The Truth About 529 College Savings Plans

There is a great flaw in the college financing system that people seem unwilling to mention.  It sounds great…if you can, put some money aside so you can save for college.  When your child is ready to go, they’ll have a nice little nest egg waiting for them without the extra stress of how to pay for a higher education.  The most talked about college savings option is the 529 plan.

The way the college financing system is currently set up punishes families that have scrimped and saved throughout their children’s growing up years to put their kids through college and instead rewards families with less.  If you are a family that made sacrifices to save for your kids’ education in a 529 plan, the schools/government will reward you by offering you the potential for a full price tuition.  Families that either weren’t able to scrimp and save or chose not to are rewarded with the potential for a discounted tuition because they are more eligible for financial aid, merit scholarships and grants (free money). In a land of equal opportunity, does that seem like a fair system?  To better understand, and before you make the leap into college planning investments, we need to peel the marketing off of the 529 plans and show you how they really impact your child’s education cost.

Here in Washington State, you’ve undoubtedly seen ads for the GET program.  This state run 529 plan has a large and effective advertising campaign.  A 529 plan, is a tax advantage college savings plan designed to help families set aside funds for college tuition costs down the road.  There are two types of 529: a regular 529 through your advisor or a state funded 529 (GET).  Any gains earned on the account are tax free IF they are used for qualified higher education expenses.  If you take the money out for anything other than a qualified higher education expense, you’ll pay tax on the gain in the account plus a 10% penalty on that gain.  

As we are cuddling our little bundles of joy, we can’t help but imagine what their lives will be like.  For many of us, the expectation that they’ll attend college is a given.  Which makes the idea of setting aside money great.  But should it be in a plan that can only be used for qualified education expenses?  As your child grows up, how many unforeseen roadblocks will they encounter?  As your child develops, maybe it becomes clear traditional college isn’t the best route for you child. Would you prefer to then access your own money without the risk of a penalty if you child chooses a different route?  529 Plans are easy to set up, but before you do, ask yourself what are you not being told about these plans?

To better understand what’s not being discussed, you first need to understand EFC.  The information you report on your Free Application for Federal Student Aid (FAFSA) is used to calculate your Expected Family Contribution, or EFC.  Your EFC is a measure of your family’s financial strength and is calculated according to a formula established by law. Your family's taxed and untaxed income, assets (529 plans included), and benefits (such as unemployment or Social Security) are all considered in the formula.  Schools use the EFC to calculate the amount of federal student aid you are eligible to receive.  The lower your EFC, the better your chances at qualifying for “Need” based aid as well as getting offered discounts on tuition from the schools (institutional grant money).

For example, a family that has “need”:

The School’s Tuition Cost:  $30,000

Minus the EFC:                 -$10,000

Equals the amount of need to which that family could be eligible:   $20,000

Some financial experts have said 529 is kept off the FAFSA.  This is not true.  Any 529 is considered an investment on the FAFSA and like all investments must be listed. This ultimately impacts EFC.  As you can see, the higher your EFC, the less eligibility for aid.

What happens if your grandparents decide to set up a college savings plan for you and open a 529 plan?  It can increase your EFC.  You will have to report the asset when asked about grandparent held assets. Also when the grandparent distributes money to the student it is considered money received or paid on behalf and will show up as income to the student, which will increase your EFC as well. 

What happens when you draw from a 529?

Qualified Education Expenses are limited to students who are pursuing a degree on at least a half-time basis and can go towards: tuition, fees, books, supplies, equipment, and the additional expenses of a "special needs" beneficiary. You CANNOT include the following expenses:

• Insurance, sports or club activity fees, and many other types of fees that may be charged to your students but are not required as a condition of enrollment
• A computer, unless the institution requires that students have their own computers.
• Transportation costs
• Repayment of student loans
• Room and board costs in excess of the amount the school includes in its "cost of attendance" figures for federal financial aid purposes. If your student is living off campus, ask the financial aid department for the room and board allowance for students living at home with parents, or living elsewhere off campus, as the case may be.
• Taking time off to travel

If you’ve managed your distributions perfectly, once you child graduates, your 529 should be depleted.  But, that is not always the case.  Unless your student is planning postgraduate education, or you have another child in the family to whom you can transfer the plan, you'll be left with a 529 account that will incur tax and a 10% penalty on all earnings.

Like any investment that seeks gains via the stock market, the amount you put into and earn is subject to market volatility.  After the crash of 2008, many people saw not only their retirement accounts take a hit, but also their college savings accounts. And because a falling stock market is often caused by a sputtering economy, losses in 529 accounts often coincide with government cutbacks in student financial aid or rising tuition at state schools.  This means you ended up with less money for college, less aid available and higher tuition costs.

Aside from stock market volatility and limited investment options, there are other drawbacks to 529 plans including, eligible schools and No Individual Protection. Many junior, technical and vocational colleges will not accept money saved from a 529 plan. And if you want to study abroad, you need to carefully research the study program.  Funds available to a college student in a 529 plan are not protected from creditors or third parties. Should a family have assets seized or other judgments levied against them, the 529 plan would be considered a repayment vehicle, and could be used in court settlements.

If you are using a 529 plan, you can assume that because you were responsible and saved for college you get the privilege of paying for it full price while others who didn’t scrimp and save get it on sale!  The college financing system is not equal, but since this is the way the system is, understanding the system and knowing how to lower your EFC can equalize the playing field.

Crystal Anderson is the president of Crystal Clear College Planning, which helps Seattle-area families plan financially and academically for college. Learn more about our free local workshops on planning for college.