Good intentions sometimes have bad consequences. A perfect example can be opening a 529 plan for your child or grandchild. Depending on the financial situations of the parties involved the intentions of helping the child can possibly (key word is possibly) have the consequence of hurting the child's chances of financial aid in the future. Let's explore how.
What Is A 529 Plan?
A 529 Plan is a Tax-Advantaged savings plan designed to help pay for a beneficiaries education. Tax-Advantaged simply means the money comes out of your paycheck and goes into the 529 plan without you paying income tax on the amount. The savings grow tax-deferred and withdrawals are tax-free as long as they are used for qualified education expenses. That sounds awesome doesn't it?
The Basic Problem With A 529 Plan
Not all 529 accounts are treated equally. This means two different students with the same basic financial profile might get two different financial aid packages based on who actually owns the 529 plan. This can come as a total surprise to families under the impression that 529 plans would only help their child or grandchild. Here's how it works.
Assets in a 529 plan owned by the student or their parents count against need-based aid while plans owned by grandparents do not. But here is the catch and man it's a tricky one. Once the grandparent or other relative starts taking the money out of the plan to help pay for education expenses the opposite is true. These withdrawals will actually hurt your chance of receiving financial aid the following year. Confused yet?
The Math On 529 Plans
The main issue is how the federal financial aid formula treats assets and income differently depending on who owns it. A 529 plan owned by the student or their parent will count as assets and will reduce any need-based aid by around 6% of the 529 plan's value. That means if you have $10,000 in that 529 plan it will be reduced by $600.
If the 529 plan is held and owned by the grandparents, they wont appear on the financial aid application and the money will not show up as an asset of the student. Sound good right? However, as the money is withdrawn to pay for the education expenses it MUST be reported on next years financial aid forms. And it can actually reduce the amount of aid the student is eligible for by up to 50 percent!
So if that same $10,000 college-savings plan was owned by the grandparents, and the student withdrew $5,000 from it one year, that withdrawal could increase the amount the family is expected to pay for college and reduce the aid for next year by about $2,500. And that's just the federal rules!
Best Strategies For 529 Plans
To avoid these complications, one strategy is to set up all the college savings plans in one name to be owned by the student or the parents. This way the plan is covered by one set of rules. If grandparents have 529 plans they could transfer ownership before college assuming your state allows this. Some states don't.
Another strategy is to wait and spend down the assets in the grandparents plan until the LAST year of college. Since financial aid forms are based on the previous years income this would avoid any impacts from withdrawals.
It's complicated and much like all financial planning there is no right answer for everyone. It depends on your financial situation. We recommend talking to a financial adviser before making these decisions.
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Thanks for reading!
80/20 Financial Services is an independent Registered Investment Advisory Firm. Our focus is working with retirees, and we specialize in working with retirees who are approaching or going through the retirement transition. We are located in Ozark, MO but we have the ability to work with clients throughout the United States. Contact us today for help with your retirement needs.