529 vs IRA for kids education and future scholarship

Question

I have young kids going in preschool. I have already started investing in 529. However, many of my friends mention that if I invest single penny in 529 plan for my kids, they will miss out on any scholarships they may be eligible to in future. Scholarships are good to have during extremely costly college education. Is it true that having 529 (basically money in name of kids) will deprive them of (some or all) scholarships for future education?

I am told that investing in IRA is better option. If my kids end up getting decent scholarship then they many not need financial assistance and I will be able to save for my retirement. And even if the money is in IRA, I can give it to my kids after my retirement if the need arises. Does that make sense? or there is still a case to invest in 529 vs IRA.

Answer 1

First off, we should clarify what you mean by "529 - money in the kid's name". Usually, this means that the parent sets up a 529 account in their name, but puts down their kid as the beneficiary. Therefore the parent is the custodian, or the "owner" of the account. However, if the student is both the beneficiary and the custodian of their own account, that is treated differently when it comes to calculating student aid.

Let's assume you are the custodian, and your kid is the beneficiary. Then, say you have a 529 or IRA account with $100,000 for college and plan to withdraw $25,000 a year. (Note, this also assumes that you are allowed to make withdrawals from the retirement account without penalties.)

For the 529 account, only 5.64% of the balance is used to calculate student financial aid. When you withdraw from the account, it is not reported (since it was already counted as an asset). Therefore, for a $100,000 account balance in year one of college, only $5,640 is counted as an asset, and the withdrawal is "free". For year two, only $4,230 is counted as an asset.

For a parent owned retirement account (IRA or otherwise), it is not counted as an asset, but any withdrawals used to fund education are calculated at 50% for the next year's FAFSA. So if you withdraw $25,000 to cover college in year one, $12,500 would be counted as an asset for year two.

If you use one or the other for all four years, the 529 is definitely the way to go. The amount used to calculate financial aid is much less than the retirement account. The amount would also be much less than the tax-free gains you would see from the investments inside the account.

But, you could also use the 529 account for the first three years, then the retirement account to pay for year four. That way the IRA withdrawal wouldn't matter since the child has already graduated. However, you as a parent may pay more taxes due to having a large lump-sum withdrawal from the retirement account (assuming it is a traditional).

What if my kid gets a scholarship?

In the cases where the student receives a grant/scholarship and you have a 529, you have two choices:

• Keep the money in the account and later change the beneficiary to a different child. Therefore, you have to contribute less towards kid #2's education.
• Withdraw an amount equal to the award from the 529. This avoids the 10% tax penalty for unqualified withdrawals, but you would still pay income tax on any investment gains (as well as any contributions that were not taxed by your state).

Answer 2

There are long articles, and full books that address this topic.

In general, the answer is yes. Money available is treated according to how it's owned. And your retirement accounts don't count towards that formula, but money in a child's name does. Keep in mind, your income and other assets also count towards the expected parental contribution. This is why we saved for college from the time our daughter was a baby.

Even though we retired before college started, we still had enough income from our account withdrawal to not qualify for financial aid, and once I understood this, stopped bothering with the FAFSA form.

Also note, there are need-based aid, and scholarships that are merit or interest-related.

Your plan might work, depending on the numbers when the kids start going off to school, but, it seems to me, an IRA may not be enough to store the kind of money you'll need at college time. And it will impact your actual retirement, unless you are also saving an additional 10-15% in 401(k) or other long term savings.