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Understanding the new financial aid treatment of 529 plans
by Joe Hurley, founder,
Wednesday, June 14th 2006

By now you may have seen some articles in the national press about a “529 loophole.” Attention is being focused on a new law passed back in February that removes student-owned 529 plans and Coverdell education savings accounts from the expected family contribution (“EFC”) in the federal financial aid formula.

You received a heads-up on the financial-aid changes in our February 2006 newsletter. However, at the time I wrote that newsletter I was not certain how the U.S. Department of Education would apply those changes in re-writing the FAFSA instructions. We now have the Department’s interpretation. A 529 account or Coverdell ESA is considered an asset of the account owner; however, 529 accounts or Coverdell ESAs owned by a dependent student are excluded from the FAFSA. Most undergraduates are dependents for FAFSA purpose.

This is exceptional treatment, as student assets are generally picked up at a 35-percent rate in determining the EFC. And it creates a new planning opportunity.

John and Jill have been saving for their son Billy’s future college expenses by purchasing mutual funds in Billy’s name under the Uniform Transfers to Minors Act (UTMA). They’ve saved some income taxes by having the investment earnings reported on Billy’s tax returns through the years. But Billy will be enrolling in college this fall and those investments are now going to be assessed at a 35-percent rate in determining Billy’s eligibility for federal grants and subsidized loans. Under the new law, John and Jill can dramatically improve Billy’s aid eligibility by liquidating his current investments and moving the money into a 529 plan with Billy as both owner and beneficiary. Provided the assets are moved to the 529 prior to filing the FAFSA, they will be removed completely from consideration.

“Loophole” is probably too strong a word to describe this technique. Congress clearly wants to encourage the use of 529 plans and ESAs and was deliberate in changing the financial-aid laws so that college savings plans would not be subject to the punitive 35-percent rate. Did lawmakers realize that families would simply shift any student-owned assets into 529 plans to increase aid eligibility? Perhaps not. I understand there has been some questioning from a Congressional advisory committee, suggesting a bit of confusion as to whether a minor can be “owner” of a 529 plan or ESA.

Here is where things currently stand, in my judgment:

-The law as written permits dependent students owning 529 plans and ESAs to exclude those assets from the FAFSA. If Congress decides that the changes enacted in February created an unintended loophole, it may seek corrective legislation.

-The financial-aid changes are effective for the 2006-07 school year. If you have already filed a FAFSA including a student-owned 529 account, you should consider submitting a corrected FAFSA to exclude it. If you haven’t yet filed the FAFSA, you can change your 2006-07 aid picture by moving assets into a student-owned 529 plan before you file the application.

-The benefit of moving money into a student-owned 529 account will decrease next year (the 2007-08 school year) as the asset inclusion factor for student-owned assets is dropping from 35 percent to 20 percent.

-Moving money from a student-owned or UGMA/UTMA investment into a 529 plan requires that the investment first be liquidated. Capital gains may be triggered causing income tax and a possible decrease in financial aid due to the income inclusion factor. Careful planning is necessary. So is an accurate assessment of your financial-aid prospects.

-Don’t be too quick to shift your parent-owned investment assets, including your own 529 accounts, to a 529 account under your child’s ownership. (If the student is a minor, most 529 plans will require an adult custodian on the account.) The potential financial aid benefit is small—parent assets are assessed on a sliding scale that tops out at only 5.64 percent—and the transfer is irrevocable. If Congress decides to re-work the laws, it will be too late to take your money back from your child.

-There’s been no change with respect to grandparent-owned 529s naming the student as beneficiary; they are not reportable on the FAFSA. However, the U.S. Department of Education has yet to clarify whether a distribution from a grandparent-owned 529 plan to pay for the student’s college expenses is reportable as student income.

-Schools may distribute their own scholarships and grants under non-federal formulas. The changes described above will not necessarily affect school-based grants. In fact, an increase in a student’s federal aid may cause some schools to offer less school-based aid.

» Claiming a state income tax deduction - 12/20/16
» Understanding 529 Investment Options - 12/13/16
» Should you open an UGMA/UTMA 529? - 02/06/08
» Understanding your state's slice of 529 fees - 12/13/07
» Planning for the new "kiddie tax" - 10/30/07
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