The best strategy for spending down '529' funds

Should you drain your 529-account savings in the first year of college, or spread it out?

  • By Chana R. Schoenberger,
  • The Wall Street Journal
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We again asked experts to help us answer readers’ questions on paying for college and using tax-advantaged “529” savings accounts for educational expenses.

Q: Should you drain your 529 in your student’s first year of school, or spread it out across the four years of college, supplementing the payments from some other source? What are the pros and cons of each approach?

A: This is a decision most families with 529 accounts will face. Only 37% of families in the U.S. with college-bound children plan to use a dedicated account to pay for all of their children’s college education, according to Fidelity’s College Savings Indicator Study, says Melissa Ridolfi, vice president of retirement and college leadership at Fidelity.

“The benefit to fully exhausting the 529 first is you can then delay any needed loans until later on, therefore incurring less interest,” Ms. Ridolfi says.

Alternatively, she says, one advantage of spreading the 529 out across four years is that it gives the account more of a chance to grow, so it can go further toward meeting the total cost of a college education.

Other considerations include whether the parents own the account or someone else does, and how the family plans to pay for school aside from 529 savings, says 529 consultant Andrea Feirstein, managing director of AKF Consulting in New York.

If the parents own the 529 account, up to 5.64% of the account’s value is reported on the Fafsa financial-aid form, but qualified withdrawals don’t count as the student’s income, Ms. Feirstein says. If the owners are grandparents or anyone else other than parents, the accounts don’t show up as assets on the Fafsa, but withdrawals are considered untaxed student income and considered at up to 50% for financial-aid calculations. Since the Fafsa form looks back two years, you may not want to drain an account owned by someone other than a parent in the student’s first year, she says, because that could have a negative impact on financial aid in later years.

“If financial aid is a possibility, it may be prudent to use other sources for current expenses first, and even consider delaying withdrawals from these accounts until the last year or two of college,” Ms. Feirstein says.

Parents should keep in mind, though, how spreading out or delaying 529 withdrawals will affect the rest of their finances, she says—it will leave less money available for all of life’s other expenses, including contributions to retirement savings, while the 529 money is being preserved.

Some of the education expenses can be covered by student loans, of course. But Ms. Feirstein says family finances should be structured to avoid having to take student loans if possible. “We would always suggest avoiding student loans to the extent possible, as every dollar borrowed has a future cost that can be debilitating if it is unchecked,” she says.

Also note that if you’re planning to use federal education tax credits to offset some college costs, you can’t use tax-advantaged 529 money for the same costs. “If you do, the IRS will consider it double dipping, so you’ll want to factor in whether you’ll be claiming these tax credits when deciding how much to withdraw from your 529 account,” Ms. Ridolfi says.

Q: When I retire, I would like to return to college. Am I eligible to establish a 529 plan? Are there age or income limitations? Can I invest in a 529 plan if I am self-employed?

A: Yes, you are free to fund a 529 for your lifelong-learning goals. Anyone can open and use a 529, Ms. Feirstein says. Unlike Coverdell savings accounts, 529s have no age or income restrictions, and you can open a 529 for yourself or any other person even if you aren’t related (a friend’s child, for instance). There are also no employment restrictions.

Q: Why don’t 529 plans cover college students’ health-insurance premiums? Many universities require students to carry coverage, but this cost isn’t a qualified expense under the 529 rules.

A: You are correct; health-insurance costs don’t count under the 529 rules, says Ms. Ridolfi. But note that laws can change what expenses qualify. Last year’s tax changes now allow 529 funds to be used for private K-12 expenses. So it’s possible that Congress could change the rules on health costs in the future, she says.

Q: Our family has a high net worth, including a 529, but low income, since I am retired. Our son is doing well in high school. I understand he won’t qualify for need-based financial aid, but would he be considered for merit aid? Should we fill out the Fafsa anyway? We’d rather him win a merit scholarship and use the 529 for his graduate studies.

A: Merit aid isn’t tied to financial need. The best way for your son to win merit aid from a college is to get the highest possible grades and scores, so it sounds as though he is well on his way.

But don’t assume your son won’t qualify for need-based financial aid, says Elizabeth Fontaine, assistant executive director of the Massachusetts Educational Financing Authority.

“The federal financial-aid formula is driven more by income than assets,” she says. For this reason, you should submit the Fafsa anyway, as well as any other financial-aid paperwork schools may require. You can also use the Education Department’s free Fafsa4caster site to estimate how much a college would expect you to spend each year on educational costs. Each college’s website should also offer a Net Price Calculator to help you estimate your financial aid, she says.

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