Grandparents looking to contribute funds to cover their grandchild’s college costs often turn to a 529 plan, a type of account that provides tax benefits for education savings. But grandparents must take steps to get the best value from these plans and avoid hurting a student’s financial aid options.
Typically, grandparents help pay for only a small portion of a student’s college expenses. According to the 2021 How America Pays for College survey of college students and their parents, 11% of respondents reported using money provided by relatives to pay for college, contributing an average of $5,060.
Though the contribution may be small, families aiming to afford rising college tuition costs know that every dollar counts. Before opening a 529 plan for a grandchild, review these tips.
Understand the Possible Impact on Financial Aid
Grandparents planning to save for a grandchild’s college costs should start as early as possible, but they first need to consider the best savings method for their situation.
One factor in deciding on a saving strategy is whether the grandchild and parents are likely to qualify for need-based financial aid. If they do, Mark Berg, a certified financial planner and founder of Timothy Financial Counsel in Illinois, says “putting money in a 529 plan then using it for that grandchild can count against or hurt their ability to get financial aid while in school because they have an alternate source of resources to pay for their schooling.”
[READ: Saving for College During Coronavirus: Managing Your 529 Plan.]Students are required to report any additional support they receive to pay for college, says Jim Brooks, associate vice president for student services and enrollment management and director of financial aid at the University of Oregon. But because of the information considered on the Free Application for Federal Student Aid, or FAFSA, grandparents could avoid this entirely by waiting to provide a student with 529 funds until his or her junior or senior year of college.
Currently, cash gifts from grandparents or tuition paid by grandparents count as a student’s untaxed income, says Shannon Vasconcelos, director of college finance at Bright Horizons College Coach. Half of that student income is included in the FAFSA’s calculation of available funds to cover college expenses, after an approximately $7,000 allowance for basic living expenses.
“The higher the gift amount, the more dramatic the effect,” Vasconcelos wrote in an email. “A $50,000 gift, for example, would reduce aid eligibility by over $20,000.”
Decide on Account Ownership
Grandparents hoping to chip in for a grandchild’s college education can open a 529 plan themselves or contribute to a parent-owned account.
In many cases it may be easiest to list the child’s parent as the owner of the 529 plan. But there are a few circumstances when it makes sense for a grandparent to own the account, Berg says.
For example, “Maybe they don’t trust the child to use the money for the purposes of the grandchild’s education,” he says. “Maybe it’s even due to marital reasons with that child, and they just want to make sure the fund is not considered an asset of the marriage.”
If a student will receive need-based financial aid, his or her eligibility could be hurt if the student is made the owner of the account. On the FAFSA, 20% of a dependent student’s assets count toward his or her expected contribution to the cost of college, Brooks says, while typically less than 12% of a parent’s assets count toward the expected contribution.
How FAFSA Simplifaction Will Affect Grandparent Contributions
Change is ahead for the FAFSA, thanks to the FAFSA Simplification Act of 2020, which eliminated many of the questions around untaxed income from the application. Grandparents saving for children who won’t be enrolling in the next few years may not need to worry about the affect of their contributions on a student’s financial aid options.
“Under FAFSA simplification, grandparents, noncustodial parents, and others wanting to help pay for a student’s college education will no longer need to worry about their assistance costing the student financial aid that they may otherwise be eligible for,” Vasconcelos says. “Grandparents and noncustodial parents can save in a 529 that they own. They don’t need to worry about giving up control over their savings or timing their payments to avoid negative financial aid implications.”
The simplified version of the FAFSA was set to launch in the 2023-2024 award year but has been delayed to 2024-2025. Assuming it is not delayed again, Vasconcelos says grandparent or noncustodial parent gifts made in 2022 and beyond won’t be visible on a future FAFSA.
Make Saving for College a Team Effort
Whether an account is parent-owned or grandparent-owned, anyone can write a check to the owner with the purpose of adding to a child’s 529 plan.
“When the child’s getting gifts for their baptism or bar mitzvah or holidays, the parents can always put that cash into the 529 also,” says Chadderdon O’Brien, a certified financial planner and wealth advisor at Regent Atlantic in New Jersey. “It’s a great conduit to put money in that will eventually be used for education expenses.”
Grandparents can lead by example to help families get the ball rolling on saving for college. This means getting parents involved in funding the 529 plan. One way to encourage family saving is by instituting an informal matching contribution agreement, in which grandparents agree to match any contribution a parent makes to the college savings account.
Berg says grandparents can say, “If you put in a dollar, I’ll put in three dollars,” as a way to “help the parents have some skin in the game.”
Consider the Tax Implications
The principal and earnings from a 529 plan are not taxed, so long as the money is used to pay for qualified educational expenses.
Any person can give any other individual up to $15,000 in 2021 without paying a gift tax. There is, however, an exception to this gift tax specifically for 529 plan contributions, which allows individuals to front-load a plan for up to five years at one time without having to pay the tax.
“There’s a certain amount of money the IRS tells us we can give to another individual before we have to file a gift tax return — that’s $15,000 per person this year, meaning grandma and granddad could give $30,000 this year without having to file an extra tax return,” O’Brien says. “But 529s are unique, so you can do five years of that. You can (contribute) $150,000 at the child’s birth, then it’s growing each year before they go to college.”
[Read: How to Choose a 529 Plan on Your Own.]There’s another route to help with a grandchild’s college costs: Berg says if a grandparent is financially able, it may be wise from a tax perspective to pay tuition directly to a grandchild’s school out of pocket rather than creating a 529 plan.
“For a higher net worth grandparent, it actually can make the most sense for them to pay tuition directly, meaning pay out of pocket, and preserve the ability to still do the annual exclusion gifts,” Berg says.
“That same exemption can be used to fund a 529 plan, but if you fund a 529 plan, it uses up your exemption,” he says. “Education is one of the few things that is exempt from the annual gift exclusion limit, which means a grandparent could pay a $50,000 tuition bill for a grandchild directly to the university and it doesn’t count toward their gift exemption.”
Each 529 plan has varying fees, performance histories, minimum investment requirements and associated state income tax benefits, including tax credits and deductions. The state tax breaks are available depending on a grandparent’s state of residence.
Don’t Neglect Retirement Planning
Financial advisors caution grandparents against sacrificing their retirement savings to fund a grandchild’s 529 plan or college tuition.
[Read: Avoid 529 Plan Withdrawal Penalty if Your Child Skips College.]But at the same time, O’Brien says grandparents and parents are sometimes unnecessarily afraid of relying on a 529 plan to save for college because of the possible penalties they may incur if the money is not used for a qualified educational expense. 529 plans can also be a valuable estate planning tool, he says.
“It’s perfectly fine to keep money in 529s, and they’ve really widened the rules on qualified expenses so you can get money out of 529s pretty easily,” O’Brien says. Grandparents can always change the beneficiary on a 529 plan to a family member of the original beneficiary, or the 529 funds could be passed down to future generations.
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