Is there a Financial Aid Penalty for College Savings?
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By Mark Kantrowitz

September 3, 2020

Some people argue that families should not save for college because college savings will cause the student to qualify for less need-based financial aid.

Like most myths, there’s a kernel of truth to this myth. There is a penalty for saving for college (or for other purposes), but only a slight penalty, if you save in a 529 college savings plan. 

Reporting of 529 Plans on the FAFSA

Normally, an asset is reported on the Free Application for Federal Student Aid (FAFSA) based on the account owner. However, 529 college savings plans have special treatment.

  • If a 529 college savings plan is owned by a dependent student or the student’s parent, it is reported as a parent asset on the FAFSA. Distributions from such a 529 plan are ignored.
  • If the 529 plan is owned by an independent student, it is reported as the student’s asset on the FAFSA. Distributions from such a 529 plan are ignored.
  • If the 529 plan is owned by a grandparent, aunt, uncle or other relative, it is not reported as an asset on the FAFSA, but distributions count as untaxed income to the beneficiary.

If a dependent student’s parents are divorced, a 529 plan that is owned by the non-custodial parent will be treated the same as a grandparent-owned 529 plan. A 529 plan that is owned by the custodial parent – the parent who is responsible for completing the FAFSA – is reported as a parent asset on the FAFSA. 

Non-qualified distributions are reported as income to the recipient on the FAFSA.

How the FAFSA Assesses Income and Assets

Income and assets are assessed at different rates on the FAFSA, depending on whether the asset is reported as a student asset or a parent asset. Likewise, income is assessed at different rates on the FAFSA, depending on whether the income is the student’s or the parent’s.

  • The assets of a dependent student are assessed at a flat 20% rate with no asset protection allowance. So, $10,000 in the student’s name, such as an UGMA or UTMA account, reduces aid eligibility by $2,000. But, a custodial 529 plan account is treated as a parent asset on the FAFSA.
  • There are two different formulas for assessing the assets of an independent student, depending on the type of independent student. If the independent student does not have any dependents other than a spouse, the student’s assets are assessed at the same 20% rate as for dependent students. But, if the independent student has dependents other than a spouse, their assets are assessed on a bracketed scale with a top bracket of 3.29%. So, $10,000 in the student’s name will reduce aid eligibility by either $2,000 or up to $329, depending on the type of independent student. 
  • The assets of a parent are assessed on a bracketed scale, with a maximum rate of 5.64%, after subtracting a small asset protection allowance. So, $10,000 in the parent’s name, including custodial 529 plan accounts that are owned by the student, reduces aid eligibility by up to $564.
  • Distributions from a grandparent-owned 529 plan (or a 529 plan owned by anybody other than the student or parent) are assessed at a 50% rate after subtracting an income-protection allowance. The income protection allowance is $6,840 in 2020-2021 and is subtracted from total student income, including taxable and untaxed income. So, a $10,000 distribution from a grandparent-owned 529 plan will reduce aid eligibility by up to $5,000.

Use our Financial Aid Calculator to estimates the expected family contribution (EFC) and your financial need.

This chart summarizes the impact of a 529 plan on eligibility for need-based financial aid.

Impact of 529 Plan on Aid Eligibility

Account Owner
Reduction in Aid Eligibility Maximum 
Reduction 
per $10,000
Dependent Student Up to 5.64% of asset value $564
Independent Student (Without Dependents) 20% of asset value $2,000
Independent Student (With Dependents) Up to 3.29% of asset value $329
Parent Up to 5.64% of asset value $564
Grandparent, Aunt, Uncle or Other Relative Up to 50% of distribution amount $5,000

The actual reduction in aid eligibility depends on the income and assets of the student, income and assets of the parents, household size, number of children in college at the same time, and age of the older parent.

There are also workarounds for a grandparent-owned 529 plan, such as waiting until January 1 of the sophomore year in college to take a distribution (if the student will graduate in four years) and to rollover a year’s worth of expenses from the grandparent-owned 529 plan to a parent-owned 529 plan in the same state after the FAFSA is filed. 

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