My grandparent saved money for my college costs in a state 529 account. What effect does this have on my financial aid picture? See the attached and understand the impact and the workarounds.
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by Mark Kantrowitz
Here is the New York State Specific Information for this article:
Your New York 529 plan options
Great news! As a resident of New York, you can claim a state tax deduction on contributions of up to $5,000 a year ($10,000 for married couples filing jointly) to New York’s 529 College Savings Program — Direct Plan. Remember, the best way to grow your college fund is to save early and often. Get started today.
The financial aid impact of a 529 college savings plan depends on who owns the 529 plan. Generally, if a 529 plan is owned by a dependent student or a dependent student’s parent, it has a minimal impact on eligibility for need-based financial aid. But, if the 529 plan is owned by anybody else, such as a grandparent, aunt or uncle, it will hurt aid eligibility. There are, however, a few workarounds that can mitigate the harm.
Impact of a 529 plan on eligibility for need-based financial aid 529 plans are or are not reported as assets on the Free Application for Federal Student Aid (FAFSA), depending on who owns the 529 plan.
If a 529 college savings plan is owned by a dependent student or by a dependent student’s custodial parent, it is reported as a parent asset on the FAFSA. Distributions are ignored.
If a 529 plan is owned by an independent student, it is reported as a student asset on the FAFSA. Again, distributions are ignored.
But, if a 529 plan is owned by anybody else, such as a grandparent, aunt, uncle, cousin or non-custodial parent, it is not reported as an asset on the FAFSA. Instead, distributions count as untaxed income to the beneficiary.
This affects the impact of the 529 plan on eligibility for need-based financial aid.
• If the 529 plan is reported as a parent asset on the FAFSA, it will reduce eligibility for need-based aid by as much as 5.64% of the asset value.
• If the 529 plan is reported as a student asset on the FAFSA, it will reduce eligibility for need-based aid by as much as 20% of the asset value if the student does not have dependents other than a spouse and as much as 3.29% if the student has dependents other than a spouse.
• Distributions from a 529 plan owned by anyone else will reduce eligibility for need-based aid by as much as 50% of the amount of the distribution.
• For example, $10,000 in a 529 plan owned by a dependent student or their parent will reduce aid eligibility by as much as $564, $10,000 in a 529 plan owned by an independent student will reduce aid eligibility by as much as $2,000 and a $10,000 distribution from a grandparent-owned 529 plan will reduce aid eligibility by as much as $5,000.
Thus, who owns the 529 plan can have an impact on the student’s eligibility for need-based financial aid. (The student must be the beneficiary of the 529 plan when money is withdrawn from the 529 plan to pay for college costs. Otherwise, the withdrawal will be a non-qualified distribution and not tax-free.)
Grandparents sometimes set up their own 529 plans for their grandchildren, not realizing that they don’t need to be the account owner to contribute to a 529 plan. Or they may want to qualify for a state tax benefit. Almost a dozen states do require a taxpayer to be the account owner to claim a state income tax deduction on contributions to the state’s 529 college savings plan.
Workarounds for grandparent-owned 529 plans
There are a few possible workarounds that can address the negative impact on financial aid from a grandparent-owned 529 plan.
Change account owner. The grandparent can change the account owner to the parent, if permitted by the 529 plan. This will yield a more favorable financial aid treatment. However, some states will recapture state income tax benefits if the account owner is changed.
Rollover 529 plan funds. The grandparent can roll over a year’s worth of funds to a parent-owned 529 plan. If the rollover occurs after the FAFSA is filed, the funds won’t be reported as an asset on the FAFSA (assuming the funds are spent before the next FAFSA is filed).
Distributions from this 529 plan also will not affect aid eligibility because the 529 plan is owned by the parent. The parent-owned 529 plan should be in the same state as the grandparent-owned 529 plan to bypass recapture rules.
Take a distribution later. The grandparent can wait until after January 1 of the beneficiary’s sophomore year in college to take a distribution. Since the FAFSA uses the prior-prior year for income and tax information, there will be no subsequent year’s FAFSA to be affected by the distribution if the student graduates in four years. If the student will graduate in five years, the family should wait until January 1 of the junior year to take a distribution.
Wait until after graduation. The grandparent can wait until after the student graduates to take a distribution to pay down the student loan debt. Distributions from a grandparent-owned 529 plan are considered untaxed student income on the FAFSA and can reduce a student’s financial aid package by up to 50% of the value of the distribution. Grandparents can avoid this by waiting until January 1 of the student’s sophomore year of college (when it will no longer affect untaxed income on the FAFSA) to take a 529 plan distribution or wait until the student graduates to pay down their student loans.
Note that assets are reported as of the date the FAFSA is filed, unlike income, which is based on the prior-prior year.
Do you have questions about the college admissions process or the above information? Don’t hesitate to contact me at firstname.lastname@example.org or by phone, 845.551.6946.