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529 Plans DemystifiedSubmitted by Townsend Asset Management Corp. on December 8th, 2016
Strategies with 529 Plans
College Savings (529) Plans have become popular vehicles for saving money for college. You do not get a tax deduction on your federal return for putting money into these plans, although some states (not N.C.) do offer a deduction on the state return. The big attraction is that the earnings on the investments in the 529 plan escape both federal and state tax when the money is eventually withdrawn, as long as it is used for “qualified” higher education expenses. Obviously, a 529 plan is most beneficial when funding starts early in a child’s life.
Often, the question arises as to who should be the owner of a 529 plan? Should it be a grandparent, parent, or the child?
The tax treatment of distributions is not impacted by who owns the 529 plan, and is solely determined by whether the distributed money is used for qualified expenses or not. However, the ownership of the 529 does affect the ability of the student to qualify for financial aid. Students apply for financial aid using the “Free Application for Federal Student Aid” (FAFSA) form, and this form looks at both assets and income.
Grandparent Owned 529 Plan
If a grandparent owns the 529 plan, the value of the plan is not listed when applying for financial aid. Therefore, a grandparent-owned plan certainly helps for initial financial aid qualification. However, while the assets in the plan don’t show up on a FAFSA filing, up to 50% of future distributions from a grandparent-owned plan are counted, for FAFSA purposes only, as student income, with potential negative consequences on financial aid qualification.
Parent Owned 529 Plan
When the parent owns the 529, it is treated as a parental asset for financial aid purposes, and this results in 5.64% of the plan value counting towards what the family is expected to contribute towards the college cost (the “Expected Family Contribution.” or “EFC”). Therefore, the parent-owned plan is not as attractive as the grandparent-owned plan for initial financial aid qualification. However, it is a totally different situation with distributions from the plan, as qualified distributions from a parent-owned 529 plan are not counted as income for FAFSA purposes.
Student Owned 529 Plan
If the student is actually the owner and beneficiary of the plan, it is still treated like a parent-owned plan for financial aid purposes, as long as the student is a dependent of the parent. But, if the student is not a dependent, then 20% of the value of the 529 counts toward the student’s EFC. But regardless of whether the student is a dependent or not, qualified distributions from student-owned plans do not count as income for financial aid purposes.
Grandparent-owned plans are better for initial financial aid qualification purposes, but not as attractive subsequently, since distributions become part of the student’s income for financial aid purposes. On the other hand, a parent-owned plan is not as attractive from an initial qualification perspective, but more attractive later, since qualified distributions don’t count as income for financial aid determination. Confusing, huh? Read on, it gets even more interesting.
The Impact of Timing
FAFSA forms are filed annually, so both assets and income are reviewed each year in order to determine the EFC for financial aid purposes. However, there is a lag time when counting the income. If a student is completing a FAFSA for the upcoming Fall of 2017 – Spring of 2018 college year, “income” is determined by reference to the 2015 income tax return. In essence, there is a two-year lag.
Since parent-owned plans impact initial financial aid but future distributions are ignored, it makes sense to use the assets in a parent-owned plan first. The ideal situation would be having enough money in a parent-owned plan to cover the first two years of college costs.
Since grandparent-owned plans do not impact initial financial aid, but distributions from these plans do negatively impact financial aid, it also makes sense to delay distributions from them until the junior and senior years of college. Because of the two-year delay in counting income, any distributions from grandparent-owned plans that occur during a student’s junior and senior years of college will occur too late to count as income during a traditional four-year college time frame. Of course, if a student plans on graduate school, it would be wise to delay distributions even longer, in order to avoid the income inclusion.
Bottom line: If financial aid qualification is an important part of future college cost planning, in addition to the necessity of saving money for higher education costs, it is also important to consider how these savings accounts are titled.
Gerald A. Townsend, CPA/PFS/ABV, CFP®, CFA®, CMT® is president of Townsend Asset Management Corp., a registered investment advisory firm located in Raleigh, North Carolina.