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Does a 529 plan affect financial aid?
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Calculating the impact on financial aid by 529 plans is relatively simple where a parent is the holder of the 529 plan. The impact on financial aid is complicated when the plan is in the student's name. This is something to consider when you take out a 529 plan.
529 plans held by parents or other non-beneficiary
A 529 account owned by a parent for a dependent student is reported on the federal financial aid application (FAFSA) as a parental asset. Parental assets are assessed at a maximum 5.64% rate in determining the student's Expected Family Contribution (EFC).
529 Plans owned by the student
Beginning with the 2009-2010 school year, student- and UGMA/UTMA-owned 529 accounts are to be reported as parental assets, if the student files the FAFSA as a dependent and has to include parent assets and income. This treatment confers a financial aid benefit as the parental rate of 5.64% is considerably less prejudicial than the 20% rate on non-529 assets owned by the student.
529 distributions treated favorably
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.
Year 1: Your child's eligibility for federal financial aid this year will decrease by no more than 5.64% of the account value, or $1,128 ($20,000 x 5.64%). 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.
Year 2: You have $15,000 left in the account when your child applies for aid for sophomore year, and it will again be assessed up to 5.64% of the account value or $846 ($15,000 x 5.64%). 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 more complicated than what is described here, but this gives you a general idea of how to calculate impact.
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.