529 plans have become a popular tool for parents and grandparents who are hoping to help their next generation with higher education expenses. Reinforced by the passage of the Tax Cuts and Jobs Act in 2017, 529 plans allow tax-free compounding and growth of invested funds and provide tax-free withdrawals when used for qualified educational expenses like tuition, room, and board.
Grandparents are progressively using 529 plans as a way to transfer wealth to their grandchildren in order to help them afford the ever-increasing cost of higher education. One benefit of this approach is that it does not affect the calculations for student financial aid. Generally, assets from a grandparent-owned 529 plan do not need to be reported on the Free Application for Federal Student Aid (FAFSA), and thus remain out of the equation when it comes to calculating the resources available to pay educational costs. Keeping these assets off the FAFSA often results in the student receiving a better financial aid package, enabling students with limited resources to have a more viable path towards achieving their higher educational goals.
While 529 plans offer advantages, it’s important to be aware of the potential risks associated with them and avoid common pitfalls. One pitfall occurs when funds are disbursed from a 529 plan owned by a grandparent and funneled to their grandchild for college expenses. When the student continues their studies and files the FAFSA for the subsequent academic year, these disbursements need to be reported as income, which could reduce the student’s chances of receiving greater financial aid in that year by as much as 50%.
Luckily, there are some workarounds. According to the FAFSA, beginning in 2017, applicants are required to report their income for two years prior to the application year. This means that if a grandparent were to wait until their grandchild is in the second semester of his or her sophomore year before making a disbursement, it wouldn’t be reported on their FAFSA until after the student had graduated (assuming he or she graduated in four years). This would allow for maximum aid without repercussions.
For grandparents who don’t wish to delay their financial assistance, there is another often overlooked strategy: A grandparent can transfer ownership of the 529 plan partially to the student’s parents. Unlike grandparents, a student’s parents can use these funds to pay for qualified educational expenses without triggering income to the student. For example, if a student has a $50,000 bill for college, and their financial aid only covers $40,000 of it, a grandparent could shift partial ownership of the 529 plan to the parents of the student in order to cover the remaining $10,000. This technique could make all the difference when it comes to affording college and beginning life after graduation without being weighed down by debt. However, before utilizing this method, it’s critical to make sure that the 529 plan sponsor will not list the partial ownership change as a distribution, as this would trigger income tax and a 10% penalty.
Grandparents, parents, and students alike can rejoice with the recent announcement from the Department of Education that upcoming changes to the FAFSA form will include eliminating the requirement to report financial support received by students from grandparents altogether. This change will not take effect until 2024–25, but is a welcome relief for families, as it removes an extra step in filing for financial aid.
Are you a parent or grandparent who is hoping to send your child or grandchild to college? We can help! At Method, our range of services is designed to help you achieve your short- and long-term financial goals, including planning for higher education costs. Please reach out to continue the conversation.