How to Use a 529 Plan Strategically

Impact 529 plans on financial aid

How to Use a 529 Plan Strategically

Published May 9, 2024

Impact 529 plans on financial aid

Saving money in a 529 plan for college expenses puts you ahead of the game. However, you need to know how to use the money the right way. You can avoid costly mistakes by understanding its effects on financial aid and how to mitigate them.

How a 529 Plan Works

A 529 plan allows parents, grandparents, guardians or the student  to save money for future college expenses. The key benefits are tax-deferred growth and withdrawals if used for qualified educational expenses.

Before making decisions, ask yourself these important questions:

  • Who owns the 529? The federal financial aid system has different rules for a 529 owned by a parent, guardian or the student than one owned by grandparents or other family members.
  • Is the student likely to be eligible for need-based aid? If so, you need to be aware of who will report 529 assets, since that affects need-based aid. If the student isn’t likely to get need-based aid due to the family’s finances, then it doesn’t matter. 
  • How are the assets performing? A 529 allows you to invest money in a variety of assets and benefit from the gains. This might influence which resources you draw on to pay for college expenses and when. For example, you might delay withdrawing from the 529 if it’s in a fast-growth period.
  • Does a scholarship reduce your need for the 529? If your child receives a full or partial scholarship that reduces or removes your need for the 529, you can still access the money if you do it right.

Impact of Using a 529 Plan on Financial Aid

A 529 plan can affect how the government views your financial situation and what aid you qualify for. The plan’s impact depends on who owns the plan, how it’s used, and whether student’s FAFSA filing status for federal aid is dependent or independent.

Importantly, a 529 plan can affect your Student Aid Index (SAI), the government’s measure of financial aid eligibility.  

As the chart below shows, who owns the plan is a key factor. SAI is affected if the 529 plan owner is a parent of a dependent student, a dependent or independent student, or a divorced parent of an independent student who filled out the FAFSA. In those cases the plan is considered an asset, which can affect how the government views a family’s financial need.

However, there’s no impact on SAI if the owner is a grandparent or a divorced parent of a dependent who did NOT fill out the FAFSA. 

Further, 529 distributions (vs. assets) have no impact on SAI no matter who owns the plan.

OWNER OF 529 PLAN
SAI IMPACT OF 529 ASSETS
SAI IMPACT OF 529 DISTRIBUTIONS
WHEN TO USE 529 DISTRIBUTIONS
Parent of Dependent StudentCustodial Parent Asset, Assessed at 5.64%NoneAny Year of College
Dependent StudentCustodial Parent Asset, Assessed at 5.64%NoneAny Year of College
Independent StudentStudent Asset, Assessed at 20%NoneAny Year of College
GrandparentNoneNoneAny Year of College
Divorced Parent of Dependent Student Who Fills Out FAFSACustodial Parent Asset, Assessed at 5.64%NoneAny Year of College
Divorced Parent of Dependent Student Who Does Not Fill Out FAFSANoneNoneAny Year of College
Parent of Independent StudentNoneNoneAny Year of College

So, it may be more advantageous if the 529 is owned by a grandparent, other family member or certain divorced parents vs. a married parent.

In fact, with changes to FAFSA, a 529 owned by another relative does not have any implication on a student’s financial aid if the school only uses FAFSA to determine student need. However, if your school of choice uses the CSS Profile from the College Board instead of the FAFSA, all 529s are treated as available assets no matter who owns them.

Notably, under the new FAFSA rules, in the case of divorced couples only the parent who provides the most financial support for the student during the year includes their financial information for FAFSA. Therefore, the parent who does not include their information on the FAFSA does not need to report the 529 they have for the student and that money does not affect the student’s financial aid.

In addition, another new FAFSA change is that only the student’s 529 amount is reported to FAFSA, not the 529 accounts of other children in the family. So, parents could move the college student’s 529 balance to the other children’s 529 accounts when reporting to FAFSA and move the money back to the student’s account after FAFSA has been processed, making it look like the student does not have money in a 529 account.

Are Contributions to 529 Plans Tax-deductible?

More than 30 states, along with the District of Columbia, provide a state income tax deduction or credit for contributions to 529 plans. Typically, to qualify for these tax benefits, taxpayers are required to make contributions to the 529 plan offered by their home state.

The following nine states offer tax deductions if you make a contribution to any 529 plan, not just the state sponsored plan:

  • Arizona
  • Arkansas
  • Kansas
  • Maine
  • Minnesota
  • Missouri
  • Montana
  • Ohio
  • Pennsylvania

Another advantage is that most taxpayers don’t need to maintain their money in a 529 plan for a specific amount of time to claim a state income tax benefit. 

Taxpayers can make a contribution to a 529 plan, quickly withdraw funds for college tuition expenses, and still receive the state income tax deduction. However, states like Montana and Wisconsin have closed this loophole by setting minimum holding periods, while Michigan and Minnesota calculate state income tax benefits based on the yearly net contributions minus distributions.

Distributions from a 529 that are used for qualified school expenses are free from income taxes.

You can also get income tax benefits using the American Opportunity Tax Credit and the Lifetime Learning Credit, but you can’t use both tax benefits on the same college expenses.

The best bet is to use up the tax credits first, and then use the 529 funds on remaining expenses.

To avoid penalties, make sure you withdraw money from the 529 in the same year it will be used for educational expenses.

If your student is able to get a scholarship that reduces or eliminates the need for the 529 funds, you can withdraw the amount of the scholarship from the 529 each year to use for other purposes.

You will pay income taxes, but only on the capital gains. In this situation, the 529 essentially functions as a Roth IRA.  However, beginning in 2024, you can convert up to $35,000 to a Roth IRA tax and penalty-free if you’ve held the 529 for 15 or more years.

What Are Qualified Expenses for a 529 Plan?

Using 529 money for non-approved expenses triggers significant financial penalties, so it’s best to be aware of what “qualified expenses” are.

Money in a 529 can be used for tuition, books, and room and board.

Room and board expenses only qualify if your student is enrolled in school at least half-time. 

What many parents don’t realize is the number and types of schools that qualify.

If your student decides to become a chef, you may be able to use the 529 for a culinary institute. Hundreds of international schools also qualify.

Qualified Expenses

Besides room and board, your child can use money from a 529 for books, supplies, computers, internet access, and software.

Off-campus rent and groceries can also qualify, but only up to the limits of actual expenses or the allowance for room and board included in the school’s federal financial aid calculations, whichever is less.

If the apartment rent, utilities, and food go beyond that allowance, other financial resources should be used.

Unqualified Expenses

It’s vital not to be caught off-guard by the expenses you can’t use a 529 for. Approved computer software does not include games, and furnishing and entertainment costs also don’t qualify.

Most importantly, transportation back and forth to school does not count as a qualified expense. If you use money from a 529 for airline tickets, gas, or other transportation expenses it will cause financial penalties.

Are You Using Your 529 Strategically?

If you don’t qualify for need-based financial aid, you may choose to spread your use of the 529 over the entirety of college.

This is particularly true if the assets in the fund are performing well.

However, for most families, if available, it’s best to use parent-owned or student-owned 529 funds 529 funds during the freshman and sophomore years, and grandparent owned 529 funds during junior and senior year. The logic for this is to use up parent or student owned assets first, since these assets are reported on FAFSA and could have an impact on financial aid, if your student is determined to have financial need by the college. If your student will not receive financial aid from the college, then when you use 529 assets and from which owner, will not have an impact. 

You never know how school will go for your child. Many circumstances can cause people to change their mind about college.

If your student chooses to leave college after a year or two, it’s best for them to have used the 529 instead of having debt.

It’s always great when a family has planned ahead and saved for at least some of their children’s college education, and a 529 is a great vehicle.

Knowing the ins and outs of the plan are crucial to your family getting all the benefits from it.

_______

Use R2C Insights to help find merit aid and schools that fit the criteria most important to your student. You’ll not only save precious time, but your student will avoid the heartache of applying to schools they aren’t likely to get into or can’t afford to attend.  

👉 Looking for expert help on the road to college? See our Preferred Partner List!

Other Articles You Might Like:

How My Average Student Got a Full Ride to College

How Grandparents Can Pay for College with 529 Plans

Teen Jobs May Come with a Bonus: Scholarships

JOIN ONE OF OUR FACEBOOK GROUPS & CONNECT WITH OTHER PARENTS: 

PAYING FOR COLLEGE 101

HOW TO FIND MERIT SCHOLARSHIPS

 

SaveSave

SaveSave

SaveSave

SaveSave

SaveSave

SaveSave

SaveSave

SaveSave

SaveSaveSaveSave

SaveSave

SaveSave

SaveSave

SaveSave

SaveSave

In this article:

Upcoming Events

Similar Articles for You

Dear Roadie, My Son Struggles in AP Courses. Is The Stress Worth It for College?

Advice

Dear Roadie, My Son Struggles in AP Courses. Is The Stress Worth It for College?

Dear Roadie, My son wants to load up on AP classes his senior year because he thinks it will impress...

6 Types of Insurance for College Students and How to Save on Them

College Life

6 Types of Insurance for College Students and How to Save on Them

Navigating insurance options is essential for college students to protect their health, belongings, and finances. However, many people aren’t aware...

How to Write a College Essay That Works

Apply

How to Write a College Essay That Works

Millions of high school students apply for college each year, and many have to write at least one college application...

Become a Member

At Road2College you’ll find everything you need to make the admissions and paying for college process less stressful and more transparent.

TOOLS

Explore R2C Insights™ — your source for finding affordable colleges and merit scholarships.

Coaching

Get coaching on admissions and college financing.

Community

Join Road2College where parents and experts work together to inform and inspire college-bound families.