:max_bytes(150000):strip_icc():format(jpeg)/GettyImages-1305308968-00b38ed65fde42e79c94332459e97a3c.jpg)
If you’re the parent of a future college student, you have to save now, but tucking money away in a savings account isn’t going to work. Many people turn to a 529 savings plan—a tax-advantaged plan that can help pay education expenses—to grow their money. Having a 529 plan strategy that maximizes your student aid options is ever more crucial. In the best possible scenario, you would combine 529 funds with help from the government to cover the complete cost of college for your child. But government help is often income-based—and that’s where handling those 529 funds strategically comes in.
Key Takeaways
- Spending all the money in your 529 plan before taking out student loans might make you eligible for more financial aid. However, that strategy can backfire if you’re unable to get loans later.
- Parents with relatively high incomes may be ineligible for aid regardless of how much money they have in their 529 plans.
- A number of tax reform laws have given 529 account holders more options for using their plan’s funding, such as allowing for some student debt repayment.
When and How to Spend 529 Funds
Once a child reaches college, it might work to the family’s advantage to spend all of its 529 funds in the first two years to get financial aid in the third and fourth years—if the parents expect a high-expense or low-income year. But that may not work for everyone.
Depleting the 529 account first can make sense for some families, says Gretchen Cliburn, a certified financial planner and managing director at Forvis Mazars.
“If you know your education costs will exceed your 529 savings, I would recommend spending the 529 balance first before borrowing any money,” she says.
However, this isn’t advisable if you think you might have trouble getting a loan later. Running through 529 funds in the first two years can backfire, says Joseph Orsolini of College Aid Partners.
“Families need to budget out the four years of college to determine the best course of action with spending savings and borrowing,” he says. “I have seen a number of families spend down their 529 accounts in the first couple of years but later run out of money and unable to borrow in the final years. These students are left without resources to finish college.”
What if you anticipate a falloff in family income?
“Low income is a relative term for people,” Orsolini says. “Dropping from $150,000 to $100,000 is a huge reduction, but in most cases, it will not result in additional financial aid. If your child is at an elite college that matches 100% of need, it might be worth relying on this strategy, but most colleges will not increase an aid package simply for spending down your 529 fund.”
The rules can be different for grandparents. “One important aspect to remember while considering when to spend the 529 money is who owns the plan,” says Ryan Kay, a certified financial planner and the founder and president of Arena Wealth Management.
“If a grandparent is the owner, for example, and they distribute funds from the 529 plan, the money will count as student income for next year’s Free Application for Federal Student Aid (FAFSA) and could negatively impact the student’s ability to qualify for financial aid,” he adds. “So when the grandparent is the owner, often it’s best to leave the money in the 529 plan until the student has filed the final FAFSA (typically the junior year of college; deadlines vary by state and college).”
Factor in the Federal Tax Credit
The American Opportunity Tax Credit (AOTC) provides a tax credit of up to $2,500 when you spend $4,000 on tuition, fees, textbooks, and other course materials. However, it phases out at certain income levels ($90,000 for individuals or $180,000 for married couples filing jointly). Also, you can’t use the same expenses to justify a tax-free distribution from a 529 plan—there’s no double-dipping.
“The tax credit is worth more per dollar of qualified expenses than the tax-free 529 plan distribution, even considering the 10% tax penalty and ordinary income taxes on non-qualified distributions,” says Mark Kantrowitz, president of Cerebly Inc.
“Families should prioritize $4,000 in tuition and textbook expenses to be paid using cash or loans before relying on the 529 plan. Otherwise, [it’s preferable] to spend down the 529 plan balance as quickly as possible so that the assets do not persist year after year to reduce aid eligibility by 5.64% of the asset value.”
(The money in a 529 plan is considered a parental asset, and 5.64% is the percentage of parental assets that counts toward the Student Aid Index each year on the FAFSA.)
New Rules for 529 Plans
Three tax reform laws—the Tax Cuts and Jobs Act (TCJA) of 2017, the Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019, and the SECURE 2.0 Act of 2022—also made some relevant changes involving 529 plans.
For example, account holders can now use their 529 plans to pay the beneficiary’s K–12 education tuition at public, private, and religious schools. Those withdrawals will be tax-free on the federal level and in many states. So it’s now possible to spend down a 529 account before your child sets foot on a college campus.
The SECURE Act, signed into law in December 2019, expanded 529 plan coverage to allow for some student loan repayment. Previously, student debt wasn’t considered a qualified educational expense or eligible for tax-free withdrawals. Under the new rules, plan holders can withdraw a lifetime maximum of $10,000 from their 529, federally tax-free accounts to help pay off qualified education loans. That applies to the beneficiary; siblings can also draw $10,000 each.
The SECURE 2.0 Act, signed into law in 2022, further expanded the use of 529 funds. The law allows up to $35,000 of the total balance of a 529 to be transferred to a Roth individual retirement account (IRA) in the beneficiary’s name. The 529 account must have been open for more than 15 years for this to apply, and transfers must still be made according to the annual Roth IRA limits, so it may take several years to meet the $35,000 maximum.
If I Start a 529 for My Baby, Can I Transfer It Into a Roth IRA Before the Child Reaches College Age?
Yes, so long as the account has been open for more than 15 years, you may move up to the annual contribution limit into a Roth IRA in the name of the beneficiary of the 529. If you start the account at birth, you may be able to liquidate some of the funds using this method before the child applies for the FAFSA.
Can I Use a 529 to Pay Off My Student Loans?
If you’re a parent who started a 529 for your child and they are named as the beneficiary on the account, then no, you may not use it to pay your student loans. However, you may change the beneficiary’s name on the account to your own. In that case, you could use up to $10,000 of the balance to pay off student loans.
Does the Money in a 529 Belong to the Owner or the Beneficiary?
Although the money in a 529 should pay for expenses for the named beneficiary, it’s still considered an asset of the parent or whoever opened the account. This means that it isn’t counted as a student-held asset when applying for federal student aid.
The Bottom Line
Like many financial questions, there are a lot of what-ifs here, but our experts generally recommend not spending all your 529 money now and betting on future financial aid. However, they note, the strategy could represent a cost savings for certain people.
