Frequently asked questions about 529 plans
How will a 529 plan affect my
child's chances to qualify for financial aid?
A new law enacted in early 2006 (Deficit Reduction Act of 2005)
made substantial changes to the treatment of 529 plans in the federal
student aid eligibility formula. The changes are first effective
for the 2006-07 school year. Before these changes, we relied on
guidance from the U.S. Department of Education stating that a 529
savings account is treated as an asset of the parent or other account
owner in determining eligibility for federal financial aid. This
was generally considered good news because it meant that your expected
contribution toward your child's college costs would count only
5.6 percent, or less, of the value of any 529 account owned by you.
However, a 529 account owned by your
child, including a "custodial" 529 account
funded from an existing UGMA/UTMA account, was still
considered to be a student asset. Students assets
are assessed in the financial aid formula at a much
higher 35 percent rate (this rate decreases to 20
percent beginning with the 2007-08 school year).
The new law now precludes ANY 529 account from being
treated as a student asset. This means a custodial
529 will no longer be subject to the 35 percent
assessment rate. Unfortunately, the law does not
specify how the custodial 529 is to be treated.
We do not yet know if the account will be treated
as a parental asset, or if it will not be counted
at all. You should probably plan on the "worst
case" which is that it will be counted as a
parental asset subject to a maximum 5.6 percent
assessment rate. Along with favorable asset treatment,
a 529 account also garners favorable treatment in
the income portion of the financial aid eligibility
formula. A tax-free distribution from a 529 plan
to pay this year's college expenses will not be
part of the "base-year income" that reduces
next year's financial aid eligibility. Here is a
simplified example of how this all works: 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 no more than 5.64% of the
account value, or $1,128. 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 5.64%, or $846, of the account
value. The $5,000 withdrawal brought $2,500 of excluded
earnings with it, but as indicated above, none of
the withdrawal is counted as financial aid income.
The federal aid formula is even more complicated
than what is described here. Another major change
in the new law is the way a 529 prepaid tuition
plan is treated. Under the old law, your investment
would not show up at all on the FAFSA, but the benefits
paid out would be considered by the institution
as a resource that reduced your child's overall
financial "need". The bottom line effect
for most families was a dollar-for-dollar offset
in eligibility. Going forward, a 529 prepaid tuition
plan will be treated the same as a 529 savings plan.
It will no longer cause a dollar-for-dollar reduction
in financial aid. Instead, the reduction will be
no more than 5.6 percent of the refund value of
the prepayment account. 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.