Grandparents: Avoid This FAFSA Pitfall with 529 Plan Distributions

Qualified tuition plans, commonly called 529 plans after IRC Section 529, are a very popular tool for parents and grandparents who want to help the next generation pay for higher education expenses. First, the funds in a 529 plan enjoy tax-free compounding and growth, enabling them to increase over time without the drag imposed by taxes on dividends, interest, or capital gains. Second, funds withdrawn from the plan to cover qualified educational expenses are tax-free for the recipient, whether that is a student paying college tuition or a parent paying on the student’s behalf. And these plans have become even more popular since the 2017 passage of the Tax Cuts and Jobs Act, which expanded the definition of qualified educational expenses to include tuition and other costs of attending a private elementary or secondary school.

Many grandparents are advised to 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. This is because a grandparent’s assets are not generally required to be reported on the free application for federal student aid (FAFSA), and therefore they are not factored in to the resources available to the student for paying educational costs. The fewer the resources available to the student and their parents, the greater the financial aid package they will generally be awarded.

But there is a pitfall that can occur when funds are disbursed from a 529 plan, particularly when the owner of the plan is the student’s grandparent. The problem can arise when the student files their FAFSA for the next academic year, because the funds from 529 plans used to pay for the student’s educational expenses must be reported as tax-free income to the student. For example, if a grandparent orders a disbursement from her 529 plan to pay for a granddaughter’s freshman-year college expenses in 2021, those funds will show up on the granddaughter’s 2023 FAFSA, reducing the amount of financial aid she will be grated for that year by as much as 50% of the amount of the disbursement.

There are a couple of ways around this difficulty, however. 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 2023) to make her disbursement, the income would not need to be reported on the FAFSA until 2025, 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 to the parents of the student, giving them just enough of her 529 plan to cover the $10,000 gap. The parents can use these funds to pay for qualified educational expenses without triggering income to the student. The only tricky part of this strategy is making 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.

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