Many grandparents want to help pay for their grandchild’s college tuition. Not only can it bring them great personal satisfaction, it can also be a smart way to pass along wealth without having to pay gift and estate taxes. But grandparents beware—giving money at the wrong time or in the wrong manner can do damage to financial aid packages!
Understand first that there are two types of financial aid: need-based aid, based on the financial circumstances of the student and her parents, and merit aid, which is independent of the family’s finances. Merit aid is generally not affected by money you give, loan, or pay directly to a college. Need-based aid, on the other hand, can be gutted by the wrong kind of giving strategy.
529 accounts can be a great way for grandparents to help save toward college tuition. Contributions grow tax-deferred and withdrawals used for the beneficiary’s qualified expenses are tax-free at the federal level and usually at the state level as well. But it’s crucial that grandparents understand how withdrawals from their 529s are assessed and why the timing of those withdrawals can make all the difference in regards to protecting a student’s need-based aid.
Why It Matters Who Owns a 529 Plan Account
When it comes to the things that impact need-based financial aid, income is more toxic than assets. If a 529 plan is parent-owned, it’s considered an asset. If the 529 plan is in a grandparent’s or some other non-parent’s name, the withdrawals are considered student income.
Parental assets can reduce need-based aid by 5.64% of the asset’s value. So, $10,000 in a parent-owned 529 plan could reduce aid by $564.
Distributions from grandparent-owned 529 accounts are treated as student income and could reduce their eligibility for need-based aid by as much as 50% of the amount of the distribution. So, if a grandparent withdraws $10,000 from a 529 to pay for tuition, that withdrawal could (two years later) increase the amount the family is expected to pay by $5,000.
That’s why it might make sense for grandparents to contribute money to a parent-owned 529 plan instead of funding their own.
Why It Matters When Grandparents Withdraw from a 529 Plan Account
Grandparent-owned 529 savings have no impact on a financial aid package so long as they remain in the grandparent’s account. However, once those dollars are transferred to the child, they can count against need-based financial aid. The workaround for this problem is to delay making withdrawals from a grandparent-owned 529 until there are no more subsequent year’s FAFSA filings that can be affected by them.
The FAFSA uses the prior-prior year for income and tax information, so a grandparent should wait until after January 1 of the beneficiary’s sophomore year to make a withdrawal if the student is expected to graduate in four years. If the student is expected to graduate in five years, a grandparent should wait until January 1 of the junior year to make a withdrawal. If the grandchild is expected to go on to graduate school, a grandparent may want to wait even longer so as not to impact financial aid for graduate school.
Cash Gifts for College: Why Payee Choice and Timing Matter
A cash gift from a grandparent to a student can create the same problems that a grandparent-529 withdrawal does since that cash gift is treated as student income.
One remedy is the same as it is for grandparent-owned 529 withdrawals: timing. Hold off on making cash gifts until there will be no more subsequent year’s FAFSA filings that can be affected by them. You might even wait until your grandchild graduates college, when a cash gift can be used to pay off school loans.
Another workaround is to make a cash gift to the student’s parent. The gift, if treated as a parent asset, will be assessed at 5.64%, while the same gift to the student could reduce the student’s need-based aid by as much as 50% of the amount of the gift.
The cash-gift-to-the-student’s-parents strategy can be even more powerful if savvy spending-timing is deployed. Consider a grandparent who makes a $60,000 cash gift to a student’s parent (the parent is his daughter).
At the time the gift is made, the daughter has $60,000 of additional assets, which could impact the financial aid formula on a FAFSA. However, between the time she receives the gift and when the student’s and parents’ FAFSAs are completed, the daughter could use the $60,000 to pay off her own student loan debt. Or, she might use the $60,000 to pay down credit card debt or make a home improvement. In any of these scenarios, the daughter will have no additional reportable assets and the $60,000 gift will not impact the financial aid eligibility of the grandchild.
Another option for a grandparent is to make a cash gift as a direct payment to a grandchild’s college. Under federal law, tuition payments made directly to a college aren’t considered taxable gifts no matter how large, which makes it an attractive way to remove money from an estate.
However, since direct payments to colleges can only be used for tuition, many colleges consider them a “resource,” and in turn they have the effect of reducing a student’s eligibility for need-based aid dollar for dollar. Be sure to contact the school to gain an understanding about how direct payments will affect your grandchild’s eligibility for college-based aid.
Talk to Your Advisor
It’s wonderful to be in a position to help your grandchildren pay for an education. But like so many areas of financial planning, the rules and exceptions can be intertwined and confusing. The last thing you want is to have your generosity backfire in a way that harms your grandchild’s financial aid package. If you’re thinking of helping with college tuition, reach out to your advisor and let them help you with all the moving parts.
By Joan M. Hill / Communications Coordinator
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