Funding a 529 plan is a great way to invest money for your child's college costs. It works kind of like a Roth IRA -- but for educational purposes. You can't deduct your contributions on your taxes, but you get tax-free growth and withdrawals, as long as the distributions are for IRS-approved education expenses.
But if you expect your child will qualify for financial aid, you may worry about the impact on their award. Read on to learn more.
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Do 529 plan assets affect financial aid?
In a nutshell, yes. But the effect will be minimal.
Your child's financial aid will be based on the information you provide on the Free Application for Federal Student Aid (FAFSA), which considers both the income and assets of the parent and student. If you open a 529 plan for your child, you'll be the owner and your child will be the beneficiary. Money in the 529 plan is considered a parent-owned asset.
But parent-owned assets have a relatively minuscule impact on financial aid. Parent assets (we'll explain what does and doesn't count in a moment) will reduce the student's aid award by no more than 5.64% of the asset's value. In other words, if you had $10,000 invested in a 529 plan for your child, their financial aid would be reduced by $564 at the most (and often less).
Income counts a lot more for financial aid purposes. Parents may be expected to contribute as much as 22% to 47% of their available income toward their children's education. (Note that "available" income and overall income are two different things. Available income can be negative in some circumstances.)
One of the biggest perks of a 529 plan is that distributions don't count as income, as long as they're taken for qualified education expenses, like tuition, fees, books, and supplies.
What else counts as a parental asset?
Many other parental assets are off limits in FAFSA's calculations, including retirement accounts, a family's private residence, life insurance policies, and annuities. However, bank and brokerage accounts, cash, real estate that isn't a primary residence, and the net worth of any businesses with 100 or more employees will count as parent assets.
What's especially important for parents to consider, though, is that while retirement accounts won't count as assets, distributions from retirement accounts will count as income. And remember, income reduces financial aid a lot more than assets.
Parents often debate whether to save for college in a Roth IRA vs. a 529 plan, since Roth IRAs allow penalty-free distributions for higher education. While the account itself won't count as an asset, any Roth IRA distribution would still count as income for college financial aid. That's a big argument in favor of saving for college in a 529 plan instead of a Roth IRA.
Should you invest in a 529 plan?
If you can afford to invest in a 529 plan for your kids, doing so is usually a smart move. Starting as early as possible is key, considering that college expenses typically increase at a higher rate than overall inflation.
An added perk of 529 plans? Beginning in 2024, parents will be able to roll over up to $35,000 in unused 529 plan savings into a Roth IRA for their child. That means even if your kid doesn't need all that money for college, you can still use those funds to give them a head start on retirement savings.
