The Effect of a 529 Plan on Financial Aid

Many parents establish a 529 savings account for their children’s future higher education. However, there is a notable concern associated with it. A 529 account can have an adverse effect on a student’s eligibility for need-based federal financial aid. These implications primarily depend on two factors:

1. Ownership of the account
2. Distributions and withdrawals

A comprehensive understanding of both factors can give a clearer picture of the impact.

Ownership of a 529 plan

Every student seeking financial aid needs to fill the Free Application for Federal Student Aid (FAFSA). The information provided in this form is used by colleges to compute the Expected Family Contribution (EFC) of the student. The nature of the 529 plan’s ownership is essential because it determines whether the fund value will be considered as an asset or not. In addition to this, ownership status is used to classify the fund value as a parental asset or student asset. When a dependent student or the custodial parent of a dependent student owns a 529 account, the FAFSA considers it as a parental asset. A 529 plan is considered as a student asset if an independent student is the owner. However, if a grandparent, a non-custodial parent, or anyone apart from the student or custodial parent of a dependent student owns the plan, it does not account it as an asset.

In the case of parental assets, approximately $20,000 is exempted and considered as the Asset Protection Allowance. The actual exemption amount varies with the parents’ age, but the financial aid can be reduced by up to 5.64% of the excess fund value. The loss, in this case, is usually offset by the returns from the 529 plan. Conversely, 20% of student assets are included in EFC by the FAFSA.

Distributions and withdrawals

When a 529 plan is owned by the student or the custodial parent of a student, it has no impact on financial aid eligibility. Any withdrawals made from these accounts for funding the qualified higher studies are exempted from the base-year income and, therefore, do not affect the financial aid of the student. Consequently, if a parent has to dissolve the 529 account to fund the first year of college, the student’s financial aid for the next year will not be adversely influenced.

Another scenario is where the funds from a 529 plan are used to fund non-qualified higher education expenses. In this case, the withdrawn amount will appear under the adjusted gross income (AGI) of the owner’s federal income tax return. It will be included in the EFC in the FAFSA.

However, withdrawals made from a 529 account owned by a grandparent or any other relative can pose certain complications. These withdrawals made for the payment of college expenditures are treated as untaxed income by the FAFSA. As long as no withdrawals are made from the account, the student does not have to mention it in the application. Any withdrawals will be assumed as student income, thereby resulting in a 50% (of the amount withdrawn) reduction in the financial aid eligibility.

Solution for grandparent-owned 529 plans

A student’s financial aid eligibility is considerably hindered by the distributions from a 529 plan owned by a grandparent or any other relative (other than a parent). However, there are some solutions to completely avoid any effect on the eligibility or at least reduce it to a certain extent. Here are a few things to follow:

1. Transfer of ownership

This is the most common way out chosen by people. The ownership of the account has to be transferred either to the parent or the student. The withdrawals must be made only after the transfer process is complete. This will ensure that the account is not included as an asset and the distributions are not treated as untaxed income in the FAFSA. The grandparent or any other relative should try to set up the account in the same state as that of the parent/student. The grandparent or the relative can also remain the custodian of the account by transferring it to the student. There are certain states which do not allow any form of transfer. However, there are other options available in such cases.

2. Withdrawals made at an appropriate time

There are two ways to ensure that the student’s financial aid eligibility for the next year is not affected by the current year’s distribution. One is that the distribution could be made during the last year of the course so that the following years are not affected. The second option is to make the distribution during the third semester since the FAFSA takes into account the income from the previous two years. In both the cases, there will be no impact on financial aid.

3. Debt Repayment Via The 529 Plan

The student can take a loan for financing higher studies. After the completion of the course, funds from the 529 savings account can be used to repay the debt. This non-qualified distribution will not affect the student’s financial aid.

To sum it up

A 529 account only affects a student’s financial aid if the plan is owned by an independent student or a grandparent/relative. However, in the case of a grandparent/relative-owned 529 plan, many alternatives can be adopted to prevent any negative impact on financial aid eligibility. But there is no way out if student assets are involved and can result in a significant amount of loss as far as the eligibility of financial aid is concerned. There are many complexities involved when dealing with the impact of a 529 account on the student’s eligibility for financial aid. Thus, a 529 account must be established carefully if the student is seeking federal financial aid.

If you need help with the establishment of a 529 plan and its subsequent distributions in a way that it will have a minimum or no adverse effect during the submission of the FAFSA, you can reach out to professional financial advisors.