Since their creation in 1996, 529 college savings plans have become a popular vehicle to help parents save money to help pay for their children’s ever-increasing higher education costs.
Assets in 529 plans grow tax-deferred, and distributions from them are tax-free as long as they’re used to pay qualified educational expenses for the beneficiary, such as tuition, fees and books.
Another attractive benefit is that the owner of the plan can change the beneficiary whenever they want to.
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That’s why some parents establish and fund a single 529 plan to help pay for the college costs of all of their children. This can be useful for parents of children with significant age gaps.
However, it’s not a good strategy if you have more than one child in college at the same time. Why? Because each 529 plan can only have one beneficiary at a time.
Here’s another reason: If you’re planning on using the Free Application for Federal Student Aid (FAFSA) to apply for financial aid for your child, the value of a 529 plan you own may negatively impact the amount of financial aid your child is eligible for.
A potential problem solver for parents
Establishing separate custodial 529 plans for each child, or splitting one large 529 plan up into separate, smaller custodial 529 plans, may help solve both of these problems.
Here’s why: Recent updates to FAFSA have eliminated certain benefits that sometimes resulted in lower out-of-pocket college costs for parents with multiple children in school or for divorced or separate parents.
Let’s take a look at these key changes and then discuss how 529 plans fit into the process.
The all-important 'out-of-pocket-expenses' number
In the ’olden days’ it was called the Expected Family Contribution, or EFC. Now it’s called the Student Aid Index, or SAI. Basically, it means the same thing — the percentage of a student’s college costs FAFSA determines that the student (or, more accurately, their parents) should pay out of pocket, based on the applicant’s income and assets.
Higher income usually results in a higher SAI, which usually translates into less financial aid (and, thus, higher out-of-pocket costs).
Supposedly the updated FAFSA process is more beneficial because it allows more of your own income and your child’s income to be left out of SAI calculations.
However, this update also removed certain longtime benefits that previously resulted in lower out-of-pocket costs.
No more benefits for parents with several kids in college at the same time
In the past, FAFSA would reduce your parental EFC if you had two or more children in college.
Now, FAFSA no longer cares how many kids you have in school when calculating your overall SAI. This could significantly raise your out-of-pocket expenses, especially if your family income is $100,000 or more.
No more 'who you live with' benefits for divorced parents
When parents are divorced or separated, only one parent needs to report their income and assets in FAFSA. In the past, this parent would be the one at whose home their dependent college student child was living. If this parent had significantly lower income than their ex-spouse, this could result in a lower EFC — and thus more financial aid.
Now, it doesn’t matter where the dependent child lives. FAFSA now requires the filer to be the parent who provides the most financial support for the child.
As before, only that parent needs to report their income and assets. But if they’re making much more money than their ex, this could result in a higher SAI.
Assets count, too
In addition to income, FAFSA also considers a family’s net worth. Parents and children must enter the value of all of their liquid assets, including money in bank accounts, CDs, taxable investment accounts and, yes, their own 529 plan accounts.
Retirement accounts and real estate don’t need to be included. Also, 529 plans established by grandparents with their grandchildren as beneficiaries don’t need to be entered in FAFSA, either.
This impact can be considerable. Student-owned assets can increase the SAI by 20% of the asset value. After certain allowances, the value of parental assets can increase the SAI by up to 5.64% of the assets’ amount.
Considering that married parents no longer receive “sibling breaks” and divorced or separated parents can no longer take advantage of “who our child lives with” benefits, it may be in everyone’s best interests to try to lower the financial aid-reducing impact of assets.
Where do 529 plans fit into all this?
If you own one 529 plan that was originally meant to help pay for the college costs of all your children, its overall value could work against you if you’re trying to maximize each child’s eligibility for financial aid.
That’s because when you’re using FAFSA to apply for financial aid for one 529 plan beneficiary, you have to enter the entire value of the 529 plan, even if you’ll only be using a small portion of it to pay for that child’s college expenses.
This same issue exists even if you’re the account owner for separate 529 plans you’ve established for each of your dependent children. You’ll have to include the value of all of these separate 529 plan accounts as parental assets even if you’re only filing a FAFSA for one child.
Fortunately, there may be a solution
You may be able to get around this issue by splitting a large 529 plan into separate custodial 529 plans for each dependent child. With custodial accounts, each child is both the account owner and beneficiary.
If you already own separate 529 plans for each child, you could transfer all of the money out of each plan to establish a new custodial 529 plan for each child.
These transfers are done through full or partial direct 529 rollovers. In most cases, these rollovers are tax-free if you’re moving these assets into a 529 plan in the same state, although you’ll want to confirm this with your 529 plan provider.
Using this method, you’ll only have to enter the value of one child’s smaller custodial 529 plan into FAFSA when you’re applying for financial aid for that child. The assets in those plans will still be considered parental assets for SAI calculation purposes.
This strategy can be particularly beneficial if you have more than one dependent child in college at the same time. Since you file separate FAFSAs for each child, you’ll only have to include the value of their individual custodial 529 plan account in each separate application.
But — it might be not a good solution for CSS filers
Some colleges require parents and students seeking financial aid to file a CSS Profile as well as a FAFSA. The CSS Profile is used by some colleges and scholarship programs to award non-federal financial aid to students in need. Each college that requires applicants to fill out the CSS Profile may use a different methodology to weigh the impact of parental and student assets on aid decisions.
Other issues to consider
Considering that FAFSA only counts a maximum of 5.64% of parental assets in its calculation of SAI, establishing separate custodial 529 plans may not significantly reduce out-of-pocket expenses.
Also keep in mind that if you split one large 529 plan into several different custodial 529 plans, you may have to pay enrollment fees and annual account maintenance fees for each plan. You’ll have to decide how the investments in each plan should be invested. And you’ll have to manage distributions from each plan and keep track of gifts to each plan made by you or other people.
And, if you have younger children, there’s a chance that at some point FAFSA may make more changes to its methodologies that reduce or eliminate the potential SAI-reducing benefits of this strategy.
That’s why before you make any changes to your 529 plans, you may want to speak to an accountant or a financial adviser to determine whether this strategy makes sense for you.
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This article was written by and presents the views of our contributing adviser, not the Kiplinger editorial staff. You can check adviser records with the SEC or with FINRA.
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