Grandparents and 529 College Savings Plans: What You Need to Know
By Joe Messinger, CFP®
June 15, 2018
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. Grandparents can make one time deposits up to $75,000 each per child without running into gift tax penalties. (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.
When the Tax Cuts and Job Act became law, the federal estate and gift tax limit was raised to $11,180,000 per person. If you have that kind of money, paying for college is pocket change. However, 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 consideration?
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.
When filling out the FAFSA, the ownership of the 529 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.)
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 a higher percentage in the FAFSA calculation.
What does all 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. The need based aid eligibility is reduced by 5.64% of the value of the 529 or $564.
- 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 by 5.64% of the value of the 529 or $564 even if the student is the owner. (The rules for independent students are different.)
- 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 asses 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.
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.
So, what can grandparents do?
If they decide to go the 529 route (and eligibility for need based aid is a consideration), grandparents can 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. As a parental asset, 529 money will have the least impact on need determination.
Take advantage of timing.
It is worth noting that the freshmen year is referred to as the “base year.” The base year is the first time student’s apply for financial aid and is the most important year because your future financial aid for all years will be based off that first year. A student wants to appear as poor as possible in that base year to qualify for as much financial aid as they are eligible for.
An alternative is to wait until the student’s junior year of college after you have applied for and been granted financial aid for the last time (assuming they’ll graduate in four years) before making distributions from the 529 for qualified expenses.
What non-529 options are available?
Grandparents can simply gift the student money–up to $15,000 per person each year. However, this gift will count as unearned income of the student and have a significant impact on their calculation of need. Giving the gift to the parents will allow the asset to be subject to a lower percentage in the FAFSA calculation and be protected by an asset protection allowance, and worst case scenario assessed at the lower 5.64%. Payments by the grandparents directly to the college to pay for tuition are not subject to gift tax penalties but will often be considered a untaxed income to the student and reduce their need.
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.
Custodial accounts like UTMAs will be counted as student assets in the FAFSA and the need calculation will be reduced by 20% of the asset value. In cases where need based financial aid is not a consideration, this tactic can be utilized to gift appreciated securities and potentially avoid capital gains tax on a portion of the proceeds. Learn more in a recent post The Kiddie Tax: Changes to The Tax Code in 2018.
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.