529 Plans Can Increase College Cost

Female college student sitting on a bench with a laptop computer
Savings in 529 Plans may actually increase the cost of college

If you do the right thing and plan for your child or grandchild’s college education by contributing to a 529 plan, you would expect that to be a good thing, right? However, a 529 plan is frequently what you shouldn’t do. The truth is, a 529 plan can have negative consequences and make college cost more expensive.

With a 529 plan assets grow tax-free. The big financial firms like tax-free growth because it leads to bigger account balances and higher management fees. The longer-term nature of 529 plans allow financial firm to collect fees for a longer time. 

Why a 529 Plan May Increase the Cost of College

The fact that savings in a 529 college saving plan can increase college costs may sound improbable, if one doesn’t fully understand how college tuition is paid. Nevertheless, contributions to a 529 college saving plan can truly increase the cost of college. This is because 529 plans makes it appear that more money is available to pay for college expenses. 

You need to understand that not all students in the same school and programs pay the same tuition. College tuition often depends on what the student and their family can afford. What you end up paying is not the stated tuition, but is instead the Expected Family Contribution (EFC). 

Most schools request parents to complete a FAFSA form, which stands for Free Application for Federal Student Aid. What you disclose on your FAFSA determines what you pay for tuition and college cost.

Wall Street doesn’t train advisors on how to structure assets for FAFSA calculations in a way to benefit parents. Instead, Wall Street just asks parents to invest more money in 529 plans for college. This basically just generates more investment management fees for the firms. This is shameful! 

Often, higher earning parents don’t bother to file a FAFSA because they just assume there would be no benefit. However, frequently they can qualify for benefits, if they know how to structure their income and assets.

Understanding What the FAFSA Form is Looking for

The FAFSA form is more like a budget review than an income-limiting statement. A higher income by itself may not disqualify the family. In fact, the FAFSA form does not ask for the parents’ gross income. It instead asks for the IRS reported Adjusted Gross Income (AGI) which can be more manipulated. Many expenses can reduce AGI. Self-employed people can investing more in their business reducing AGI in the short term. If you own rental real estate, investing in more, making improvements, or borrowing more on the rental properties, you can also reduce cash flow and lower your AGI. 

The FAFSA form is looking for net income not gross. It asks for the amount of taxes paid because this reflects on the amount of deductions you have. For example, a higher home mortgage expense and other itemized deductions can reduce taxes paid. The number of college students in the household also has a significant effect. 

The point is, by restructuring your personal finances you reveal less cash flow available to support college expenses. Surprisingly, by temporarily adding debt through a larger mortgage, you could reduce your taxable income and the cost of tuition. And counter-intuitively, buying a more expensive personal home could also reduce your cost of tuition. 

More important than current taxable income is how the FAFSA calculations determine what savings are available to support tuition. The FAFSA calculations assume that most tuition costs will be come from savings and far less from current income. The saving component on the FAFSA is more important than the income for most families. Saving and investment values count three times more than income when determining the expected family contribution, EFC. This is fortunate because savings and investments are easily restructured for favorable FAFSA calculations.

The first things FAFSA calculations reviews are savings held for the child’s education expenses. These include education savings accounts (e.g., Coverdell savings, 529 savings plans, and 529 prepaid tuition plans). All savings held for the child’s education expense will be extracted for college expense before tuition aid is considered.

You would think there would be some reward or kudos for saving for college expenses. However, the money within a 529 plan is extracted before other calculations determine if assistance is available.

Goals for Completing the FAFSA Form

The goal in completing a FAFSA form is to make less money appear available for tuition. Savings should not be kept in the student’s name or education saving account. Such saving would be considered 100% available for college expenses without consideration of otherwise available assistance. This includes all saving, checking, and investment accounts in the child’s name and any investments in 529 plans. 

However, FAFSA assumes that only 25% of money held in the parents’ name is available for college expenses. This means that saving money held in the parents’ name is far better than in the child’s name. Reduced college savings result in reduced cost of college tuition, or reduced EFC. Reducing college savings can increase tuition grants and other support, when compared to having money in a 529 plan. Of course, you don’t get the same tax benefits as a 529 plan. We will discuss a better tax advantaged solution later on this page.

As steps are taken to reduce the parents’ apparent available income, parents’ available savings available should also appear less. This is much easier to do. You can eliminate the parents’ savings due to the narrow way FAFSA calculates funds available for college expenses.

Most colleges do not consider the value of the parents’ home. Money held in life insurance, annuities, tax-deferred IRAs, 401(k)s, and pensions is not available to support children’s college expenses. They see that money as sacredly devoted to retirement or death benefits and absolutely not available for college expenses.

Most parents’ assets can be hidden from the view of the FAFSA form by placing them in cash value life insurance, annuities or tax-deferred retirement plans. After graduation, these assets can be converted back to spendable assets.

Assets You Should Try to Reduce

What investments should or should not be reported on the FAFSA forms? The forms directions say:

  • Investments include high equity real estate (do not include the home in which you live), trust funds, UGMA and UTMA accounts, money market funds, mutual funds, certificates of deposit, stocks, stock options, bonds, other securities, installment and land sale contracts (including mortgages held), commodities, etc. 
  • Educational assets including qualified educational benefits or education savings accounts (e.g., Coverdell savings accounts, 529 college savings plans and the refund value of 529 prepaid tuition plans). 
  • Investments do not include the home you live in, the value of life insurance, retirement plans (401[k] plans, pension funds, annuities, non-education IRAs, Keogh plans, etc.) or cash, savings and checking accounts already reported in questions 41 and 90. 

(Source: 2017/2018 FAFSA. p.9)

Actions to Take for Grater Tuition Assistance

One solution to help students qualify for greater tuition assistance is to reduce the visibility of the family’s liquid assets. This can be easily done by liquidating stocks, bonds, mutual funds and similar assets not in retirement accounts. Further, by moving the proceeds along with cash and savings in to shorter term insurance or annuity products. This removes these assets from the FAFSA calculation and may save a boatload of tuition.  

In order to also reduce reportable FAFSA income, borrow additional on your business or rental properties and move the proceeds into insurance or annuities so those proceeds also are not counted.

Borrowing additionally on your house increases your mortgage deduction, and reduces your taxable income. (However, one must take into consideration the $750,000 mortgage limit imposed by the Trump 2017 tax changes.) Moving the proceeds from the additional mortgage debt into an insurance product prevents these additional liquid assets from being counted as available for tuition.  

When your child graduates, liquidate the insurance product and payoff whatever you borrowed, to make your taxable income lower. The gains on the insurance product are deferred until the cash is taken out. Withdrawals from insurance product may cause taxable gains, but who cares if you saved a lot of tuition dollars! Normally, I advise against borrowing money to make an investment. But in this case, it is only for the short-term. Plus, you are investing in a secure fixed or indexed insurance product guaranteed not to lose money. Avoid using a variable annuity or variable life product for this purpose because it could lose value.

It is also possible to put money in a tax-deferred retirement account, removing the funds from the FAFSA calculations. But deposits into tax-deferred accounts are restricted due to IRS annual contribution. The lack of liquidity of these tax-deferred accounts is another reason they are not suitable for this purpose. Simply put, it is too expensive to take the money out of a tax-deferred account to pay down debt later.

In contrast, it is easy to put a large lump sum into a shorter-term (4 to 6-year) fixed annuity, or in a special form of highly liquid life insurance called a MEC. (See Chapter 13 of my book for the advantages of MECs, which can be designed to be more liquid and could earn more than a fixed or indexed annuity.)

Another way to reduce AGI taxable income, as well as reduce the apparent value of investments, is to borrow more on these investments. The FAFSA requires you to report the net value of investments (value after debt). For example, borrowing more money on a rental investment property will increase expenses, reduce the cash flow and reportable AGI, in addition to reducing its reportable net investment property value. By also placing the proceeds from the borrowings into an insurance product, you remove that cash from the FAFSA calculations. 

If you own your own business, making large investments in your business may also improve the FAFSA calculations, as well as ultimately improving your business. 

Regardless of whether you are using an annuity, a MEC, or cash value life insurance you will need to work with an insurance professional, one who knows how to select and structure a product for this short-term purpose.

You will need to consider a conservative way to invest this money for two reasons. First, it is only held for a short period of time. Second, you will need this money sooner rather than later for paying off debt you created, and you cannot afford risk.

A Better Tax Advantaged Way to Pay For College

Restructuring your assets before college expenses occur, as shown above, could save you a lot of money. However, it is not very tax efficient. Fortunately, there is a better way, if you have enough time to properly save for college expenses. Consider contributing $250 to $400 per month into an IUL cash value building life insurance contract where your child is the insured. The parents remains the owner and beneficiary of the policy, so control remains with the parent. With the child as the insured, the cost of insurance is low, allowing the policy’s cash value to grow faster.

FAGSA calculations do not count the cash value of IUL policies. As discussed in Chapter 8, there is no taxation on the growth because the money is in life insurance. Further, if you borrow from the cash value during the tuition years, there is no taxation on the money borrowed to pay college expenses. This is a great alternative to a 529 plan. You can, at your option, pay the borrowed money back by just continuing to place the monthly $250 to $400 into the policy and continue to build cash accumulation value.

This IUL cash value can be used later for a huge retirement cash flow for the child, for a house down payment, or both. Another advantage is no further health qualification will be needed if this policy stays in force. Ownership of the policy can be given or willed to the child, or ownership could be held in trust for the child’s benefit.

A life insurance policy based on the parent’s life can also be used to fund college expenses. Again, you need to work with an investment and insurance professional knowledgeable about how to structure plans for these purposes. The earlier you begin structuring your finances for college planning, the better. But some changes can still make a difference, even after college has already begun.

Go to the Calendley.com calendar link below to schedule an appointment with a college plan expert, Curtis Hill. Discover how there are better plans than 529 plans for preparing and saving for college expenses.