Meanwhile, the colleges have questions, too. They’re just waking up to the presence of these tax-favored plans and wondering how to handle them. The government has rules on who qualifies for federal aid. But the schools write their own rules when making grants and loans from their own funds.
This year many colleges started asking students to disclose any family 529s on their financial-aid applications. “In the past, schools may not have known that students had these plans until the money arrived,” says Mary Garren, an aid officer at the University of North Carolina in Chapel Hill. The bursar’s office wouldn’t even have noticed the source of funds. Unless a school tags it for special consideration, a payment from a 529 will simply be applied to the bill.
But count on it–in the future, those payments will be tagged. Now that the colleges have discovered that students might have 529s, they’ll want to be sure to factor the money into any aid award.
Defining 529s: The 529 plans (named after a section of the tax code) were authorized by Congress in 1996. They’re run by the states and soon all 50 will be offering plans. They come in two forms:
(1) A prepaid-tuition plan–the conservative choice. These plans guarantee that the money you save today will match the growth in tuition inflation at state-run colleges. Currently, that gives you an average 4.4 percent return. In most cases you can also use the money out of state. Prepaid plans appeal especially to people with modest incomes who are aiming for a state college or university.
(2) A college-savings plan–the more aggressive choice. You contribute to a pool of money that’s managed by the state treasurer or an outside investment adviser. A typical savings plan leans toward stocks when the child is young, then moves toward bonds and cash as college draws near. A few let you choose all-stock or all-bond accounts. You can use the money at any accredited school for tuition, room, board, books and supplies. If your state’s plan is poor or doesn’t disclose performance and fees, you can invest in another state.
Both types of 529s offer tax breaks. All gains are tax-deferred, then taxed in the student’s bracket when the money is withdrawn for college bills. The student pays ordinary income taxes, presumably at 15 percent. Higher-bracket parents would pay 20 percent if they took the gains themselves outside the plan. Some states let you deduct part or all of your 529 contribution on your state tax return. A few even let all the gains pass state-tax free.
The 529 plans help with estate taxes, too–grandparents, dears, take note. For example, the contribution won’t be included in your estate even when your name is on the account. Surprisingly, you can usually take the money back if you need it yourself or if the student doesn’t. But note that when you use 529 funds for something other than school, you’re taxed on the earnings and may owe a 10 percent penalty. Some donors will lose interest in 529s if estate taxes go.
The two plans differ, however, in the way the colleges treat them when awarding aid.
You’re treated more harshly if you’re in a prepaid plan. Every dollar you use for tuition takes a dollar away from your eligibility for aid. Potentially, that means smaller work or study grants, smaller subsidized student loans and less money from funds the schools award themselves. (Of course, that assumes you even qualify for aid.)
By contrast, only a portion of a college-savings plan is counted toward your eligibility for aid. If the plan is in a parent’s name, the college will count no more than 5.6 percent of the money each year. So you potentially qualify for more aid than you would in a prepaid plan.
If the plan is in the child’s name, the school might want 25 or 35 percent of the money annually. But some of the private schools take just 5.6 percent, even from a student account or prepaid plan. “We’re trying to get away from the notion that people get hit harder if they put the money in kids’ names,” says Tom Keane, financial-aid director at Cornell University. Plans in grandparents’ names are another story. When the plans are discovered, some schools assess them at up to 35 percent. Others might use them to reduce aid dollar for dollar.
One last tax point: when the student takes money from a savings plan, the earnings show up on his or her tax return. If counted in the aid formula, those earnings alone could reduce your award by quite a bit, says K. C. Dempster of College Money in Marlton, N.J.
A gamble: So is it worth having a 529? You’re balancing tax savings against possible losses in student aid. In other words, gambling.
If you want to take the risk that you’ll indeed qualify for aid, skip 529s, says Rick Darvis of College Funding, Inc., in Plentywood, Mont. With $70,000 in earnings today, you could expect aid from an expensive private college but probably not from a state school. Be prepared for any “aid” to come in the form of loans.
If you probably won’t get college aid, 529s are a great idea, says savings-plan expert Joseph Hurley in Pittsford, N.Y. For details on all the state plans, see his Web site, savingforcollege.com.
What if things go wrong? Today 529s look terrific; Congress may even make withdrawals tax-free. But tax laws change. Something better might turn up. Your exit cost is taxes plus 10 percent.
The best alternative to a 529 would be a simple mutual fund held in your name. In any case, save, so you won’t be at the mercy of college aid. Your reward for saving is borrowing less.
