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FINANCIAL AID
A Threat to Financial Aid?
by Kristin W. Davis

As parents shovel money into tax-advantaged college savings plans, a niggling doubt is emerging: Will saving in a 529 plan today hurt a student's chances for financial aid tomorrow?

When figuring how much aid to grant a student, colleges consider the wherewithal of the family to pay the bills. Any savings you have weigh against the amount you receive. When parents hold assets in ordinary taxable accounts, the impact is usually small. But 529 plans -- named after the section of the law that allows earnings to remain tax-free if the money is used to pay college bills -- are relatively new, and no one knows how heavy the hit will be for this class of assets.

Double whammy

For now, money in these plans is assessed gently by financial-aid formulas that determine how much a student's family should pay versus how much aid will be offered. Money in a 529 plan is considered a parental asset, so no more than 5.6% of it is assumed to be available to pay college bills each year.

But what the arbiters of aid haven't decided is whether a distribution from a 529 plan also should be considered student income. That's critical because such income reduces aid 50 cents on the dollar (after a modest allowance that protects the first $2,330). So a $20,000 withdrawal from a 529 plan could reduce aid eligibility by $10,000, assuming the student's allowance had already been used up. Even if only the earnings in a 529 were considered income to the student -- rather than the full payout -- the aid offset easily could outstrip the tax benefits of using the plan.

The federal aid formula for another newly enhanced college-savings tool -- the Coverdell education savings account -- is both explicit and horrible. Coverdells are considered student assets, so aid eligibility is reduced by 35% of the balance each year. And distributions -- both principal and earnings -- are treated as student income. Unless the formula changes, Coverdells are the worst place to have your college savings if you expect to qualify for financial aid.

The good news is that if you prefer the investment flexibility of a Coverdell, you can roll the account into a 529 plan at any time without tax consequences. (Although contributions to a Coverdell are limited to $2,000 a year for any one student, your investment choices are almost unlimited. With 529 plans, on the other hand, annual contributions are almost unlimited, but investment options are restricted to a few offered by the plan.)

A wild card

Because few families have yet to use money from 529 savings plans or Coverdells, financial-aid officers don't seem to have the double-whammy issue on their radar screens. "I wasn't aware of that complication," says Joe Paul Case, director of financial aid at Amherst College. But, he says, regardless of how the official formulas treat 529 income, he'd be inclined to take it out of the equation when awarding the final aid package.

Duke's director of financial aid, Jim Belvin, agrees. "We're not going to assess it in both places," he says. "We don't want to do anything to create a disincentive to save." It might, however, be up to you to nudge an aid director to discount the income, and some won't interpret the matter the way Case and Belvin do.

Since most upper-income families (say, those with $100,000 to $125,000 in income with only one student in college) won't qualify for need-based grants, they can generally ignore the uncertainty. But families with modest incomes are in a quandary until aid policies are settled. The Department of Education says it will decide how to treat 529-plan income in time for next year's financial-aid season. And if the result is unfavorable, it's likely that the 529-plan community will lobby Congress for friendlier rules.

One approach is to contribute now with an eye on "actions you can take down the road," if double assessment against 529 plans becomes the established aid practice, says 529-plan expert Joseph Hurley. You could, for instance, take most of your 529 distributions in the last year and a half of a student's academic career, when they are no longer captured by the aid formulas. One caveat: Distributions are tax-free only in years when you have qualified education expenses, so you'd want to avoid overfunding the account.

Or you could make a philosophical decision that money in the bank (plus the 529 tax break) is better than the uncertain prospect of financial aid -- 60% of which these days is loans -- and then cross your fingers that the double whammy gets nixed before you have to use your savings.