529s Are a Financial Aid Powerhouse

529 college savings accounts have loads of well-publicized benefits: tax-free growth and distributions for qualified expenses, state tax benefits for contributions, gifting pages, and much more. But the unsung benefit of 529s is their preferential treatment in financial aid formulas. How is that?

First, the new simplified FAFSA only has you report the student's 529 balance as an asset, not the student's siblings' accounts. If you are a parent of three and you're trying to decide whether to put money into 529s for each child or just use a taxable account for simplicity's sake, know that dividing that money among the 529s will reduce its value on each child's FAFSA by 2/3 as compared with the taxable account. (The CSS Profile does still ask for all 529s.) If each student had $20,000 in their 529, then each student's Student Aid Index would increase by 5.64% of $20,000 or $1,128. If the total $60,000 were in a taxable account, then each student's Student Aid Index would increase by 5.64% of $60,000 or $3,384.

Second, since distributions from the 529 are tax-free as long as they're used for qualified education expenses, they don't generate income on your tax return. Taking money from a taxable brokerage account or a Roth IRA generates income which is reported on your tax return and then flows through to the FAFSA, which in turn increases your Student Aid Index. And yes, even though Roth IRA distributions are tax-free, they are reported on your tax return and the FAFSA includes untaxed income from your tax return. Suppose you contributed $10,000 to each student's 529 and now it's worth $20,000. When you withdraw that $20,000, you get $20,000 because no taxes are due, and nothing is added to your SAI. Suppose you put the same $10,000 into a taxable account and now it's worth $20,000. Withdrawing that $20,000 would result in $10,000 of income-- which would raise SAI by $4,700-- and a capital gains tax bill on the $10,000 gain. Withdrawing it from a Roth IRA would add $20,000 of income to the FAFSA, raising SAI by $9,400. And of course if you're withdrawing for multiple students in the same year, that income would flow through to multiple FAFSAs.

One of my personal favorite reasons to use 529s isn't about the FAFSA at all. It's this: having dedicated dollars available for college makes it a whole lot easier to have a budget for college and to guide your student towards financial choices that work for your family.