Business & Corporate Law

WHAT ARE 529 PLANS AND FINANCIAL AID?

What are Section 529 Plans?

            Section 529 plans are named after Section 529 of the Internal Revenue Code (IRC), which was created in 1996 to authorize tax-free status for qualified tuition programs. A 529 plan is a tax-advantaged savings plan designed to encourage saving for future education costs. These qualified tuition plans are sponsored by states, state agencies or educational institutions. Each state has its own set of rules regarding 529 plans and it depends on which state the plan is opened to fully understand the rules for your plan.

            Education savings plans allow a person to open a tax free investment account to save for the beneficiary’s future qualified higher education expenses such as tuition, mandatory fees, room and board, books, computers, printers, internet services and equipment needed to complete coursework. Due to the Tax and Jobs Act of 2017, these savings plans can also be used to pay up to $10,000 per year per beneficiary for tuition at any public, private or religious elementary or secondary school from kindergarten through 12^th grade. 

Effects of investing in a 529 plan

State and Federal Income Tax

Many states offer tax benefits for contributions to a 529 plan including deducting contributions from state income tax or matching grants. One of the benefits of 529 plans is the tax-free earnings that grow over a period of time. Withdraws from 529 accounts for qualified higher education expenses are not subject to federal income tax and in many cases state income taxes. However, withdraws not used for qualified higher education expenses will be subject to state and federal income taxes and an additional 10% federal tax penalty.

Financial Aid Eligibility

            When applying to college all schools that offer federal need-based financial aid require students to compete the Free Application for Federal Student Aid (FAFSA). Schools then use the information provided on the FAFSA to calculate a students Expected Family Contribution (EFC). The EFC is then used to determine how much aid and what type of aid the student is eligible for.

            The effect of a 529 plan on a student’s EFC depends on who owns the 529 plan. The value of a 529 plan owned by a dependent student or one of his/her parents is considered a parental asset on the FAFSA. (However, earnings of a student-owned 529 plan do not have to be reported on the FAFSA and will not affect the student’s financial aid.)The first $20,000 of parental assets falls under the Asset Protection Allowance. Any parental asset over $20,000 will reduce a student’s aid package by a maximum of 5.64% of the assets value. If the 529 plan is owned by a grandparent or other relative the value is not included on the student’s FAFSA.

Withdraws from a 529 plans will also effect a student’s FAFSA amount. However, this also depends on who is the account owner. Withdrawals from a parent or student owned 529 plan does not get reported on the student’s FAFSA. Any money withdrawn from the plan and used to pay for the student’s qualified tuition and expenses will not affect FAFSA. The student runs into trouble when the account is owned by a grandparent or other relative. Withdrawals from a grandparent accounts will be counted as untaxed student income on the FAFSA and student income is assessed at 50%. Therefore, if the grandparent uses his/her 529 account to pay $10,000 of college expenses it would reduce the grandchild’s eligibility for aid by $5,000.

When applying for FAFSA the student reports prior-prior year income. Therefore, one way to avoid this problem is to wait to take a withdrawal until the student’s second semester of their sophomore year. Another option is to roll one year’s worth of funds at a time from the grandparent’s 529 plan to the parent’s 529 plan. If you wait until after the student’s FAFSA is filed it will not get reported as an asset and then when it is withdrawn from the parent’s account there is no income to account for.

Changing a 529 Plan Beneficiary

A 529 plan is designed to save for education expenses for a single beneficiary. The question arises when the beneficiary graduates and there is still money in the account. A 529 plan account owner can change the beneficiary at any time and beneficiary changes are not treated as a distribution when the new beneficiary is a member of the family of the current beneficiary. The IRS provides a broad definition of a family member, which includes the beneficiary’s blood relatives and relatives by marriage and adoption, including spouses, siblings, nieces, nephews, first cousins etc. Distributions used to pay for college expenses for anyone other than the beneficiary will be subject to income tax and a 10% penalty on the earnings.

Recommendation

There are pros and cons to both parent/student and grandparent owned 529 plans. However, the use of a 529 plan will almost always produce favorable results compared to a normal savings account. The benefits include: income tax breaks, the donor is in control over the account, low maintenance, simplified tax reporting, and flexibility. It is important to remember each state has its own set of rules but you can open an account in any state of your choosing. Therefore, you should research the plan benefits for a state before you make a decision. Feel free to contact any member of our firm if you have any questions on this topic.