The cost of college has risen so high that many families are relying on two generations to help cover expenses.
There are the parents, who are increasingly saving in 529 college-savings plans, where earnings are tax-free if used for qualified educational expenses. Then there are the grandparents, who are joining in the mission to get children through college with less debt. They, too, are saving in 529 plans.
Here's the problem. Many grandparents become concerned that their 529 contributions will adversely affect their grandchildren in the federal financial-aid process.
The Free Application for Federal Student Aid (FAFSA) looks at income and assets for parents and students. A 529 owned by a grandparent doesn't get reported on the FAFSA.
But once money is withdrawn from a grandparent-owed 529 and used to pay for college expenses, it's considered income to the student, and it has to be reported on the FAFSA. Because up to 50 percent of a student's income is considered available to pay for college, money used from a grandparent's 529 can reduce aid by as much as half of the distribution amount.
There are ways for grandparents to manage 529 withdrawals to minimize the impact on financial aid.
— Instead of opening a 529 themselves, grandparents can contribute to a parent-owned 529 plan, which reduces eligibility for need-based financial aid only up to 5.64 percent of the net worth of the assets.
— Grandparents can open an account and reap any state tax deductions for themselves. But when it comes time to withdraw the money, they can transfer ownership to a parent. Be sure to check first with the financial company managing the 529 plan to confirm you can switch ownership and/or that there are no tax consequences in doing so.
— Families can use the grandparent’s 529 money last. The FAFSA uses tax information from two years ago. So grandparents can wait until after Jan. 1 of the sophomore year to take a distribution and it won’t affect a subsequent year’s FAFSA, assuming the student graduates in four years, says Mark Kantrowitz, publisher and vice president of research for Savingforcollege.com, a site created to help families understand 529 plans.
Kantrowitz said if it will take a student five years to graduate, then grandparents can wait until Jan. 1 of the junior year to take a distribution. During a recent online discussion, I invited Kantrowitz to answer questions about 529 plans.
Q: My in-laws are making 529 contributions for my three kids. At some point, my in-laws will pass away, and I hope this is long after my kids are out of college. But if it’s before they start college, is there anything my husband and I need to do to make sure that the kids have access to these funds?
Kantrowitz: A 529 plan has an account owner and a beneficiary (the child). There are three typical scenarios involving grandparents and 529 plans:
— The grandparent is the account owner, and the grandchild is the beneficiary.
— The parent is the account owner and the grandchild is the beneficiary.
— The grandchild is the account owner (a custodial account) and the beneficiary, with the grandparent acting as custodian until the grandchild reaches the age of majority.
If the grandparents are the account owners, ask them if they have specified a successor owner, in case they pass away. If they haven't, suggest they name you or your spouse as the successor.
Q: If the grandparents are owners of a 529 account and they transfer ownership to the parents to reduce the effect on aid, does that count as taxable income to the parents for that year?
Kantrowitz: Generally, a change in account owner or rollover of a 529 plan is excluded from income at the federal level. At the state level, it depends on state law. Some states treat a rollover to an out-of-state 529 plan as a non-qualified distribution, which will subject the earnings portion to income taxes at the beneficiary’s rate, plus a 10 percent tax penalty, plus recapture of state income tax benefits. So it is best to roll over from a grandparent-owned 529 plan to a parent-owned 529 plan in the same state as the grandparent-owned 529 plan.
Singletary: I understand the concern about how FAFSA rules treat distributions from grandparent-owned 529 plans. It makes many wonder if it’s worth funding a 529 for their grandchildren. They worry they are getting in the way of free money.
However, if the alternative is not to save, that doesn’t make financial sense. Much of the need-based aid is in the form of loans. And, as I’ve repeatedly reported, most students don’t get enough in scholarships — need-based or merit — for a full ride to college. So there will be a gap, and savings in a 529 plan can help fill it.