The Secret 529 Plan Bonus

I would like to thank Ann Garcia CFP® for writing this very informative article on education planning.  Ann Garcia, CFP®, is a fee-only financial advisor with Independent Progressive Advisors and author of The College Financial Lady blog.  Thanks again Anne!  – Steve Reh

When it comes to college savings, the tax benefits of 529 plans are pretty well-known: tax-free growth and withdrawals and in some states, a tax deduction on contributions. Many people, especially those in states that don’t grant a tax deduction for contributions, believe that tax-efficient investments in a taxable account are just as good a college savings option.

But 529 plans have another, far less well known but potentially much more significant, advantage over taxable accounts when it comes to college savings. To understand that benefit, you first need to understand the financial aid formulas that colleges use.

Financial Aid Formulas

Eligibility for need-based college financial aid is determined based on the student’s Expected Family Contribution, or EFC. There are two methodologies for calculating EFC: the federal methodology which uses the FAFSA form, and institutional methodology using the CSS PROFILE. There are similarities and differences in these forms; for the purpose of this analysis we’ll use the FAFSA methodology because it is more transparent, and for purposes of this discussion it’s reasonably similar to the CSS PROFILE. Keep in mind that about 70% of college students receive some form of financial aid. Even though a good amount of that is merit aid which typically does not consider ability to pay, need-based aid is granted to students coming from families with household incomes approaching $200,000 annually.

The Four Factors of the Expected Family Contribution (EFC)

Four factors go into the EFC: parents’ income and assets and student income and assets. Each of those has a different formula applied to it to determine how much is “available” to pay for college. The formulas generally assume that students have nothing better to do with their money than pay for college, so their income and assets are assessed far more than parents’: 20% of their assets—including checking and savings accounts—are considered available for college and 50% of their income over about $6,000.

Parents, on the other hand, are assumed to have other uses for their money so they get more favorable treatment. The formulas offer (limited) allowances against income (approximately equal to the federal poverty level) and assets (usually around $20,000 for married parents; considerably less for single parents). Several adjustments are made to income—most significantly, income taxes paid are subtracted from income and pre-tax retirement contributions are added back—and the remaining amount, the “adjusted available income,” is assessed in various brackets, much like income tax brackets. The top rate of 47% kicks in at about $32,000 of available income. Parents with household income of around $100,000 could expect their contribution from income to be around $17,500.

Parent assets—including 529, taxable investment, checking and savings accounts but not retirement savings accounts—are given much more favorable status. Only 5.64% of assets above the asset protection allowance count towards the EFC. $100,000 in savings for education—regardless of account type—would only increase EFC by about $1,125. Again, no matter whether the money is in a 529 account or a taxable brokerage account.

The 529 Plan Asset Distribution Advantage

Once you try to use your savings for college expenses, though, the 529 plan becomes vastly superior to the taxable account. That’s because you don’t have to report the gain in the account as income when it’s distributed, either in your tax filings or on the FAFSA. Here’s a simplified example of how that works. Let’s say you are going to use $25,000 from your savings to pay for freshman year of college. You started saving early and your account has doubled in value while you’ve held it, so your basis is $12,500 and your gain (long term) is $12,500. If you took that money out of your 529 account, you would have $25,000 to spend for college, and the following year your EFC would decrease by $25,000 x 5.64% or $1,410.

If you took it out of the taxable account, you’d report that $12,500 as income next time you file the FAFSA. Assuming you already had $32,000 in other available income, this withdrawal would increase your EFC by about $4,500 net of the withdrawn amount.

529 Plan’s Advantage over Roth IRAs

You may be looking at this and thinking, “Why do either of these? Instead, I’ll use a Roth IRA. I don’t have to report it as an asset, plus I get tax-free withdrawals!” The obvious reply to that is, a Roth IRA is for retirement, not college. Setting that aside, Roth IRAs have a bigger drawback than taxable accounts when used to pay for college: even though the distribution may be tax-free, it still must be reported as income on the FAFSA. In that case, even though none of it may be taxable, 100% of the distribution is considered income for FAFSA purposes. That means your $25,000 withdrawal increases your EFC by $11,750.

All in all, parents of college-bound students are far better served by a 529 plan than any other savings vehicle. Your financial advisor can help you find the best plan for your family’s circumstances.

Ann Garcia, CFP®, is a fee-only financial advisor with Independent Progressive Advisors and author of The College Financial Lady blog.