529 loophole

Source: Understanding the new financial aid treatment of 529 plans by Joe Hurley, founder, Savingforcollege.com

529 plans let the parents to put money aside for educational expenses of their and their dependents. In general, they can withdraw the money (contirbution and gains) tax-free to pay for educational expenses.

529 loophole

A new law passed back in February 2006 had removed student-owned 529 plans and Coverdell education savings accounts from the expected family contribution (EFC) in the federal financial aid formula.

We now have the interpretation from US Department of Education.

A 529 account or Coverdell ESA is considered an asset of the account owner; however, 529 accounts or Coverdell ESAs owned by a dependent student are excluded from the FAFSA. Most undergraduates are dependents for FAFSA purpose.

This is exceptional treatment, as student assets are generally assessed at a 20% rate (2007-08 school year) in determining the EFC.

Example:

John and Jill have been saving for their son Billy's future college expenses by purchasing mutual funds in Billy's name under the Uniform Transfers to Minors Act (UTMA). They've saved some income taxes by having the investment earnings reported on Billy's tax returns through the years.

But Billy will be enrolling in college this fall 2007 and those investments are now going to be assessed at a 20% rate in determining Billy's eligibility for federal aids.

Under the new law, John and Jill can dramatically improve Billy's aid eligibility by liquidating his current investments and moving the money into a 529 plan with Billy as both owner and beneficiary.

Provided the assets are moved to the 529 prior to filing the FAFSA, they will be removed completely from consideration.

Here is where things currently stand:

--The financial-aid changes were effective starting the 2006-07 school year.

--The law as written permits dependent students owning 529 plans and ESAs to exclude those assets from the FAFSA.

--Starting the 2007-08 school year, the asset inclusion factor for student-owned assets is lower to 20% (from 35%).

--Moving money from a student-owned or UGMA/UTMA investment into a 529 plan requires that the investment first be liquidated. Capital gains may be triggered causing income tax and a possible decrease in financial aid due to the income inclusion factor. Careful planning is necessary.

--Don't be too quick to shift your parent-owned investment assets, including your own 529 accounts, to a 529 account under your child's ownership. (If the student is a minor, most 529 plans will require an adult custodian on the account - UTMA 529 account.) The potential financial aid benefit is small, as parent assets are assessed on a sliding scale that tops out at only 5.64% and the transfer is irrevocable. If Congress decides to re-work the laws, it will be too late to take your money back from your child.

--There's been no change with respect to grandparent-owned 529s naming the student as beneficiary; they are not reportable on the FAFSA. However, the U.S. Department of Education has yet to clarify whether a distribution from a grandparent-owned 529 plan to pay for the student's college expenses is reportable as student income.

--Schools may distribute their own scholarships and grants under non-federal formulas. The changes described above will not necessarily affect school-based grants. In fact, an increase in a student's federal aid may cause some schools to offer less school-based aid.