Jason Nowitzki, CRPC
529 Plans and The Financial Aid Consequences
Ownership and financial aid considerations
Before exploring what are some investment strategies in regards to 529 plans, there are some important points to consider first. It is very important to understand the financial aid rules that apply to 529 plans and the ownership of the plan. Under the federal methodology, both parent owned and student owned 529 plans are assessed as parent assets. Under the institutional methodology, however, student owned 529 plans can be treated as a student asset depending on the college. This can be a big difference in a financial aid award since 5% of parental assets are added to the Expected Family Contribution (EFC) and 25% of student assets are added to the EFC. If the account value was $100,000, the resulting difference in EFC would be $19,360 if the 529 plan was in the student’s name.
Another point to keep in mind is a 529 plan owned by a third party, such as a grandparent. Even under the Federal Methodology, the reporting of the asset is not required, however, once a distribution takes place for qualified college expenses, the distribution is treated as untaxed income to the student on the FAFSA (Free Application For Federal Student Aid). This could result in 50% of the distribution being assessed.
Prior to investing in a 529 plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s qualified tuition program. In Illinois, for example, residents can deduct up to $10,000 ($20,000 for married couples) from their income from combined contributions to all of their 529 plans for that tax year. In addition, the contribution portion of rollovers from out-of-state plans in Illinois also qualify for the deduction in the tax year that the rollover takes place. Please consult a tax advisor for more details.
Age Based Investment Options
Most 529 plans offer age-based investment options. These options take the child’s age into account in determining the mix of stock, bond, cash and alternative investments. The younger your child, the more aggressive the fund will be. Once the child hits specific ages, the funds automatically shift to a fund that is more conservative. These age-bands vary by plan. Some plans have even taken risk tolerance into account as well by offering age-based options for different levels of risk, some slightly more conservative than the others.
Age based options are appropriate for parents that are emotionally comfortable with high allocation to stock funds when the child is younger and also want a plan that they can “set and forget” since they will automatically adjust the risk of the fund as the child gets closer to college.
Static Investment Options
Static options, also sometimes knows as target or asset allocation options are funds that have a specific model of investment mix between stocks, bonds and cash. Unlike the age based options that start aggressive and become conservative over time, the static option maintains the same allocation as long as you hold the fund. Typically there will be anywhere between 5-7 different options from as high as 100% stocks to the most conservative that can be 100% in a money market fund. The investor can change to different funds by choice.
The static option can be appropriate in several situations. If as a parent that is not comfortable with risk, you might find the age-based option to be more aggressive than your comfort level. It might be better off to maintain a less aggressive portfolio long-term than to react to market drops by making changes after you experience a loss. Also, if your child reaches the next age band in the age-based options during periods of high market volatility, the portfolio might become more conservative, not giving you the chance to allow the market to recover. The money market fund might be an option if your child is a senior and you need to quickly re- position cash for tax or financial aid purposes.
Individual Fund Options
Some 529 plans offer the option to invest in individual funds. This allows you much more control over the funds included in your portfolio, much like you might see in a 401(k) plan. Some plans might have 20-30 different individual funds from multiple investment managers.
The individual fund option might be appropriate for a sophisticated investor with higher balance accounts that might want to avoid certain areas of the market. The downside, however, is that the 529 rules only allow for two investment changes per year which could limit an investors ability to manage the plan investments. For investors, either the static option or age-based options may be more appropriate.
Investing in 529 plans or other securities mentioned involves risk, including possible loss of principal. There is no assurance that the techniques and strategies discussed are suitable for all investors or will yield positive outcomes. To determine which investments or strategies may be appropriate for you, consult your financial advisor prior to investing.