An Education on 529 Plans - Parent Versus Grandparent-Ownership

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Saving for college is no small feat. With the continually rising cost of tuition year after year it’s more important than ever to start saving early and often for a child’s college education. Thankfully, many extended family members sometimes contribute toward a child’s education. Grandparents are sometimes major contributors to a child’s college education as well as aunts, uncles and friends. While parents should happily welcome assistance contributions from third parties, there are a few notable differences to be aware of regarding exactly who the owner of the child’s 529 plan is. But before elaborating on that, let’s summarize how 529 plans work, in general.

A 529 plan is a college savings vehicle that offers immense tax benefits. Just recently, with the changes in the tax law starting in calendar year 2018, 529 plans can also be used to fund up to $10,000/year of K-12 private education, so they’ve become even more flexible. Amounts contributed to a 529 plan are potentially eligible for a state tax deduction (depending on your state of residence and which state’s plan is being funded). Contributed dollars can be invested and the funds (both principal and growth), when distributed for qualified education expenses (tuition, books, room and board, computers, etc.), are not subject to income taxes. This tax-free growth can be a major benefit, especially for those who have been saving for almost two decades since the child was born! A 529 plan must have an owner (such as a parent or grandparent) and a beneficiary (the student). The owner controls the contribution level, investment allocation and how and when to disburse funds. The owner also can change the 529 beneficiary. Oftentimes, if there are excess funds left in a 529 after fully funding one child’s tuition, owners will change the beneficiary to a younger child, using those excess funds for their education. Again, significant flexibility. 

But what about naming the 529 owner? There are important distinctions between a parent-owned 529 plan and a third-party owned (such as a grandparent-owned) 529 plan, most notably as it relates to applying for financial aid or grants. Students who wish to apply for federal aid must complete the Free Application for Federal Student Aid (FAFSA). Among other things, several of the items that determine a student’s eligibility for aid are student and parent-owned resources. Generally, the amount of aid a student receives can be reduced by the level of certain types of parent and/or student-owned resources. For example, a custodial account (in which the child is the owner of the account and parent acts as a guardian of the account) is considered a student-owned asset while a 529 plan is considered a parent-owned asset (even though the student gets the benefit of the funds, the parent is the owner and maintains control of the account). 

So what’s the reduction? A custodial account, which we know is counted as a student asset, can reduce aid by as much as about 20%. Therefore, a $10,000 custodial account, for example, could reduce aid by about $2,000. A 529 plan, however, as a parental asset, only reduces aid by about 5%. A $10,000 529 plan, for example, could reduce aid by about $500. But what about a 529 plan that’s owned by a grandparent or other third party? Because the asset is not owned by the student or the parent, that asset need not be reported on the FAFSA. This is often where people stop their research, resulting in an unpleasant surprise later. 

While the balance of the grandparent/third-party owned asset isn’t reportable on the FAFSA, any withdrawals from the third-party owned asset are reportable on the FAFSA and counted as untaxed income to the student. For example, let’s say a grandfather wanted to pay his granddaughter’s $50,000 sophomore-year tuition from the 529 plan he owns for her benefit. On granddaughter’s initial FAFSA applications, she will not report grandfather’s 529 balance. But when she files future FAFSA applications, she will be required to report the $50,000 distribution as student income, which reduces aid by as much as 50%! So, in this $50,000 example, that means a potential $25,000 reduction in aid. One potential way around this reduction pitfall is to exhaust student-owned assets like custodial accounts first (perhaps before college begins or before the first FAFSA is filed) and only use third-party owned 529 assets to pay for final tuition payments, after the student’s last FAFSA has been filed.

So, who should be the owner of the student’s 529 plan? Of course, it all depends on individual goals and circumstances. There is no catch-all or one-size-fits-all approach, especially when trying to plan up to 18 years in the future. The best thing to do is be completely aware of all the financial aid rules, understanding what is required on the FAFSA and when it’s reportable, and have open discussions with your family and professional advisors on a regular basis so you all can properly plan.