Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / How the FAFSA Simplification Changes College Savings
Transcript
- Lucas: For years, the golden rule of college savings was simple: max out the five twenty nine plan, protect the retirement account, and pray the financial aid formula doesn't penalize you too hard. But as we sit here in October twenty twenty six, that rule book is being rewritten overnight because the Department of Education just finalized the long-awaited simplification of the FAFSA process. Luna: Right, and I think most parents still think it's just about filling out fewer pages, but the actual asset exclusions are what change the math entirely. Lucas: Exactly. The old formula treated almost every dollar sitting in a taxable brokerage account as available parental income, which crushed your eligibility for grants and subsidized loans. Under the new rules starting with the twenty twenty seven to twenty twenty eight award year, certain retirement-related assets and even some small business holdings are now completely excluded from the calculation. Luna: So if you have money parked in a regular brokerage account instead of a five twenty nine plan, you might actually be hurting yourself less than you thought. Lucas: That is the counterintuitive part. Historically, we told people to dump everything into tax-advantaged vehicles like five twenty nine plans or 529 prepaid tuition contracts because those counted differently. But now, the new formula looks more closely at discretionary cash flow rather than total net worth. This means liquidity matters more than ever. Luna: Does that mean families should be pulling money out of those five twenty nine plans to keep it liquid for unexpected costs? Lucas: Not necessarily pull it out, but rethink the allocation. A five twenty nine plan is still incredibly powerful for tax-free growth, but the new FAFSA treats distributions from these plans as student income, which has a higher penalty rate than parent income. So timing withdrawals becomes a strategic game. Luna: Wait, student income gets hit harder? That seems harsh compared to how parent income is assessed. Lucas: It is harsh. Student income is assessed at a flat twenty percent contribution rate, whereas parent income can vary based on a sliding scale. If you withdraw from a five twenty nine plan during the student's junior year of high school, that withdrawal shows up as income on the FAFSA for their senior year application, potentially slashing aid eligibility. Luna: So you basically want to wait until after the application is submitted before taking any major distributions? Lucas: Ideally, yes. Or structure the payments so they come from other sources first. But here is where it gets really interesting for the middle-class family. The new formula also excludes home equity entirely again, and it raises the income protection allowance significantly. Luna: I remember when home equity was stripped away in the previous iteration; it felt like a massive penalty for owning a house in a good school district. Lucas: It was brutal. And now it's back. This means two things. First, wealthier families who own homes without massive mortgages are suddenly seeing their calculated family contribution drop sharply. Second, it shifts the burden back onto investment assets, which brings us back to that taxable account dilemma. Luna: Because if you don't have home equity sheltering your wealth, the government sees your stocks and bonds as fair game for college costs. Lucas: Precisely. And this is why the debate between five twenty nine plans and taxable accounts is getting louder. In a taxable account, you only pay capital gains tax when you sell. You can choose not to sell, meaning no income is reported on the FAFSA at all. A five twenty nine plan forces a distribution event eventually, and that triggers the student income assessment. Luna: So a taxable account acts as a better shield against financial aid reduction because you control the realization of gains? Lucas: In terms of aid eligibility, absolutely. You can hold that asset forever and never report it as income. With a five twenty nine plan, you are locked into using it for qualified expenses, which means distributions are inevitable. However, you cannot ignore the tax bill. The five twenty nine plan saves you thousands in taxes over time. Luna: But if losing fifty thousand dollars in grant eligibility outweighs the tax savings, the math flips. Lucas: It does. And that is the nuance most advisors miss. They say 'always use the five twenty nine plan' without running the aid simulation. For families making one hundred fifty thousand dollars with moderate savings, the aid cut could be devastating. For families making three hundred thousand, it barely matters. Luna: So the strategy is highly dependent on where you sit on the income spectrum right now. Lucas: It is. And there is another layer. The new rules allow students to exclude income earned from work-study programs and certain scholarships from the calculation. This encourages students to work more during college without punishing their future aid eligibility. Luna: That feels like a positive shift toward rewarding effort rather than just assessing static wealth. Lucas: It is a step in the right direction. But let's talk about grandparents. The old 'grandparent 529' strategy involved keeping the account off the child's name so it didn't show up on the FAFSA. Now, those distributions count as unearned income to the student. Luna: Oh, so that loophole is effectively closed? Grandparents paying directly used to be free money. Lucas: It's not closed, but it's taxed heavily. Those distributions are assessed at the twenty percent student income rate. So while the money isn't on the FAFSA form itself, the act of spending it reduces aid by twenty cents on the dollar. It's still better than having the asset listed, but it's not the magic bullet it once was. Luna: So grandparents should probably start contributing earlier or switch to covering direct expenses like room and board if possible? Lucas: Covering direct expenses paid to the institution can sometimes bypass the student income flag, depending on how the school reports it. It's a gray area, but it's worth exploring with a fiduciary advisor before making large gifts. Luna: This whole system feels like it's becoming more about timing and structure than just saving enough money. Lucas: It is. And that makes professional guidance more valuable, not less. But since we are talking about complex structures, I want to pause for a second and talk about how we keep this podcast running. Luna: Sure, we appreciate the support from our listeners more than anyone knows. Lucas: Quick honest thing — a handful of listeners chip in monthly through buy me a coffee dot com slash fexingo, and that's literally what funds making this many of these. It keeps us independent and ad-free. That's F. E. X. I. N. G. O. Luna: Yeah, if you enjoy the deep dives, checking that link is the best way to help us keep digging into the details. Lucas: Back to the college fund. There is one more trap I want to warn you about. The new rules assume a certain level of inflation adjustment for tuition, but private colleges are raising prices faster than the federal index. Luna: So even if your aid increases due to the new formula, the cost might be rising just as fast. Lucas: Exactly. You need to model the real cost, not the sticker price. If you are saving in a five twenty nine plan, ensure your investments are aggressive enough to beat private school inflation, which is hovering around four to five percent annually. Luna: And if you are in a taxable account, you have the flexibility to rebalance or move into higher-yield assets if needed. Lucas: Flexibility is the keyword. The old system punished you for having money. The new system punishes you for having it in the wrong place at the wrong time. Know your assets, know your timeline, and time those withdrawals carefully. Luna: It sounds like the era of set-it-and-forget-it college saving is over. Lucas: It is. It requires active management. But at least the playing field is slightly less tilted against homeowners now. Luna: Here's hoping the next simplification round makes it easier to just save and spend without a degree in federal policy. Lucas: Until then, we will keep decoding the fine print for you.