How 529s Affect Scholarships (and Vice Versa)
529s Are Designed to Work With Scholarships
A 529 plan is a type of tax-advantaged investment account specifically designed for college savings. With tax-free growth and withdrawals for higher education, it’s widely considered the best account to use when saving for higher education.
However, many parents worry that having a chunk of change set aside for college could impact their child’s eligibility for scholarships or other financial aid. And what if the child does get a scholarship and the full amount isn’t needed for school? Can you still access the leftover money?
Here’s the high-level answer: 529s don’t impact merit-based scholarships and they can minimize the impact of savings on need-based grants. Plus, if you get a scholarship, you can withdraw the amount of the scholarship without any penalty.
Before we dive into the detailed answer, however, there are a few things to know about financial aid.
First, there are several types of financial aid. These include scholarships, grants, loans, and work-study programs. The important difference to remember is that unlike loans, scholarships and grants don’t need to be paid back.
There are a number of factors that go into determining a student’s eligibility to receive financial aid, which types they qualify for, and the amount they can get. And it’s typical for students to use several of these in combination to pay for college, along with savings and family income.
For the purposes of this article, we’ll focus on scholarships and grants (i.e., stuff that doesn’t need to be paid back). While terminology can be confusing, at a basic level we can define the difference as merit-based scholarships or need-based grants.
How a 529 Impacts Scholarships
The good news is that for merit-based scholarships, 529 savings have no impact. And while it doesn’t hurt to be a straight-A student, depending on the organization providing the scholarship, there are a variety of “merits” besides grades that may be taken into account.
These include sports, extracurricular activities and interests, clubs, essays and other competitions, major or field of study, and more. Plus, there are tons of scholarships out there, given by the colleges and universities themselves, alumni organizations, private donors, companies, communities, and other organizations.
For need-based grants, 529 plans do have some impact, but they can also help to minimize the impact of college savings vs. savings in other types of accounts.
What Need-Based Means
The most common grants are provided by the federal government, but states also typically have grant programs. Many other organizations, institutions, and communities also offer grants to students based on need.
For the federal government and most other grant-giving institutions, eligibility is determined using FAFSA, or the Free Application for Federal Student Aid. Based on the information you provide when completing the FAFSA, your Expected Family Contribution (EFC) will be determined.
From there, the Federal Student Aid Office calculates the student’s Financial Need by subtracting the Expected Family Contribution (EFC) from the total Cost of Attendance (COA), including tuition, fees, room and board, books and supplies, and transportation. The difference is the student’s Financial Need, however, the resulting financial aid package (including grants and loans) may or may not actually cover your total Financial Need. For this reason, it can be risky to avoid saving for college hoping the financial aid will fill in the gaps.
The ownership of the 529 account also makes a difference in the impact it has. Since 529s are typically assets owned by the parent, they are usually assessed at up to 5.64% for EFC. This means the student's aid package is reduced by a maximum of 5.64% of the asset's value. On the other hand, a student-owned asset (like a trust or custodial account) is assessed at the much higher rate of 20%.
If the 529 is owned by someone else (e.g., grandparent), the account has no impact until you begin taking withdrawals. Those must be reported as untaxed income to the student which impacts the following year’s financial aid.
Some schools may also use the CSS Profile in assessing eligibility for financial aid, however. This form uses a different methodology in counting a family’s assets and might have specific exemptions for 529 plans. For example, assets in a grandparent-owned 529 plan are not reported on the FAFSA, but students may be asked to include them in the CSS Profile. Only a few hundred schools use the CSS Profile, so unless your student is attending one of these, it’s unlikely to impact your student’s financial aid eligibility.
How Scholarships Impact 529s
What if your child earns a scholarship and you no longer need all the money you’ve saved in your 529? While you can always withdraw your original contribution without taxes or penalties, the “earnings” portion is subject to a 10% penalty if it’s not withdrawn for qualifying expenses.
However, 529 plans offer a special exemption for scholarships. If your child earns a scholarship, you are able to withdraw the amount of the scholarship without paying the penalty.
But, you will have to pay taxes on the earnings portion of the withdrawal, so it’s a better idea to spend it on other qualified expenses or change the beneficiary if the money is not needed by the original student.
The Bottom Line
While financial aid eligibility formulas are subject to change and there may be state- or school-specific exceptions, in general, 529 plans are designed to be supportive if you qualify for scholarships or grants.
For students who do receive a scholarship, the amount of it can be withdrawn without penalty from the 529 account (or it can be used for a wide range of other expenses.)
Merit-based scholarships aren’t impacted by 529 plans, and because the value of these plans is assessed at a lower rate, they can minimize the impact of savings on eligibility for need-based grants.
Whether they have college savings or not, many students find that there’s a gap between the actual cost of college—including tuition, room and board, books, and more—and the financial aid package they receive. A 529 plan can help to bridge that gap and enable the student to graduate with less (or no) debt.