A 529 plan can affect a student’s financial aid package, but how much of an impact depends on who owns the account, the type of aid applied for, and when withdrawals occur. Although a 529 plan will affect federal financial aid eligibility to some degree, there are important nuances to consider.
With more and more high school students attending college, paying for higher education has become a stressful endeavor. Due to the expense and ever-rising college costs, many parents struggle to afford their children’s educational goals without sending them into student loan debt.
In response, the government implemented several programs to help with the expense, including the 529 savings plan as well as offering federal aid under the Free Application for Student Aid (FAFSA) program. The downside? The amount of federal student aid a person receives through the FAFSA depends on the student’s expected family contribution (EFC). But if the money saved in a 529 plan can only help pay for qualified college costs, won’t that count as EFC?
The answer to this is complicated and is a mix of who the plan is owned by, what school they are going to, and how they are structuring the withdrawals.
What is the FAFSA?
FAFSA is a program under the federal government of the United States that was part of the Higher Education Act signed by Lyndon Johnson in 1965. The idea behind the program was to give students from lower-income backgrounds the opportunity to go to college by offering financial aid and assistance to pay for college expenses.
To determine the amount of federal aid a student receives, FAFSA typically looks at the following:
- Federal income tax returns
- Records of untaxed income
- Cash, savings, and checking account balances
- Investments (other than the home in which you live)
How the FAFSA works
When a student applies, they can either apply for the FAFSA online directly or through their school, who can file it on their behalf. This measures how much money the family has and how much aid the dependent student is eligible for.
When looking at the assets of a family or student, there is automatically a $10,000 asset protection allowance. This means that the first $10,000 of assets are not included in the FAFSA calculation. The government then looks at all assets and income and determines if and how much the student is eligible for.
Do 529 plans affect need-based financial aid?
A 592 plan is a savings plan that allows you to grow your income with significant tax benefits. Therefore, if you start early, by the time your children are older, the 529 plan should be worth much more than the $10,000 exclusion under the asset protection allowance. That being said, the 529 plan does affect the amount of financial aid a student may receive.
However, even though the federal government considers a 529 plan to be an asset, it’s not as big of a liability as you might think. In fact, its impact can be extremely minimal depending on who owns the plan and how you structure it.
529 plans owned by parents
529 plans are typically owned by parents, guardians, or custodians. The beneficiary of this plan is the students that will attend college.
Luckily for parent-owned FAFSA accounts, the government realizes there is a contradiction here. If a 529 plan encourages parents to save for college, why does FAFSA punish the same parents later down the line? For this reason, the government introduced a hard cap of 5.64%.
How does the 5.64% cap work?
As mentioned before, the FAFSA gives an asset protection allowance of $10,000. Anything over the $10,000 of parental assets will start to reduce a student’s aid package, which is capped at 5.64%.
This means that if a student’s parents are $1,000 over the asset protection allowance, the aid offered can only be reduced by a maximum of $56.40. If the parental assets exceed the allowance by $10,000, then only a maximum of $564 can be removed from the child’s financial award.
Non-parent-owned 529 plans
It’s not only students, parents, or guardians who can contribute to 529 plans; non-parental family members can contribute as well. In this case, those 529 plans are not counted as assets under the FAFSA application. However, there are some caveats.
Withdrawals of non-parent-owned 529 funds
If a student withdraws money from a parent-owned 529, that does not count towards their application for FAFSA. However, if their grandparents or rich uncle own the account, 50% of all withdrawals are included in the FAFSA as untaxed income. This can be complicated because a student must renew their FAFSA application every year.
Let’s say that a student has two 529 accounts. One account is parent-owned, while the other account was set up by an uncle. Under 529 account rules, you can only withdraw money for qualified education expenses.
When the student originally applied for federal aid through the FAFSA application before his freshman year, the assets from the uncle’s account was not counted in the student’s assets. However, once that student is in his freshman year, he can draw from both his parent’s and his uncle’s accounts.
Let’s say the student withdraws $3,000 from his uncle’s account and $1,000 from his parent’s account. When the federal government looks at the student’s FAFSA for sophomore year, $1,500 (50% of $3,000) will count as untaxed student income on his FAFSA.
Solutions for non-parent-owned 529s
It may seem a little backward to get punished for supporting your grandson or niece’s higher education dreams. Fortunately, you have a few options available that can help skirt these additional fees.
Transfer to the parent
One option for avoiding income from a non-parent-owned 529 is to transfer the account to the parent. This will usually increase the financial aid a student is eligible for. However, some states will recapture the state income tax benefit if the account owner changes.
Furthermore, because of the 5.64% cap, non-parents don’t have to worry about the funds’ value affecting the child’s financial aid award. However, this could affect the parent’s tax situation, so it’s best to get some professional advice before this endeavor.
Need to know what your tax situation is for transferring a 529 from a grandparent to yourself? Here are some options for tax software that can help you better understand your current tax responsibilities.
Another option is to delay the distribution of a non-parent-owned 529. As far as the federal government is concerned, the funds within a 529 don’t exist when reviewing the FAFSA unless the student made a withdrawal.
For instance, you could delay withdrawals until the student’s junior or senior year, but this comes with one major downside. If you delay the distribution, you might have to pay a lot more money in fees and tax. This is because the 529 money can only be used for qualified higher education expenses.
If you have $50,000 sitting in a 529, and only $20,000 was used for qualified education expenses, the remaining $30,000 will be subject to a multitude of taxes and fees if used for other purposes.
Consolidated Appropriations Act of 2021
During the pandemic, the federal government passed sweeping legislation under the Consolidated Appropriations Act of 2021. As a part of the Act, the law stipulates that withdrawals from non-parental 529 accounts such as grandparents and rich uncles will not be included as income.
Unfortunately, this does not come into effect until the 2024-2025 school year. With that in mind, there’s no guarantee that this Act will remain in place for long, so be sure to prepare accordingly.
How can you avoid the negative impacts of 529 plans?
The only significant impact on the student’s FAFSA application will be felt with non-parent or non-custodial 529 accounts. The easiest way to avoid this is to transfer the 529 to the parent or delay the withdrawal of the plan held by a non-parent.
Another option for parents is to deposit the money they plan to save for their children’s education in their Roth IRA. You can use the money in your Roth IRA for education expenses without paying a penalty and it won’t work against your child when it comes to calculating their financial aid.
How will 529 plans affect the new FAFSA?
Under the Consolidated Appropriations Act of 2021, FAFSA will not include the 50% of income received from a non-parent 529 account
How does a 529 plan work?
A 529 plan lets parents or non-parents contribute money to a government-sponsored investment account that provides both federal and (sometimes) state tax benefits. The money in the plan grows and can be withdrawn tax-free.
- 529 plans are a way to save money for education and receive tax benefits. FAFSA is financial aid backed by the federal government for students applying to college.
- Although a 529 account will affect the amount of aid a student receives through the FAFSA, the effect is minimal.
- In a parent-owned 529 account, the plan is capped at 5.64% of total assets.
- A non-parent or custodian account is not counted towards assets in a FAFSA application. However, withdrawals from this 529 account are considered income from the student, which will affect the FAFSA application.
- You can structure a non-parent 529 to minimize the impact on a FAFSA, including transferring the funds to a nonparent 529 account and delaying withdrawals.
View Article Sources
- The EFC Formula, 2021-2022 — Federal Student Aid
- How Will My 529 Plan Affect My Financial Aid? — Washington College Savings Plan
- What is a 529 Plan? — SuperMoney
- Is a 529 Plan Worth It? — SuperMoney
- How Many 529 Plans Can a Child Have? — SuperMoney
- 529 Plan Tax Benefits — SuperMoney
- 529 Qualified Expenses: A Complete List — SuperMoney
- The Ultimate Guide to Student Loan Refinancing — SuperMoney
- Do You Have to Pay Back Financial Aid? — SuperMoney
- 2021 Student Loan Industry Study — SuperMoney
- Does FAFSA Check Your Bank Accounts For Eligibility — SuperMoney
- Ultimate Guide to Financial Aid — SuperMoney