Avoiding a FAFSA Pitfall for Grandparents Making 529 Plan Distributions

Avoiding a FAFSA Pitfall for Grandparents Making 529 Plan Distributions

Many parents and grandparents who wish to help fund higher education expenses for the next generation are utilizing qualified tuition plans, commonly called 529 plans after IRC Section 529. This popular tool permits tax-free compounding and growth for the funds in the plan. Funds withdrawn from the plan are also tax-free when used to cover qualified educational expenses, whether by a student or a parent or grandparent paying on the student’s behalf. With the 2017 passage of the Tax Cuts and Jobs Act, the definition of qualified educational expenses was expanded to include tuition and other costs, up to $10,000, of attending a private elementary or secondary school.

Often, grandparents utilize 529 plans as a way to transfer wealth to their children or grandchildren, and one advantage of doing so is that assets held in a grandparent’s 529 plan do not affect the calculations for student financial aid. Grandparents’ assets are not generally required to be reported on the free application for federal student aid (FAFSA); thus, they are not factored in to the resources available to the student for paying educational costs. Keeping such assets off the FAFSA generally results in a better financial aid package for the student.

However, a pitfall can occur when funds are disbursed from a 529 plan, particularly when the owner of the plan is the student’s grandparent: when the student files their FAFSA for the next academic year, the funds from 529 plans must be reported as tax-free income to the student. So, if a grandparent orders a disbursement from her 529 plan to pay for a granddaughter’s freshman-year college expenses in 2022, those funds will show up on the granddaughter’s subsequent FAFSA, reducing the amount of financial aid she will be granted for that year by as much as 50% of the amount of the disbursement.

But there are a couple of workarounds. The first is to delay disbursing funds until past the point when they will be considered. Beginning in 2017, the FAFSA began collecting income information for two years prior to the year of the application. So, if the grandmother in the above example waited until January of her granddaughter’s sophomore year in college (the spring semester of 2024) to make her disbursement, the income would not need to be reported on the FAFSA until 2026, by which time the granddaughter would have graduated (assuming she completes her studies in four years). It would thus have no effect whatever on her financial aid.

But suppose a grandparent doesn’t want to wait to begin helping with college expenses? Well, there’s a second way to make funds available and reduce the impact on the student’s subsequent financial aid. Suppose a student is looking at a total college bill of $45,000, and financial aid will only cover $35,000 of it. The grandparent could shift partial ownership of the 529 plan to the parents of the student, giving them just enough to cover the $10,000 gap. Unlike grandparents, the student’s parents can use these funds to pay for qualified educational expenses without triggering income to the student. A crucial detail of this strategy is to make sure that the 529 plan sponsor will not list the partial ownership change as a distribution that triggers income tax and a 10% penalty. Most plan sponsors will not, but anyone considering this strategy will need to be certain before proceeding.

All that said, there is better news on the horizon. According to a recent announcement from the Department of Education, certain changes in the FAFSA will eliminate the requirement to report financial support received by students from grandparents. While this change to the form will not take effect until the 2024–25 financial aid award year, it will be welcome news for students seeking help with college expenses and for grandparents who want to help. Parents and families need to be attentive to their desired school’s method to calculate financial need. Some colleges and universities use a different formula and may ask about distributions from grandparent-owned 529s. The new rule has not yet gone into effect so we have to wait to see what colleges and universities using the consensus or institutional method of financial aid calculation will do.

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