It’s common that grandparents want to help with college expenses for their grandchildren. Most grandparents helping their grandchildren want to do so in a way that won’t affect financial aid eligibility.
One of the most common ways that grandparents help is through use of a 529 Plan. A 529 Plan is a special type of tax-deferred account that has both an “owner” and a beneficiary. In most cases, it’s beneficial that the grandparent be the “owner” of the account. The beneficiary is the student incurring college expenses. Generally speaking, a 529 Plan has the following advantages:
- Contributions to a 529 Plan are removed from a grandparent’s taxable estate.
- The contributions grow free of income taxes.
- Withdrawals from the plan are free of tax so long as used for qualified higher education expenses.
- The “owner” (usually the grandparent in this case) can change the beneficiary on the account to another family member of the original beneficiary if the original beneficiary doesn’t end up needing the funds for college.
Most questions I get about 529 Plans revolve around their affect on student aid. The good news is that so long as the grandparent (not the parent) of the student is the owner, the 529 Plan doesn’t count as an “asset” for determining financial aid. However, the bad news is that any distributions from the grandparent-owned plan do count as “income” for student aid purposes. There are two main strategies that can mitigate this income effect:
- By January 1 of the student’s junior year, the student will have filed his last FAFSA. This means that distributions from a grandparent-owned 529 Plan after this date will not affect financial aid. If the student’s parents have saved anything for the student’s college, the strategy here is to use their savings for the first 2.5 years of college, and then use the grandparent-owned 529 Plan to pay for the final 1.5 years.
- If the parent’s funds (or financial aid) is not sufficient to cover the first 2.5 years mentioned above, an account-owner transfer may work. Under this strategy, the grandparent rolls over one year’s worth of college expenses into a separate 529 Plan (with the same student as beneficiary). After the student files their FAFSA for the year, the grandparent then transfers ownership of the separated 529 to the student’s parent. [The grandparent transfers only the smaller 529 holding one year of expenses, not the original 529 Plan.] The parent then spends those funds on the student’s tuition for the year. Unlike a grandparent-owned 529 Plan, distributions from a parent-owned 529 Plan are not income the to student. The downside of a parent-owned 529 Plan is that the assets in the plan are countable in determining financial aid. However, in this case, the parent-owned 529 only contained one year of expenses, which will all be spent by the time the student must file a FAFSA again. The balance will be zero by the time the next disclosure comes on a FAFSA.
Strategy 1 above is pretty “vanilla” and is commonly used. Strategy 2 is also used, but is definitely more aggressive, and could potentially be challenged by a financial aid office (although this isn’t something I’ve personally seen). In 2008, the IRS also issued a notice stating that it might issue regulations to restrict 529 account owner transfers, but it has not taken any action to do so yet.
This stuff is tricky, so don’t attempt it without first consulting with a tax advisor. And feel free to contact me.