Avoid the FAFSA tripwire with grandparent-owned 529 plans
For parents in a quandary about how to pay for their kids’ college without sacrificing their own retirement and risk protection goals, there may be a time-honored solution: Ask grandma and grandpa.
Grandparent-powered 529 plans are a valuable source of funds for the children of clients headed for the halls of higher education. And, with a bit of astute maneuvering, such plans can be put to use without jeopardizing financial aid.
These vehicles merit such high grades because of the way the Free Application for Federal Student Aid treats family assets, including 529 accounts, and income from those accounts. For 529 plans owned by custodial parents or custodial stepparents, the value is considered part of parental assets, but any qualified distribution is not considered income to the parent or the student.
Having grandparents wait to notify their 529 plan to send money to the school until after the student is out of the base income years for the FAFSA can keep such distributions from impacting financial aid, says Kal Chany, founder and president of Campus Consultants, a college financial aid planning firm in New York. Under FAFSA rules, a 529 account owned by a student’s parents can be assessed by as much as 5.64% as part of an expected family contribution.
Consequently, if a parent reports a $100,000 balance on a 529 account on an annual FAFSA, the child’s aid award could be reduced by $5,640. But money accumulated inside a grandparent-owned 529 plan won’t show up on the FAFSA and thus won’t reduce any financial aid award.Although grandparent 529 assets are not listed on FAFSA, qualified distributions from those accounts are counted as income on the subsequent year’s FAFSA — and assessed up to 50% — for the student who is the account beneficiary. Thus, if grandma has $10,000 distributed from her 529 plan to pay some college expenses for her grandson in 2019, the payment would be reported on the FAFSA he fills out in 2020. The result: grandson’s financial aid award could be reduced by $5,000.
The solution is to handle grandparent 529 distributions so they don’t show up on a FAFSA that impacts financial aid.
A few years ago, the FAFSA switched from looking at prior-year income to prior-prior year income, notes Mark Kantrowitz, publisher at Savingforcollege.com. “Therefore,” he says, “Instead of waiting until Jan. 1 of the junior year in college to take a distribution and not have it affect a subsequent FAFSA, assuming the student graduates in four years, distributions can be taken as early as Jan. 1 of the sophomore year in college.”
Suppose a young woman will be starting college in the fall of 2021. As early as Oct. 1, 2020, she can submit a FAFSA for her first higher-education academic year. Distributions on her behalf from 529 plans during 2019 will be reported on that form. Assuming no break in her school schedule, she will fill out a FAFSA for her senior year as early as Oct. 1, 2023, reflecting 529 distributions during 2022.
With such a plan, her grandfather could notify her 529 plan to begin distributing money for her college bills as early as January 2023, midway through her sophomore year of college. That way, the distributions won’t show up on a relevant FAFSA and won’t reduce financial aid.
But this wait-to-pay plan may come with some issues attached. For instance, if the student intends to go to graduate school and file more FAFSAs, the payout postponement from the grandparent-owned 529 could be extended. Even without graduate school, some grandparents may not be happy with any delay in supporting grandchildren’s college years.
Moreover, this strategy might not be perfectly implemented. “There are 10 states where you have to be the account owner to claim the state income tax break on contributions," says Kantrowitz. "That may encourage grandparents to open 529 plans with themselves as the account owner, not realizing the potential impact on the grandchild's eligibility for need-based financial aid.”
Then again, if grandparents are holding 529 accounts in their names primarily or solely to get state income tax breaks, they might distribute funds for college too soon, resulting in lower aid. In such cases, it’s important for financial planners to urge the grandparents to delay their 529 distributions.
Susie Bauer, 529/UIT manager at Baird, a Milwaukee-based wealth management firm, typically suggests that advisors explain to grandparents the benefits of waiting until the grandchild has filed their last FAFSA to help pay for college. If, however, grandparents want to help right away, “I have another plan,” she says.
In this method, a grandparent would own a 529 plan that is unreported on the FAFSA. Once an award letter has been received, and the resulting gap is known, a partial change of ownership of the 529 plan to the student’s parent can be executed.
If the total cost at a college for the year is $45,000, for example, and $35,000 of aid has been awarded, the gap would be $10,000, and $10,000 of the 529 plan could be changed to the parent’s ownership. Then the parents’ 529 plan can make a qualified $10,000 529 distribution to pay the remaining expenses — without triggering income to the student.
“Most 529 sponsors will not list such an ownership change as a nonqualified withdrawal,” says Bauer, “but there are exceptions.”
Therefore, she explains, advisors should be sure the sponsor’s policy won’t cause a partial ownership change to generate income tax and a 10% penalty. If that trap is avoided, the change and a distribution from the parents’ 529 plan won’t show up on the FAFSA and won’t reduce aid, according to Bauer.
“I’m frequently on calls with advisors to explain this strategy,” she says. “They love it.”