Saving for College is a great idea, but how will a 529 plan affect my child's chances to qualify for financial aid?? Guidance from the U.S. Department of Education says that your 529 savings account is treated as an asset of the parent or other account owner in determining eligibility for federal financial aid. This means that your expected contribution towards your child's college costs will include 5.6%, or less, of the value of your account for each academic year. This is much better than the 35% assessment against assets owned in your child's name or in a custodial account.

However, the amount of income shown on your child's prior year tax return is assessed at a 50% rate on the current year's application. So if you withdraw 529 account earnings to pay this year's college expenses, it will hurt eligibility next year.
Example: You file the FAFSA aid application when your child is a senior in high school. Let's say you have a 529 savings account with $20,000 in it, of which $10,000 represents your original contribution and $10,000 is earnings. 

Your eligibility for federal financial aid this year will decrease by as much as 5.6% of the account value, or $1,120. Assume there is no further appreciation in the account and you withdraw $5,000 in the Fall to pay for the first semester college bills. If you have $15,000 left in the account when you apply for aid for sophomore year, you will again be assessed up to 5.6%, or $840, of the account value. But your child's tax return for the previous year now shows $2,500 of income because the $5,000 withdrawal brought $2,500 of taxable income with it. Based on a 50% assessment rate, your eligibility for federal aid decreases by another $1,250. The federal aid formula is actually a bit more complicated than what is described here. 

A 529 prepaid tuition plan works differently in the federal financial aid formula. Here your investment doesn't show up at all on the FAFSA. But the benefits paid out will be considered by the institution as a resource that reduces your child's overall financial "need". The bottom line effect for most families is a dollar-for-dollar offset in eligibility. That is, if your prepaid tuition contract pays out $5,000 in tuition benefits this year, you will be considered as having $5,000 less need for financial aid. Low income families that qualify for the Federal Pell grant will generally not be affected by a prepaid tuition plan (but they will be affected by a 529 savings plan).

It is too early to tell how the new tax law will impact the financial aid treatment of 529 plans. The income tax exemption for qualified withdrawals beginning in 2002 will likely lead to an upward adjustment to student's income computed on the FAFSA for those aid applicants who in the prior year used withdrawals from a 529 savings plan to pay for college. We may see no change in how prepaid tuition plans are treated. 

Sound complicated? Saving for college is. Also consider that the financial aid rules are subject to frequent change. Finally, remember that most financial aid comes in the form of loans, not grants, and so you end up paying it back anyway.