In this segment from the episode of Motley Fool Answers, Robert Brokamp and Alison Southwick interview Brock Jolly and Tim McFillin from TheCollegeFundingCoach.org about how 529 plans can affect a college student's financial aid. The Free Application for Federal Student Aid (FAFSA) determines the expected family contribution largely based on income, not assets like a 529 plan.
A full transcript follows the video.
This video was recorded on April 10, 2018.
Robert Brokamp: Myth No. 3. "529 plans will dramatically reduce any chance my kids have of receiving merit or need-based aid."
Tim McFillin: This one comes up all the time. Parents say, "Why would I do a 529 plan? This could hurt my eligibility for getting financial aid." I understand their logic, but like Brock mentioned earlier, the biggest driver, by far, of the formula for the FAFSA that determines your Expected Family Contribution is your income. After they make the deductions and depending on the parents' age and some other factors, your income essentially counts at roughly 47% against you; whereas an asset, a parental asset [which is what a 529 plan is considered] only counts at up 5.64% against you.
Let's say you've got two kids or three, and let's say you've got $100,000 in combined family 529 plans. It doesn't matter which kid it's in. It's considered a parental asset. That $100,000 will reduce your financial aid eligibility on the FAFSA by $5,640 if your income exceeds $30,000-35,000. For most families in this area, even if you have a significant amount in there, it's not going to necessarily completely bump you out of getting financial aid.
The other thing is if your income is high enough, you don't want to be planning for need-based financial aid. You need to be planning for reducing costs, taking on subsidized Stafford loans, finding ways to get grants and scholarships, and doing whatever you can to reduce those out-of-pocket costs. That's more of the important thing. And I use my stepsister as the shining example. I'm sure I've mentioned her before.
She got into Stanford, and she got offered zero dollars. My stepdad went to Stanford, so he wasn't going to tell her no, but I know they were sweating bullets because Stanford costs $70,000 a year, roughly, times four years. There's no way they could help her afford it. They need to retire at some point. They're behind on retirement. They know that. And fortunately, she also got into Georgia Tech, and they offered her a 100% free ride. Why? Because Stanford doesn't need to.
McFillin: Everybody's top of their class. Everybody's near valedictorians that's going to Stanford. They don't need to incentivize students with necessarily a ton of merit aid, but they will give you a lot of need-based aid if your family doesn't have the income. You've got the brains but not the bucks; otherwise they know you're probably willing to pay to have that red bumper sticker.
McFillin: Georgia Tech knows Tim's stepsister Lydia is not going to Georgia Tech unless we heavily incentivize her and guess where my parents wanted her to go? Georgia Tech. She graduated with the same engineering degree. Got the same consulting job with Deloitte. Living in Atlanta, now. Has zero dollars of debt vs. having $300,000 of debt at 5-7% interest.
Brokamp: Any advice about the timing of 529 withdrawals? This might have more to do with who owns it. I know a lot of people who have grandparents, for example, who have opened up 529s for their grandkids.
Brock Jolly: It's interesting. I always say to parents that a 529 plan is a great tool, but it's not necessarily a great strategy. You think about those parents who were sending their kids to college in 2000-2002 and 2008-2009 and, all of a sudden, the market went down in value significantly and parents thought they had done a good job of saving. That's just one example.
But to your point, with grandparent-owned 529 plans, generally speaking [and this could be grandparents, or aunts and uncles, but somebody other than Mom and Dad], in the financial aid formula, a 529 plan is always considered a parental asset, even if it's funded with custodial account money, which is sometimes a little confusing.
But if it's a grandparent or a [529 plan owned by an aunt or uncle, or a neighbor], it doesn't show up on the formula until the point at which distributions come out of the plan. When distributions come from the plan, it can be considered untaxed income for the benefit of the child. And untaxed income can count at a rate as high as 50%. So, again, the key is, and the strategy here is to draw that line in the sand, and then you can [make a determination]. If you're not going to be eligible for need-based aid, it doesn't matter. But if there's a chance that you may be eligible for need-based aid, it matters a lot.
I've seen situations where very well-intentioned grandparents put money into a 529 plan, or even gifted stocks and things like that. There's lots of strategies, there. Again, very well-intentioned and a good objective, but the problem is it can really prevent that child from maximizing their need-based aid eligibility. So, caveat emptor. Buyer beware. Before you go down that path, just make sure you understand the rules of the game.
McFillin: I would add that if your kid is getting some form of financial aid and you're going to use [529 plans from] grandparents or aunts and uncles for the benefit of the kid, use it toward the end of their college, because it counts as income the following year. If you use the 529 plan their senior year, and they're getting financial aid, it counts against them, but not until the next year anyway.
Brokamp: Ideally, they have graduated.
McFillin: Exactly. That's the other rule. Get your kid to graduate in four years, because the average matriculation rate is closer to six.