Thursday, November 14, 2013

How does 529 work?

Some questions people always ask about 529:
1. What cost can it be used for?
It can be used for both tuition, rent, and board. But not for the cars:P

2. Does it affect financial aid?
The first wrong conception that most people have is that: if the kids have the 529, they could not get financial aid. The formula to calculate the financial aid includes: parents asset, 529, and income. The income plays more important factor than the others. Usually the 5% of asset is calculated to offset the needs of the financial aid. The 529 is calculated as parents' asset even the title is the kid's name. So it doesn't hurt to have a 529 otherwise the money under 529 is probably in the saving account  or other kinds of assets.

3. What happens if the kids get scholarship or financial aid?
The financial aid is calculated in the need basis, but it is given in the form of scholarship.

Some people are afraid that if the kid gets the scholarship, the money in 529 gets wasted. It is not true either. Even if the kid gets scholarship, the kid still can draw the money out of 529. For the amount that matches the scholarship part, one pays income tax on the growth part and there is no penalty. Considering the kid’s income is not high, tax rate should be fair. For example, the total cost of tuition fee, living expenses etc is 60k and the scholarship is 40k (30k is for tuition fee waver, 10k as cash). For the first 20k from 529 withdrawn, one doesn’t pay any tax. For the next 40k withdrawn that matches the scholarship, one pays income tax. The kid’s income could be 10k + 40k/2(it depends on the growth of the 529 portfolio, I assume 100% growth here). The tax rate 30k should be much lower than the parents tax rate if parents are both working professionals.


Assume one set up a broker account instead of 529. The deposit is 100k and grows to 200k. When one gets money out to pay the kid’s tuition, the tax rate is for the long term capital gains for the growth of 100k.  Not just that, if one does reblanace on the account, it could not leverage the compounding effect as a 529 account. So in 10 years, with the same amount of 100K deposit, the outcome in a 529 account could be much higher than a regular trading account. The theory is similar to how the Roth IRA works.


4. Comparing 529 with giving the same amount of money as gifts, what is the benefit?
When the kids have a saving/investment account, the financial aid formula uses 20% of the asset to offset the financial aid needs. For the 529 account, it uses around 5% instead. For the gift giving account, the kids can use to buy luxury stuff and pay anything. For some professors, they may prefer to give money as a gift instead of opening a 529. As some universities pay their employees' children's tuition. 


If the account is a 529 account and the kid doesn't have any financial aid or scholarship at all, one pays no tax on 100k at all. It is hard for middle class to get financial aid, and also most college provides loan instead of cash as the financial aids.


If the account is a 529 account and the kid gets FULL scholarship, when withdrawing the money, the kid needs to pay income tax on 100k. The kid’s income is at most of the double of the living cost. As today, it is around 40k.  The chance to getting full scholarship is less than 1%.


If one is rich, 529 will never hurt. As inheritance tax rate is very high for over 3M assets. Only if one is very confident that the kids can get full scholarship or financial aid in cash,  having a 529 with fair amount of money doesn’t hurt at all.

Harvard and Princeton are very generous to give financial aid, and here is the formular they are using:


Keep in mind that, not all schools are so generous to give cash, instead they are giving a loan what most people would like to stay away from. Even MIT and Berkerley only gives the freshmen cash as needed financial aid. The followings years, the financial aid is in the form of loan or work-study programs. 

A great book: Save College:
http://goo.gl/xYDaPz
Some reference:




1 comment:

  1. The most important part of the 529 is the tax deferred compounding.

    ReplyDelete