529 Strategies That Maximize Student Aid Options

Having a 529 plan strategy that maximizes your student aid options is ever more crucial. 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. You have to invest it to stay ahead of inflation. Many people turn to a 529 savings plan—a tax-advantaged plan that can help pay education expenses—to make their money grow. That can be a smart move, but how they later spend their 529 money could be just as important.

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 529s strategically comes in.

When and How to Spend 529 Funds

A columnist advised that 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 in the hopes of getting financial aid in the third and fourth years. That's if the parents expect a high-expense or low-income year. Good advice? We decided to check it out with other experts. The variety of advice we found made it clear that families would be wise to consult a college financing expert for advice specific to their own situation.

Depleting the 529 account first can make sense for some families, Gretchen Cliburn, CFP, director at BKD Wealth Advisors, notes. “If you know your education costs will exceed your 529 savings, I would recommend spending the 529 balance first before borrowing any money.”

But not if you think you might have trouble getting a loan later on. Running through 529 funds in the first two years can backfire, says Joseph Orsolini of College Aid Partners. “Families really need to budget out the four years of college to determine the best course of action with spending savings and borrowing. 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 not be able to borrow in the final years,” he warns. “These students are left without resources to finish college.”

What if you anticipate a fall-off in family income? “Low income is a relative term for people," Orsolini says. "Dropping from $150k to $100k is a huge reduction, but in most cases, it will not result in any 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 with Ami Investment Management Inc. “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 FAFSA and could negatively impact the student’s ability to qualify for financial aid. So when the grandparent is the owner, oftentimes it’s best to leave the money in the 529 plan until the student has filed the final FAFSA (typically 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, $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, publisher and VP of research at Savingforcollege.com. “Families should prioritize $4,000 in tuition and textbook expenses to be paid for 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 expected family contribution 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 tuition for K–12 education at public, private, and religious schools. Those withdrawals will be tax-free on the federal level and in many states as well. So it's now possible to spend down a 529 account even 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 accounts, federally tax-free, to help pay off qualified education loans. That applies not only to the beneficiary; any siblings can also draw $10,000 each.

The SECURE 2.0 Act expanded the use of 529 funds even further. The act, signed into law in December 2022, will not take effect until 2024. When it does, it will allow up to $35,000 of the total balance of a 529 to be transferred to a Roth IRA in the beneficiary's name. The 529 account must have been open for at least 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.

The Bottom Line

Like many financial questions, there are a lot of what-ifs here, but in general, our experts 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 some people.