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Pay Down Mortgage or Contribute to Son's 529?

Mark Kantrowitz

December 14, 2009

I just sold my house and moved in with my new husband. We have three children between us (two are his) and are looking for a bigger house. Would it make sense to save the $30,000 from the house sale in my son’s 529 college savings plan account (he is 13 now), or use this money to buy a house and get a home equity loan to pay off his school loans later? Would the $30,000 in his 529 college savings plan reduce the amount of financial aid my son will get? — Luda B.

Contributing the $30,000 to your son’s 529 college savings plan account will likely maximize your overall return on investment. The after-tax interest rate on the mortgage is probably lower than the tax-free return on investment from the 529 plan, so you will earn more from the 529 plan than you will save in mortgage interest.

The amount of money you plan on contributing to your son’s 529 plan is greater than the current annual gift tax exclusion of $13,000 per recipient ($26,000 if you and your husband give the gift as a couple). If you contribute the money as a lump sum in a single year it will trigger five-year gift tax averaging. You can avoid the five-year gift tax averaging by giving up to the annual gift tax exclusion now, before the end of the year, and the rest next year.

Fixed-rate home equity loans have interest rates that are slightly higher than the fixed interest rates on the Parent PLUS loan and much higher than the interest rates on the Stafford loan. It does not make sense to plan on using a higher cost home equity loan to pay off your son’s more favorable student loans. (Home equity lines of credit may be currently competitive with the Stafford loan, but the interest rates are unlikely to remain as favorable over the life of the loan. The interest rate on a HELOC is variable while the interest rate on the Stafford loan is fixed.)

Since you mentioned contributing the money to your son’s 529 plan and not to all three children’s 529 plans, it seems that you want to treat this money as separate property. If you were to use it to help pay for a new house it would be treated as joint property.

The net home equity for a family’s principal place of residence is ignored on the Free Application for Federal Student Aid (FAFSA). (The CSS/Financial Aid PROFILE, which is used by about 250 private colleges, does consider net home equity capped at 2-3 times annual income.) On the other hand, money in a 529 plan is treated as a parent asset on the FAFSA of a dependent student. Less than 4% of dependent students have any contribution from parent assets. Besides the family home, money in retirement plans is ignored as an asset and there’s an age-based asset protection allowance that shelters around $50,000 in parent assets for most parents of college-age children. Low-income families may have all their assets ignored on the FAFSA. In a worst-case scenario as much as 5.64% of the 529 plan account’s value will count against your son’s aid eligibility (i.e., $1,692 on $30,000 in assets). But Congress is likely to pass legislation that will ignore all assets on the FAFSA by the time your son enrolls in college.


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