What Nobody's Told You about College Savings Plans

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Articles and advertisements for college savings plans (529 plans) are everywhere in the media lately. Are they worth the hype? While it is fairly easy to find all the details on how to put money into the plan, how it grows, and how withdrawals are taxed, it is much harder to find information that describes the effect of these plans on financial aid eligibility. The financial aid process may change your contributions to college savings plans from a shrewd investment into a costly mistake.

If you are certain that you won't qualify for financial aid, then 529 palns may save taxes and make sense for you. But bear in mind that financial aid, while based on "financial need", does not mean you have to be "needy" to qualify. This is a complex topic, but a few common principles apply.

First, make sure retirement saving is on track before focusing saving for college. Remember, you or your kids can borrow for college but no one is going to lend you money for retirement. Once the kids have graduated, if you have saved more than needed for retirement, you can use your excess savings to help the kids pay off their student loans.

Different colleges use different financial aid formulas. An elite private school may have its own unique formula. Many other schools follow a common financial aid methodology, which includes computing the family's "Expected Family Contribution" (EFC). Under the EFC formula, the college expects parents to contribute from 22%-47% of their income for college costs. But it expects students to contribute 50% of their income each year. So it may make sense to keep an investment that generates a substantial return in the parents' name. Many financial aid formulas consider 529 plan distributions (withdrawals) to be income to the student. This can reduce eligibility for financial aid.

In addition, while the EFC formula typically expects parents to shell out 5.6% of their assets each year to pay for college expenses, it requires 35% of a student's assets be spent on college. So a student is expected to use $350 out of every thousand in his or her name each year for college costs, while parents are out only $56 out of every thousand of their assets annually. This means that with a 529 paln, you may want to keep it in the parent's name (or better still, the gradnparent's).

There are a few other issues with college savings plans. If your children qualify for scholarships, you may have a harder time getting the money out of a 529 college savings plan. Remember, 529 plans are specialized savings vehicles with limited options for withdrawals without penalties. If you still have money in a 529 plan when the last child finishes college, it will likely cost you a 10% or higher penalty to transform these funds into retirement savings. On the other hand, some retirement savings can be used for college with no penalty.

Unfortunately, college planning is yet another complex area of personal finance, and these general guidelines may not apply to your situation. For a customized review of your situation and how to include the potential for financial aid in the college savings process, consult your Cambridge Advisor.