Fall and the return to school may remind you of another issue looming in the future—how are you going to pay for your children's or grandchildren's college? Will your grandkids be able to afford to go to the college they want to attend? Will they qualify for financial aid if you help them? Are they going to be in debt for the first 20 years of their working life?
Most of us, at some point or another, will be haunted by the above questions. And some of the more popular ways to fund school come with lots of deliberations. For example, 529 plans can be extremely effective for paying college expenses, but be aware that there can be some pitfalls specifically with distributions and financial aid. (For related reading, see: 5 Secrets You Didn't Know About 529 Plans.)
529 Plans 101
A 529 plan is an education savings plan used to pay the costs of qualified educational institutions nationwide. Each plan is operated by a state or educational institution. It is named after Section 529 of the Internal Revenue Code, which created these types of savings plans in 1996.
Although contributions are not deductible, earnings in a 529 plan grow federal tax-free and will not be taxed when the money is withdrawn to pay for college. In addition to the federal tax savings, 34 states, including the District of Columbia, currently offer residents a full or partial tax deduction or credit for 529 plan contributions.
For example, in South Carolina you have an unlimited state tax deduction up to the plan maximum contribution amount of $370,000. And while 529 plans can differ from state to state, your choice of school is not affected by the state your 529 savings plan is from. You can be a resident of South Carolina, invest in an Ohio plan and send your student to college in New York.
What About Financial Aid?
A 529 account owned by a parent for a dependent student is reported on the federal financial aid application (FAFSA) as a parental asset. Parental assets are assessed at a maximum 5.64% rate in determining the student's expected family contribution (EFC), which is considerably less than the 20% rate on non-529 assets owned by the student.
Along with favorable asset treatment, a 529 account also has favorable treatment in the income portion of the financial aid eligibility formula. A tax-free distribution from a 529 plan to pay this year's college expenses will not be part of the "base-year income" that reduces next year's financial aid eligibility. (For related reading, see: Student Loan Debt: What Every Borrower Should Know.)
529 Plan Pitfalls for Grandparents
A grandparent-owned 529 college savings plan is not reported as either a parent’s or a student’s asset on the FAFSA, but distributions from the 529 plan must be reported as student income on the following year’s FAFSA. Therefore, owning a 529 account for your grandchild will not affect your grandchild’s eligibility for need-based financial aid, but actually using the account to pay for college expenses could have a negative impact in the subsequent year when you file for FAFSA again.
Most financial aid offices interpret the rules as requiring distributions from grandparent-owned 529s to be included as student income, even when the distributions are not reportable for federal income taxes (i.e. they are tax-free).
This aspect of a 529 plan is far less understood. Distributions from grandparent-owned 529 plans are technically considered a gift to the student and are treated as untaxed income for financial aid purposes, which can impact a student’s aid eligibility by up to 50% of the distribution. This is because students are expected to contribute 50 cents of every dollar of income toward the college bills (after an allowance of about $6,000).
So having an asset in the form of a 529 plan account that is owned by the grandparent does not count as an asset in the student’s EFC, but if the grandparent makes a distribution from that 529 plan to help the grandchild pay for college, that distribution will be considered untaxed income of the student when the student completes the aid forms the following year. (For related reading, see: 6 Life Events That Call for Professional Financial Advice.)
Easing the Impact
Here are a couple of possible solutions, but keep in mind each person’s circumstance is different; you should consult your tax advisor in order to review what your best solution may be. To minimize the possible impact on financial aid:
- You could wait to withdraw money from the grandparent-owned 529 until the final financial aid form has been filed for the student’s sophomore year of college.
- Another possible solution is to switch the owner to the parent of the student or the student themselves (the latter can bring up a host of other issues and should be considered carefully). Assets in parent-owned 529s are calculated at up to 5.6%, after an allowance of about $30,000 to $50,000, but withdrawals are not reported as income to the child. Therefore, the student will not be penalized as they would if it was distributed from the grandparents 529 plan under FAFSA.
- Some 529 administrators allow you to switch account owners by completing a form. Others do not permit such transfers. Make sure you contact your 529 plan administrator to see if your plan allows this.
- If your plan does not allow this, another solution is to transfer the money to a state-sponsored 529 plan that allows switching the owner from the grandparents to the parents.
- In the case of the South Carolina 529 and the Georgia 529 plan, they do allow for changing the account title (owner) from a grandparent to parent of the student.
There is another possible pitfall, because the student's room and board expense no longer appears on the school bill.
- You are still allowed to use the 529 plan funds for off-campus living, but only up to the amount the school charges for room and board. Anything over that is not a qualified expense. For example, if the off-campus living expense is $12,000 and the school allows for $10,000, then you can only use the $10,000 from your 529 plan.
You can also now pay for a computer and internet expenses with a 529 plan, but these must be used primarily for the benefit of the student. Also, watch out for the internet bill if it comes bundled with other services.
Withdrawing too Much Money
If you realize you've taken too much within 60 days of the distribution, you can roll it back into a 529 plan, provided you have not rolled over that child's 529 account within the prior 12 months. If it is after 60 days but within the same calendar year, you can look to prepay next year's expenses to increase this year's qualified higher education expense. If you discover the excess withdrawal after year's end, there's not much you can do about it. You need to pay tax and penalty. But remember, this is on the earnings—not the contribution amount. (For related reading, see: Are 529 Savings Plans Right for You?)
Please again remember it is always best to consult your financial and/or tax advisor in regards to your personal circumstances and if these strategies suit your circumstances.