When to undo a 529 plan

http://www.savingforcollege.com/articles/when-to-undo-a-529-plan

Financial Professional Content

Sometimes it pays to undo a 529 plan. Amy Feldman of Reuters wrote an excellent article about the impact of 529s on financial aid and quoted me as suggesting that it’s sometimes better to take a nonqualified distribution: "Most people would never think of that, but depending on the financial aid package, the financial aid penalty may be worse than the tax penalty."

That piece of advice may be surprising to many, and perhaps a bit dismaying. After all, why set up a 529 account in the first place if there’s a significant chance of it being taxed and penalized in the future? My response: It’s really not so dire.

For purposes of federal financial-aid eligibility, a 529 plan generally works out favorably. A 529 account owned by the parent, or owned by the parent’s dependent student either directly or via the Uniform Transfers to Minors Act (UTMA), is reported on the FAFSA application as a parent asset with low or zero impact on aid eligibility. A 529 account does not get reported as a student asset unless the student is independent. Even better, qualified distributions from a 529 account do not get added back to income in the aid formula (unlike IRAs).

But as Ms. Feldman points out in her article, a 529 account owned by a third party, such as a grandparent, is treated differently. The asset value is not reported on the FAFSA, which is certainly favorable, but any use of the account for the benefit of the student must be reported on the following year’s FAFSA and added back to income. Since any financial-aid income above a certain dollar amount is “assessed” at 50 percent in the aid formula, the impact of using a grandparent-owned 529 to pay for college can be significant.

If the grandparent anticipates the financial-aid dilemma with a 529 account, the lesser-cost option may be to simply liquidate the account on a non-qualified basis and pay the associated tax and 10 percent penalty.

But there may be better options. For one, the grandparent should consider holding off on any distributions until after the student has filed their final FAFSA going into the senior year of college. This way, using the 529 will have no impact on federal aid and will still qualify for tax-free treatment if the student incurs qualified expenses that match up with the distributions.

Another option is for the grandparent to look into transferring ownership of the 529 account to the parent, or even to the student, if the financial-aid consequences work out better that way. (Caution: Some 529 plans do not permit owner changes.)

The situation can become even more dramatic when it comes to non-federal grants and scholarships handed out by the college. Colleges do not have to follow federal formulas in awarding their own funds. Some will flat out ask about any 529 accounts established for the student and reduce their awards accordingly. It may not matter who owns the 529s. In these cases, getting rid of the 529 account—and paying the tax and penalty on the earnings—before the school even asks about them may provide the better outcome.

Taking a non-qualified distribution may not hurt much on your income tax. Any scholarships awarded to the student are grounds for claiming a waiver of the 10 percent penalty. And by requesting a distribution from the 529 plan to the student, rather than to the parent or other account owner, any earnings get reported on the student’s tax return where there might be little if any tax impact.