A little over three years ago when I got the wonderful news that my wife and I were expecting, I already started thinking about college. Yea I’m a planner. You’ve got to start planning early right? I opened a 529 plan without much thought. That’s what everyone does to save for their child’s college tuition and expenses I assumed. Well it seems that there are some people who think otherwise.
Recently, I overheard a conversation where a grandmother offered to contribute to her grandchildren’s college savings account as a gift. The father of the children informed the grandmother that he did not open a 529 account for his kids because he heard that having such an account would reduce the amount of financial aid that the kids would receive. The comment raised my eyebrows but I didn’t think much of it. I just assumed the father was making an excuse because he never opened an account.
Not too long after I overheard this conversation, I was having lunch with a few co-workers, and one co-worker who has college-age children said that he regretted contributing to a 529 plan. He said that he saved all that money in the 529 plan and his daughter didn’t get much financial aid, whereas his neighbor didn’t save much and his child was rewarded with a much better financial aid package. He advised us that we’d be better off taking a home equity loan or having a grandparent open a 529 plan.
I was determined to get to the bottom of this because I didn’t want to save all this money and be penalized for doing so. So I did a little research to see whether what these 529 bashers said had any merit. Before I begin, I want to say that parents should make sure they are saving enough for retirement before they think about saving for their kid’s college education. There are always lower cost options for higher education. There are also student loans, but there are no retirement loans.
First, let me go through the pros and cons of a 529 plan
PROS
-Your money grows tax-deferred
-When you withdraw the money for qualified college expenses, you are exempt from federal taxes
-Some states offer a tax deduction for contributions into your state’s plan. I live in New York which is a highly taxed state so the tax deduction is a great benefit. I learned from Holly who blogs at Club Thrifty that Indiana offers a 20% tax credit for contributing into its 529 plan which is even more awesome.
CONS
-If your child does not go to college and the money is not used for qualified college expenses, there is a penalty to withdraw the money. You can, however, transfer the account to another child or grandchild, or even to yourself.
Now let’s get to the arguments made that there is a penalty for saving in a 529 plan whereby your child’s financial aid will be reduced.
Yes, when you apply for financial aid using Free Application for Federal Student Aid (FAFSA), it will ask you for your assets in the 529 account. FAFSA reduces need-based aid by a maximum of 5.64 percent of the parents’ asset value. So if you have $10,000 in a 529 plan, financial aid could be reduced by $564. Other assets such as a stock account, CD, and savings account are also assessed as 5.64 percent. FAFSA does not, however, consider money that is in a retirement account, a life insurance policy or your home equity (many private college do consider home equity). Assets held in the students name are assessed at a 20% rate so putting accounts in your child’s name will affect financial aid eligibility much more. While saving in a 529 plan can reduce the amount of financial aid your child may receive, 5.64% is pretty negligible when you consider the benefits of the 529 plan. I will continue to contribute to my child’s 529 plan.
Income affects financial aid much more than the assets in a 529 plan.
That is what I said to my co-worker when he argued that the 529 plan was a horrible plan. He and his wife have a pretty high income so I’m sure that played a much bigger role in the reduced financial aid. The parent contribution from income is assessed on a bracketed scale, from 22 percent to 47 percent of discretionary income, and the student contribution from his/her income on the FAFSA is assessed as a flat 50 percent of discretionary income.
How about a home equity line of credit?
My co-worker suggested that he would have been better off if he had contributed extra to his mortgage payments rather than contributing to the 529 plan. While home equity is not considered an asset under FAFSA, many private colleges will consider your home equity in its financial aid calculation. Also, with home equity lines of credit, the interest rate is usually variable so there’s a risk that interest rates will increase making the payments burdensome. There are pros and cons to using a home equity line of credit and you can read more about it here and here.
What if grandparents open a 529 plan for my child?
Assets in a 529 plan that a grandparent opened will not be considered an asset for financial aid purposes. However, if the grandparent withdraws the money from their 529 plan to pay for college expenses, that money will be counted on next year’s FAFSA as income, which may drastically reduce the following year’s financial aid package. Income is assessed at a much higher rate. One way around this issue is if you wait until the last year to use the money from the grandparent’s 529 plan.* Remember: When parents withdraw funds from their 529 plan to pay for qualified college expenses, that money WILL NOT be considered income for purposes of FAFSA.
*UPDATE: A recent rule change taking effect in the 2017-2018 school year, the base-year income on the FAFSA will reflect the student’s income from two years prior rather than one. This will allow a grandparent to use 529 assets a year earlier without impacting the student’s eligibility for financial aid.
How about using a life insurance policy to pay for college?
While reading about financial aid and 529 plans, I stumbled onto a website by a self-proclaimed college financial aid expert salesman. He said that 529 plans were not the best place to save for college because the stock market is too volatile and that there are too many fees. He recommended investing with a variable life insurance policy because it is not counted as an asset when determining financial aid. First let me address the claim by this insurance peddler…I mean college financial aid expert…that the stock market was too volatile. A 529 plan is only a vehicle, you can invest in aggressively or more conservatively based on your risk-tolerance. There are different investment options where you can invest in a mix of stocks, bonds and even CDs. The Finance Buff wrote an interesting post regarding age based 529 plans where the investment becomes more conservative the closer your child gets to college age.
The argument by the “financial aid expert” that investment fees are too expensive was even more hilarious being that he was recommending a life insurance policy, which often have very high fees, expenses and premiums. I’m not sure about other 529 plans, but New York’s 529 plan uses Vanguard funds which have ultra-low fees and expenses. The only truth about investing in a life insurance policy is that the assets there do not count as an asset. However, in my opinion, the cons clearly outweigh that one pro. So if someone suggests taking out a life insurance policy to pay for college, please run for the hills.
Let me just note that some colleges use their own formulas, I mainly went over how the feds do it on FAFSA. Also, I am not an expert on this topic (But at least I’m not a self-proclaimed financial aid expert who peddles life insurance). Make sure you do your due diligence and seek advice from a reputable financial advisor or accountant as these issues can be complicated.
Check out these resources to do your own research:
The College Solution
Fin Aid
Saving For College
How are you saving for your child’s college education?
Personally, I don’t really like the 529. What happens if your kid wants to join the Air Force, or start their own business instead? Or go into what are becoming very lucrative trades such as plumbing, HVAC, etc.? If my kid was 18 and have a business plan, I’d rather take $50k and invest it in their business than spend $150k on college when they don’t even want to go. I mean if you have 3 kids, I’m sure at least 2 will go to college so then the 529 is beneficial, but otherwise I’m not too much of a fan.
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I know others who feel the same way. I don’t contribute a large amount into the 529 plan so it probably won’t be a huge deal if my child doesn’t end up going. And it’s likely that I can transfer it to another child if one does go. I’m a little old-school though…while I wouldn’t mind my child starting a business or going an alternative route, I still would want them to go get a higher education.
HVAC and other trade schools still cost money. 529 money can be used for trade schools. Some are actually quite expensive as they don’t qualify for aid outside of federal loans.
Good to know!
I’ve heard that argument about 529s, but at the end of the day, as you mention 5.64% is not really moving the dial, especially when you consider the overall costs of college. We are using the NY 529 to save money for our son because I am a fan of 529s and we get the tax break in NY. We regularly contribute to this but we also put larger cash gifts that my son receives into this account as well.
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Exactly…5.64% really isn’t a big deal! That’s great that you put larger cash gifts in that account as well…that’s why I like cash gifts! Interesting to know that you’ve heard the argument as well about 529s. I hadn’t heard of it before and assumed it was undisputed that 529 was the place to save for college.
My daughter attends a private college, and I am required to fill out both FAFSA and the College Board financial aid form yearly. The College Board requires you to list 529 plans, retirement accounts, and home equity.
Wow, they ask for retirement accounts too! I wonder if they calculate that in their financial determination. I’d want to know how colleges use the information that is filled out, but I have a feeling they’re pretty secretive about it.
Good info here, Andrew. We are unsure of what means we’ll use to help our kids with college. By the time our oldest starts, we should be mostly debt free, so we’ll have several options. We just need to do more research before we decide on a route.
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Being debt free is the most important!
I know people either love them or hate them. I know my state has one of the best 529 plans although I haven’t used it. As you say though, there are pros and cons. Good information, thanks for sharing.
I didn’t know people hated them…I thought it was what most people used to save for college!
We used the Virginia Prepaid 529 for our kids. One is finishing college this spring. The other is a freshman in college now. In hindsight, I would not have used the prepaid option, but instead just invested in mutual funds in a 529.
The college senior went to a private university, so the prepaid plan didn’t go nearly as far as it would if she went to a public school. We made the deal with them that if they graduate with a 4-year degree and there is money left in their college funds (including the 529), we would split the net (after taxes) 50%/50% with them. She still opted for a private school and will use up just about all of the money. I’m fine with it as she has learned a lot, had a lot of fun, and been in a good, Christian environment. And she’ll graduate debt free!
Now just one more to get through college……
Thanks for your work on this post!
John
John recently posted…What were you thinking?
I’m a big fan of public universities, especially when it is ranked similarly to a private university. But there are circumstances where opting for a private school might be the better decision depending on what field she is going into. And graduating debt free is wonderful!
I, too, am a fan of public universities – I went to one myself! But as you mentioned, there are times that a private school may be a better fit. Plus, in this case, it still fit within the budget we had allocated for her schooling, so all is well!
John
John recently posted…What were you thinking?
We really need to start thinking about college. My son is 10 and it seems so far off but I remember when I was 10, seemed like yesterday. The 529 plan sounds like the pros outweigh the cons. I will be looking into one of these soon.
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Yea, time flies! I can’t believe my son is 2 1/2!
I don’t have any children on the way but we do want to have kids (and ideally 4 – I know, it’s silly to have a number in mind especially past 1 or 2, but my wife has a good argument for 4 haha). Student loans have had a HUGE impact on us the past ~4 years from a financial, emotional, and even health standpoint. My wife’s parents didn’t help at all and we see firsthand what a burden it can be, especially if you go into a field like psychology and need a masters to practice. Anyway it’s made us get on the same page to pretty much save as much as we possibly can for our kids, so this sort of topic is really interesting to me.
I’ve heard that 529 plans vary by State so I’d have to look into what the benefits are for Minnesota’s plan. Overall it seems like the smart thing to do is to max out your 401k, IRA, and HSA before contributing to a 529 plan. Overall I don’t think people have great arguments against a 529, and I’d feel better being proactive and throwing money into it than hoping that things fall in my favor down the line. Definitely a good topic! I started a weekly column/post with PBS Twin Cities so I may have to write about Minnesota’s 529 plan in a future post.
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Pretty cool that you’re writing for PBS Twin Cities. My wife is 1 of 3 kids so she wants 3. I’m 1 of 2 so I’m good with 2. Both of us went to state university so it is a more affordable option, but we definitely like to help with college as much as possible. If Minnesota’s plan doesn’t offer any tax benefits you can use another State’s plan. I’ve read that Utah has a great plan with lots of choices and low fees.
Did now know you could use plans from other states, that’s pretty great.
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I live in PA (home of Vanguard) so they have a Vanguard investment option (in addition to prepaid) for the 529 plan that I’m a big fan of so we would go the investment route. PA’s 529 benefits are great for tax purposes so even if we can’t do a lot, it’ll still be something. While 529s can affect federal aid, PA529s don’t affect qualification for state aid.
I don’t know that much about the prepaid plan since they don’t offer it in NY. Glad that PA has a the Vanguard option…makes sense since it has its headquarters there. Also good to hear that PA offers a tax benefit. Thanks for the tip that the 529 plan doesn’t affect qualification for state aid. I didn’t think of that.
Good research on the topic, I tend to go more the other route, just save in a Roth for myself, and you can always take out contributions when that time comes for tuition. I will hopefully be debt free and I can cash flow the difference too. WE will see maybe lil Sally will get scholarships and wont need the funds. If that’s the case the 529 is not good route.
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Yea, I would prioritize the Roth too. You are allowed to take out contributions from a Roth to pay for tuition, but my understanding is that the withdrawal will be counted as income (on the FAFSA) so it may affect financial aid the following year. Not saying that you shouldn’t count on the Roth to help with tuition…just letting you know for planning purposes.
Ah the Minnesota 529 plan isn’t that great. But I still think it’s better than not saving. I think people should first max out their retirement accounts before participating, bu there is some benefit to not having earnings taxed (the only real benefit of the plan in Minnesota).
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I wish my folks had done a 529. I will definitely do one for my own kids (if I ever have any)! I think there are more pros than there are cons in a 529.
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Yes. The only con that I can agree with is that your child might not decide to go to college.
I’m just starting my research, so I’m not informed yet. Do state-sponsored plans restrict students to attending in state schools, or are they still allowed to spend the money from their 529 at the school of their choice regardless of where it is?
You are not restricted in attending in state schools when you contribute to a state sponsored 529 plan. Generally, if your state gives a tax deduction, it’s probably a good idea to use it. If not, then just pick the one with the best choices.
One other issue is that if you are in a predicament where you will not have a co-signer then you may genuinely wish to try to make use of all of your money for college options. You can get many grants and other scholarships or grants that will ensure that you get money to support with university expenses. Thanks a lot for the post.
Yea students definitely should try to apply to as many scholarships as possible.
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