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There Might Be a Big Problem With Your Kid's College Savings

Photograph by Twenty20

College savings are more important than ever, with some experts estimating that a four-year degree will cost $205,000 by 2030. To help ease the cost, many parents (myself included) opt for a 529 college savings account. But as it turns out, our meager contributions may inadvertently pose a problem when the time comes to go to school.

A 529 plan is a tax-advantaged savings plan designed to encourage saving for future college costs. While plans vary by state, most offer a tax benefit (contributions are tax-deductible) and you don't have to pay taxes on the interest earned when taking the money out for educational expenses. The 529 also has a cousin called the Coverdell, which allows tax-deferred growth and distributions for K-12 and college-related expenses.

Sounds Great! So What's the Problem?

Most students will fill out a financial aid application, either the FAFSA (Free Application for Federal Student Aid), which determines eligibility for grants, loans and other funds, or the CSS Profile (The College Board's College Scholarship Service), which is used by member universities to assess a candidate’s financial profile. Need-based financial aid is then determined in part based on the assets disclosed on the form, including your 529.

If your child has too many assets available to them, it may reduce their eligibility for aid.

The assets included in these applications include your home, real estate assets, income, business income, college savings and the amount you paid into retirement savings in the previous year (but not your retirement accounts). Your 529 will be treated more favorably on the FAFSA than the CSS Profile. Your home equity and your family business are included on the CSS, but not the FAFSA.

Long story short, if your child has too many assets available to them, even if they aren't allocated to covering college costs, it may reduce their eligibility for aid. (Please note that this does not apply to merit-based scholarships.)

The Liquidity Problem

One challenge the 529 poses is that the contributions can only be used for college-related expenses, meaning that if your first-born kid lands a full-ride scholarship, you can transfer it to their younger sibling, but if the youngest kid goes to school for free, you'll have to pay a 10 percent penalty and taxes on the interest earned. That, or send an immediate family member back to school to access those funds.

The Grandparent Trap

Some financial planners advocate having a grandparent or another relative open the 529 account, as that means they won't be calculated in the family’s assets when filling out the FAFSA. While the amount inside the 529 will not be counted, any deduction taken in the previous year will be counted as income and must be reported, and is actually weighed more heavily than the value inside the 529.

And no, you can't get around this by getting college loans and paying them off with the 529, because they aren't a qualified educational expense.

The Solution

One option I see more parents take is to open life insurance policies that have a cash accumulation value that they can borrow from the policy at any time, for any purpose. Newer life insurance-investment vehicles (such as Index Universal Life policies) grow with the stock market, giving returns similar to a mutual fund. The added benefits are that all withdrawals are tax-free and the cash value is non-reportable to FAFSA.

It's important to note that not everyone is keen on using insurance policies for college savings. Nailing down the proper allocations of college savings can be tricky, especially as the regulations change on a regular basis. It's best sit down with a financial professional who can work through all the scenarios for your family.

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