840, of the account value. Whether your child will be required to report $2,500 of "untaxed" income because the $5,000 withdrawal brought $2,500 of excluded earnings with it, may depend on future guidance. The federal aid formula is even more complicated than what is described here.
A 529 prepaid tuition plan works differently in the federal financial aid formula. Here your investment doesn't show up at all on the FAFSA. But the benefits paid out will be considered by the institution as a resource that reduces your child's overall financial "need." The bottom line effect for most families is a dollar-for-dollar offset in eligibility. That is, if your prepaid tuition contract pays out $5,000 in tuition benefits this year, you will be considered as having $5,000 less need for financial aid. Low-income families that qualify for the Federal Pell grant will generally not be affected by a prepaid tuition plan (but they will be affected by a 529 savings plan).
Sound complicated? It is. And we are only talking about the federal financial aid rules here -- each school can (and most will) set its own rules when handing out its own need-based scholarships, and many schools are starting to adjust awards when they discover 529 accounts in the family. Also consider that the federal financial aid rules are subject to frequent change. Finally, remember that most financial aid comes in the form of loans, not grants, and so you end up paying it back anyway.