Grandparents and 529 College Savings Plans: What You Need to Know
By Joe Messinger, CFP®
August 26, 2021
Updated August 2021.
Grandparents want to help. They see the expense ahead for their kids to pay for college education for their grandkids. The goal for everyone is to help the student get a great education, graduate with little or no debt, and live a fulfilling life. Many grandparents choose to open a 529 college savings plan to help pay for college, and they need to be aware of a few things.
A 529 plan can be an appealing option to help save and is, by and large, the best tool to do so. Many grandparents choose to use their $15,000 gift maximum (per year) to gift money to a 529 Plan for their grandchildren without tax penalty. Grandparents can also choose to make a one-time deposit of up to $75,000 from each grandparent, per child, total without running into gift tax penalties. (In this case, the $15,000 gift maximum per year is considered to be spread out over a five-year period.) Moving money in this way is a great estate planning tool for grandpa and grandma.
All grandparents can take advantage of the tax benefits of 529 plans, like tax-free withdrawals when used for qualified education expenses, tax-deferred growth of the investment, and possible state tax deductions for the grandparents.
The most important college funding consideration for grandparents.
For grandparents wanting to open 529 plans for their grandchildren, the most important consideration is the potential impact on the student’s financial need. Most colleges use the Free Application for Federal Student Aid or FAFSA to calculate financial need, or the expected family contribution based on the income and assets of the parents and the student, so that is what we will focus on in this article.
If the 529 is owned by the custodial parent or the dependent student, the plan is reported as an asset of the parent on the FAFSA. When owned by an independent student, the assets are reported as the student’s assets. When the 529 is owned by the grandparents (or anyone else for that matter), FAFSA does not view the 529 as an asset, but the distributions are considered untaxed income for the student (or beneficiary) and will be assessed at a higher percentage in the FAFSA calculation. These rules will continue to stay in effect until the end of September 2023 as of the writing of this article.
When filling out the FAFSA, the ownership of the 529 Plan determines how and if that 529 money is a factor in determining financial need. This impact could cause the student to lose financial aid they might have otherwise been entitled to. (If the student will NOT qualify for need-based financial aid, then grandparents do not have to worry about these considerations.)
What does this mean?
It is important to understand that every 529 plan has one owner and one beneficiary. The owner of the 529 controls all distribution of the funds and even retains the ability to change the beneficiary on the account to another family member.
Let’s use an example of $10,000 as the 529 asset amount to illustrate.
- Owner is the Parent – The 529 is reported as a parental asset and assessed at a maximum of 5.64%. The need-based aid eligibility is reduced.
- Owner is the dependent student – The 529 is still assessed at the parent’s rate on the FAFSA. The need-based aid eligibility is reduced.
- Owner is the grandparent – The 529 is not reported as an asset on the FAFSA. The need-based aid eligibility is not reduced for the following academic year.
- Here is where it gets confusing. The grandparents use that $10,000 to pay tuition for the year. That “resource” was never reported on the FAFSA. So, the financial aid office may consider that resource in the following year’s calculation for financial aid and assess it as “untaxed income” to the student at a rate of 50%. So, $10,000 x 50% = $5000. The next year’s financial aid may be reduced by $5,000.
- It is important to note there are some workarounds to consider. You could change the 529 plan account owner to a parent or time your 529 plan distribution carefully to avoid having to report it. The FAFSA looks at the tax return from two years prior to when your student will enroll. So, if the grandparent 529 plan funds are used to pay for year 3 and year 4 it will not be counted as untaxed income because that year has already passed.
As you can see, whoever is the owner of the 529 will make a big difference in the impact on the need-based aid calculation. In addition, not all schools will penalize the student for grandparent 529 funds that help pay for college.
New rules with the simplified FAFSA.
The Department of Education announced that upcoming FAFSA simplification changes will be delayed. They will not release a new FAFSA form on October 1, 2022 as originally scheduled. Implementation will now happen in phases, with the first items affecting the upcoming school year. The simplified FAFSA goes into effect on October 1, 2023, for the 2024-25 school year. Cash support and other types of income will no longer have to be reported on the FAFSA, including funds from a grandparent-owned 529 plan.
In short, this simplified version of the FAFSA will make it notably easier for grandparents to help their grandkids with college costs without negatively impacting their financial aid eligibility so dramatically. New updates mean that students don’t have to report cash support, so grandparent-owned 529 plans won’t impact their eligibility for financial aid, and neither will cash payments toward their tuition directly. However, because of the way these new rules are set up, grandparents may be able to start taking advantage of this opportunity now. Make sure to reach out to a fee-only financial planner with college planning expertise to ensure you’re playing by the rules if you choose to go this route.
What else can grandparents do?
If you’d prefer to play it safe, grandparents can always transfer ownership of the 529 to the parent if allowed by their plan. A grandparent can transfer ownership of 529 funds to a parent 529 in the same state. Or grandparents can make contributions directly to the parent-owned 529 plan.
What non-529 options are available?
Grandparents could wait until after a student graduates from college to gift them the money. Most students today will leave college with student loans. Assistance paying off these loans could be a great solution for grandparents wanting to help. Remember, that the gift maximum is $15,000 a year before the recipient incurs taxes.
What do we suggest for grandparents who want to help?
Talk to the parents! Grandparents need to understand the family’s situation in terms of financial aid based on need. The conversation should explore all the different options available and determine which is the best fit for everyone to maximize financial aid and minimize taxes. Oftentimes, working with a financial planner to help facilitate these conversations can be useful, and provide all family members with a big picture view of their college-bound student’s financial strategy. Want to learn more? Reach out to us today! We’d love to speak with you.