The government's college savings plan makes college more expensive

Sarah and Mike spent 18 years diligently saving $200,000 in their daughter's 529 college plan. They followed every financial advisor's advice, maxed out the tax benefits, and felt proud of their responsible parenting.

Then they filled out the FAFSA financial aid form and discovered their reward: $0 in need-based aid from their daughter's dream school.

Meanwhile, their neighbor Jim — who put the same $200K into his retirement account — qualified for $35,000 per year in grants. Same income, same savings, completely different treatment.

Here's the twisted logic: The government created 529 plans specifically to encourage college savings. But those same accounts now hurt your chances of getting financial aid.

The Free Application for Federal Student Aid (FAFSA) counts 5.64% of your 529 balance against your aid eligibility each year. That $200,000 in Sarah's 529? It reduces her aid by $11,280 annually, or $45,120 over four years.

But retirement accounts? Completely invisible to financial aid calculations.

"It's the most backwards incentive structure in American policy," says Mark Kantrowitz, a financial aid expert who's analyzed the system for decades. "We tell families to save for college, then penalize them when they do."

The numbers are staggering. Americans have socked away more than $480 billion in 529 plans, thinking they're making smart moves. Many are unknowingly pricing themselves out of aid.

Smart families have figured out the game. Instead of 529 plans, they're maxing out retirement accounts and using those for college costs.

Roth IRAs offer the perfect workaround. You can withdraw your contributions anytime without penalty. For college expenses, you can even withdraw earnings penalty-free (though you'll pay taxes on gains).

The catch? Income limits shut out high earners. For 2025, singles making over $165,000 and married couples over $246,000 can't contribute to Roth IRAs at all.

"It's like the government designed a system to confuse people," explains financial planner Rick Kahler. "The account made for college hurts aid eligibility, but the account made for retirement doesn't."

This creates a particularly cruel trap for middle and upper-middle class families. They earn too much for easy financial aid but not enough to ignore college costs entirely.

Take a family earning $150,000 annually. They're responsible savers who build a $300,000 college fund in a 529 plan. That balance will reduce their aid by about $17,000 per year.

A family earning the same amount who saved in retirement accounts instead? They'd qualify for significantly more aid while maintaining the exact same financial position.

The system essentially punishes financial literacy and rewards people who either don't plan ahead or understand the loopholes.

Here's where it gets even more absurd. The same schools denying aid to American families with 529 plans are actively recruiting international students who pay full tuition with no financial aid eligibility anyway.

International enrollment has exploded because these students are guaranteed revenue streams. They can't access federal aid, so schools don't have to navigate the complex financial aid calculations.

"Universities love international students because there's no financial aid math to manipulate," admits one admissions consultant who asked not to be named. "It's clean revenue."

Financial advisors like The College Sherpa have developed elaborate strategies to work around these rules. They call it "financial aid optimization," but it's really just exploiting policy contradictions.

The strategies include:

Some families even consider divorce — only the custodial parent's finances count for aid purposes.

"I tell clients the financial aid system rewards ignorance and punishes preparation," says college planning specialist Jennifer Chen. "The rules are so backwards that doing the 'right' thing often costs you money."

Elite schools compound the problem with their own twisted math. Many promise free tuition for families earning under $100,000-150,000 annually.

But here's the kicker: Roth IRA withdrawals count as income for the following year's aid calculation. So a family normally earning $75,000 who withdraws $35,000 for freshman year suddenly shows $110,000 in income and loses aid eligibility.

The timing becomes crucial. Families have to choose between using their college savings (and showing higher income) or taking loans and preserving aid eligibility.

The most successful college savers aren't using 529 plans for their intended purpose at all. They're treating them as wealth transfer vehicles for future generations.

Rich families can contribute up to $500,000+ per child across multiple 529 accounts. If their kids get scholarships or don't attend college, they transfer the money to grandchildren or other relatives.

Starting in 2024, leftover 529 funds can even be rolled into Roth IRAs — but only after 15 years and with tight restrictions.

So the government's college savings plan has become a tax-advantaged wealth transfer tool for people who don't actually need help paying for college.

Sarah and Mike's story isn't unusual — it's the predictable result of a system that makes no logical sense. They followed the rules and got financially penalized for it.

The lesson isn't to avoid saving for college. It's to understand that the government's official college savings plan might not be the smartest option.

The College Sherpa’s stance? "The 529 plan is the government's way of saying 'We want you to save for college, but we're going to make it as confusing and counterproductive as possible.'"

Mission accomplished.