A Crash Course in 529 Plans and Their Impact on Financial Aid
Presented by Ben Murphy, CPA, PFS™:
Start with the Basics
- Prepaid tuition plans. With this type of plan, tuition and fees for a specific school are paid in advance.
- Savings plans. These are tax-advantaged investment vehicles (the account grows tax deferred, like individual retirement accounts [IRAs]). Savings can be used at most accredited colleges and universities in the U.S. or abroad.
Make Your Plan Work for You
When timed appropriately, contributions and withdrawals can help maximize your 529 plan. With most plans:
- You can only contribute cash. This includes checks, money orders, and credit card payments. You can’t contribute stocks, bonds, or mutual funds without liquidating them first.
- Anyone can contribute. With a 529 plan set up, gift giving just became easier!
- There are investment options. You can choose how to invest your contributions from a variety of investment portfolios.
- You may be able to use funds for K–12 education. Be sure to check as not all states recognize these updated provisions for K–12 education.
- Research tax impact on financial aid. Withdrawals used to pay qualified education expenses are free from federal income tax and may also be exempt from state income tax.
The CliffsNotes on contributions. To qualify as a 529 plan under federal rules, a state program can’t accept contributions more than the anticipated cost of attendance for the most expensive schools in the country. Most states have contribution limits of $350,000 and up per beneficiary.
The type of plan determines the limits:
- Prepaid tuition plans. These limit total contributions.
- Savings plans. These limit the value of the account (contributions plus earnings).
- Minimum contribution requirements. Some plans have requirements, such as minimum opening deposits or yearly contribution amounts.
- State guidelines vary. Contributions made to one state’s 529 plan don’t usually count toward the contribution limit in another state. Be sure to check the rules of each state’s plan.
Should you fund your plan in a lump sum or over time?
- Monthly investments may be an easy option. 529 plan earnings grow tax deferred and can be withdrawn tax free if used to pay for qualified expenses. The sooner you put money in, the sooner you can start to generate potential earnings.
- A lump sum may have unwanted gift tax consequences. With limited opportunities to change your investment portfolio, you could get locked into undesirable investments for a period of time.
Timing is everything! Although 529 plans are tax-advantaged accounts, potential federal tax impacts are something to keep in mind. Under special rules unique to 529 plans, you can gift a lump sum of up to five times the annual gift tax exclusion—$75,000 for individual gifts or $150,000 for joint gifts—and avoid federal gift tax, provided you make an election on your tax return to spread the gift evenly over five years. (The federal gift tax exclusion is $15,000 for 2021.)
Withdrawals should also be coordinated with education tax credits—the American Opportunity Credit and Lifetime Learning Credit—because tuition expenses used to qualify for a credit can’t be the same tuition expenses paid with tax-free 529 funds.
Does having a 529 affect financial aid?
During the financial aid process, income and assets are examined to determine how much the student should be expected to pay for school before receiving financial aid. To maximize the beneficiary’s future financial aid options, pay close attention to who is listed as the owner of your 529 plan.
How to handle 529 plans owned by parents. The value of any parent-owned 529 plan will be listed as an asset on the Free Application for Federal Student Aid (FAFSA). Colleges and the federal government typically treat 5.64 percent of parental assets as available to help pay college costs. By contrast, student assets are assessed at a rate of 20 percent.
Here are some additional things to keep in mind about parent assets:
- Will the plan be considered an asset? Parents are required to list a 529 plan as an asset only if they are the account owners of the plan.
- A note for students who are dependents. A 529 account owned by a dependent student—or by a custodian for the student—is reported on the FAFSA as a parental asset.
- Yearly income guidelines. If parental adjusted gross income is less than $50,000 and they meet a few other requirements under the simplified needs test, the federal government doesn’t count any of their assets.* In this case, the 529 account wouldn’t affect financial aid.
- Subsequent years may look different. For parent- and student-owned 529 plans, funds aren’t classified as parent or student income the following year when they’re used to pay for qualified education expenses.
What about grandparent-owned 529 accounts? If a grandparent is the account owner, the 529 plan doesn’t need to be listed as an asset on the FAFSA. Withdrawals from a grandparent-owned 529 account, however, are counted as student income—which is assessed at 50 percent—on the FAFSA the following year. This means financial aid eligibility could decrease by 50 percent in the year following the withdrawal. Grandparents may want to wait until their grandchild’s last two years of college to make a withdrawal if they are concerned about the potential impact on financial aid.
Preparation Is Key
You should review all your options to ensure that you’re financially prepared for education expenses. If you’d like to discuss 529 plans—or any other options—or if you have any questions about the information presented here, please contact me or my office.
* An applicant who qualifies for the simplified needs test may still be required to report assets on the FAFSA if they live in a state that requires asset information to determine eligibility for state grant programs. The asset information will be used only to determine eligibility for state grant programs. It won’t be used to determine eligibility for federal student aid. The states include Colorado, Georgia, Hawaii, Illinois, Minnesota, New Jersey, New Mexico, Ohio, Oklahoma, South Carolina, Vermont, Washington, Washington D.C., Wisconsin, and Wyoming.
This material has been provided for general informational purposes only and does not constitute either tax or legal advice. Although we go to great lengths to make sure our information is accurate and useful, we recommend you consult a tax preparer, professional tax advisor, or lawyer.
The fees, expenses, and features of 529 plans can vary from state to state. 529 plans involve investment risk, including the possible loss of funds. There is no guarantee that a college-funding goal will be met. To be federally tax free, earnings must be used to pay for qualified higher education expenses. The earnings portion of a nonqualified withdrawal will be subject to ordinary income tax at the recipient’s marginal rate and subject to a 10 percent penalty. By investing in a plan outside your state of residence, you may lose any state tax benefits. 529 plans are subject to enrollment, maintenance, and administration/management fees and expenses.
Ben Murphy, CPA, PFS™ is a financial advisor located at Global Wealth Advisors 601 N. Marienfeld, Suite 322, Midland, TX 79701. He offers securities and advisory services as an Investment Adviser Representative of Commonwealth Financial Network®, Member FINRA / SIPC, a Registered Investment Adviser. He can be reached at (325) 207-5772 or at email@example.com.
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