3 Most Dangerous Myths About College Savings
Myth 1: College Savings hurt need-based financial aid
Many parents mistakenly think that their kids will not receive financial aid if they set aside funds for college. The thinking comes from assuming that colleges expect parents to pay 100% of these savings before offering need-based financial assistance to the child. This, in fact, one of the most significant myths about college savings.
Colleges determine how much need-based financial aid your child will receive after calculating the Expected Family Contribution (a.k.a. EFC) – based on the information you provide on Free Application for Federal Student Aid (a.k.a. FAFSA Application). While precise EFC is based on a complex formula from this Department of Education guide, assets, and income of the parent (and child) are the two main factors in arriving at the magic number for EFC.
It is true parents’ assets (including college savings) reduce financial assistance to some extent. However, the impact is not as significant as it is generally thought of. Here is why.
The primary residence, retirement accounts, small business run by the family are all outright ignored in calculating the EFC. Next, parents receive asset-protection up to a limit (based on older parent’s age and family size) before EFC kicks in. Out of the remaining assets, at most, 5.64% will be included in EFC.
This means if you saved $30,000 in a 529 plan with you as the owner and child as the beneficiary, and assuming your asset-protection limit is about $20,000 – your child’s need-based package could potentially reduce by a maximum of ($30,000 – $20,000) * 0.0564 = $564. Not very significant, isn’t it?
On the other hand, parents’ income has a more significant impact on EFC. After pre-defined protection, up to 47% of their income is considered the family’s responsibility. So, if you are generating high-income when your child goes to college, income alone could put you out of luck with need-based financial aid for your kid. Accordingly, impact due to saving for college becomes a moot point.
Myth 2: 529 College Savings plan is a use it or lose it proposition
Saving in a 529 is a great way to earn tax-free growth. The idea is you set aside post-tax money into the plan (for a beneficiary), choose investments offered by the program, and use the money to pay for college when your beneficiary needs it. Yes, the growth is all tax-free if used to pay for college for the beneficiary.
The catch is if funds from the 529 plan are not used for college, you will not only pay taxes on the growth; you will be penalized 10% on the earnings. The tax incentives and penalties are to encourage using the funds for college. But, this doesn’t mean you have lost it all because you have not used the funds for college!
For example, if you put in $10,000 into a 529 plan, and over time, thanks to your savvy investment selections, let’s say this fund has become $15,000. You are allowed to withdraw entire $15,000 for non-college financial needs. No questions asked. After all, the money is yours, and you can use it for anything you like! All you need to remember is that you will lose the tax incentives and have to pay taxes on $5,000 earnings. Also, you will have to pay a penalty of $500 (10% of $5,000 earnings) because you used the money for non-college purposes.
Also, in the event you find yourself overfunding 529 assets for a beneficiary, you are allowed to change the beneficiary and use the funds tax-free for a new beneficiary as long as the new beneficiary is a family member of the current beneficiary. The IRS provides a broad definition of a family member, which includes the beneficiary’s blood relatives and relatives by marriage and adoption. The list of who is considered a family member is vast and generally includes grandchildren, siblings, step-siblings, nephews, nieces, spouses, uncles, and aunts!
So, saving in a 529 plan is never “use it or lose it proposition” as some people may make you believe. That thinking, in fact, is a myth.
Myth 3: 529 College Savings distributions are qualified only for undergrad education
It is not true that 529 plan funds must be used only for undergrad education. You can use the funds to pay for grad school or professional school expenses for the beneficiary. For example, if your child goes to a medical school after 4-year undergrad, you may continue to use the 529 assets to pay for med school expenses. The same is true if your child pursues a Masters degree, Ph.D., an MBA, or considers law school.
In addition, thanks to the Tax Cuts and Jobs Act of 2017, parents can now save in a 529 Plan and use the distributions tax-free (up to $10,000 in tuition expenses) to fund the private elementary or secondary school education of their children. This means you could use the funds in 529 accounts towards the costs for educating your 5th-grade daughter in a private institution.
So, what do you think? Do you feel better clearing up some misconceptions about saving for your kid’s education? Good luck!
Did you like the post? Subscribe To my Newsletter
to receive occasional updates/blog posts/newsletter from me. My goal with every email is to provide valuable information that could benefit you.