New FAFSA Removes Roadblocks for Grandparent 529 Plans

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By Kathryn Flynn

February 18, 2021

UPDATE: On June 11, 2021, the Department of Education announced that the proposed FAFSA simplification changes will be delayed. The provisions will happen in phases, beginning with the 2021-22 award year and extending to the 2024-25 award year. A new FAFSA form will not be released on October 1, 2022, as originally planned. Therefore, until income reporting changes take effect, grandparent 529 plan distributions may count as untaxed income on a student’s FAFSA.

Grandparent 529 plans are becoming a popular way to save for college – and for good reason. With a 529 plan, you can build an educational legacy for your grandchild while taking advantage of tax and estate planning benefits.

One potential drawback of grandparent 529 plans, however, is that they can affect financial aid eligibility. But, thanks to upcoming changes to the Free Application for Federal Student Aid (FAFSA), grandparents no longer have to worry about the “financial aid trap”.

Two-thirds of existing questions are scheduled to be removed from the new FAFSA, including one that asks about cash gifts from grandparents, said Shannon Vasconcelos, director of college finance at Bright Horizons College Coach.

“The Department of Education has not issued any guidance on the FAFSA Simplification provisions of the Consolidated Appropriations Act of 2021 yet, but it does appear that grandparents (along with non-custodial parents and anyone else outside of the custodial household) will be able to assist with college payments without negative federal financial aid implications,” she said.

The new, simplified FAFSA goes live on October 1, 2022 for the 2023-24 academic year.

How Grandparent 529 Plans Affect Financial Aid

Overall, 529 plans have a minimal effect on financial aid. But, the FAFSA treats parent-owned accounts more favorably. For example, you report 529 plans assets as parent assets, which can only reduce aid eligibility by a maximum 5.64% of the account value. The FAFSA ignores distributions from a parent-owned 529 plan.

When it comes to a grandparent 529 plan, you do not report the assets on the FAFSA. However, under current rules, you must report distributions as untaxed student income. Untaxed income to a student can reduce aid eligibility by as much as 50% of the amount of cash support. For example, taking a $10,000 529 plan distribution to help pay for college can reduce your grandchild’s aid eligibility by $5,000.

There are some workarounds to help reduce the impact of grandparent support on the FAFSA, but they can be somewhat complicated. For example, you could change the 529 plan account owner to a parent or time your 529 plan distribution carefully to avoid having to report it. The new, simplified FAFSA eliminates the need for workarounds.

Changes to Grandparent 529 Plan Rules

The updated FAFSA does not require students to manually report cash support. That means a grandparent-owned 529 plan will not have any impact on need-based financial aid eligibility. With the new form, the amount of a student’s “total income”, which includes untaxed income, will come directly from federal income tax returns via the IRS Data Retrieval Tool (DRT). So, a student’s total income amount will only consist of data that comes from the federal income tax return.

A student’s FAFSA includes income and tax information from the prior-prior year, so the 2023-24 FAFSA will include information from 2021 tax returns. Because of this “prior-prior” rule for income reporting, grandparents can start taking advantage of the new rules this year.

In other words, a grandchild does not have to report a distribution that was taken from a grandparent’s 529 plan in 2021. (Prior to the new rules, the student would report the 2021 distribution as untaxed income on the 2023-24 FAFSA).

How FAFSA changes affect grandparent 529 plans

  Grandparent 529 Plan Assets Grandparent 529 Plan Distributions  
Current FAFSA Rules Not reported Reported as untaxed student income, 50% of the gift is counted as available funds for college
New FAFSA Rules Not reported Not reported

Keep in mind, however, that grandparent 529 plans are still considered on the CSS Profile. The CSS Profile is an additional financial aid form used by about 200 private colleges to award their institutional aid.

It’s still unclear how the upcoming FAFSA changes will affect the CSS Profile and institutional aid eligibility at other schools. Vasconcelos says cash support from grandparents will likely still have an impact.

“It is also possible that with the reduction of questions on the FAFSA, more colleges that are interested in collecting information that is no longer available on the FAFSA will begin to require the Profile or their own institutional application,” she said.

529 Plan Tax Benefits for Grandparents

529 plans offer tax-deferred investment growth and distributions are tax-free when used to pay for qualified education expenses. With these tax savings, you can build a substantial college fund for a grandchild. You may also be eligible for additional state tax benefits, depending on where you live, and which plan you use. Over 30 states allow residents to claim a state income tax deduction or credit for contributions to a 529 plan. Most of these states only offer tax benefits when you use your home state’s plan. Check your state’s rules to see if you qualify.

529 Plan Estate Planning Benefits

Some financial professionals advise grandparents to contribute to a 529 plan as part of an estate planning strategy. In most cases, you have to consider the Generation Skipping Transfer Tax (GST) when leaving an inheritance to a grandchild. But, 529 plan contributions up $15,000 per beneficiary (in 2020 and 2021) qualify for the annual gift tax exclusion. For example, married grandparents who contribute $30,000 to a grandchild would not include the amount in their taxable estate.

529 plan contributions above the $15,000 annual limit will count against your GST lifetime exemption. In 2020 and 2021, the GST tax exemption is the same as the lifetime gift tax exemption ($11.58 and $11.7 million, respectively).

You can shelter an even larger gift if you elect to spread a lump-sum contribution between $15,000 and $75,000 over a five-year period. This strategy is called superfunding a 529 plan.

When you save for a grandchild in a 529 plan, you retain control of the assets over the life of the account, even though you removed the value from your estate. However, you will have to add the value back to your taxable estate if you revoke the gift from the beneficiary.

The Bottom Line

A 529 plan is a smart investment that can set your grandchild up for future success. 529 plans already offer numerous benefits for grandparents, and the new financial aid treatment makes them even more attractive. But, the financial aid process can change dramatically at any time, Vasconcelos warns.

“When it comes to preparing over 18 years for college payments, the best you can do is plan based upon the information available to you at the time, but know that there is no guarantee that the rules in effect when you start saving for college will remain in effect when the time comes to pay for college,” she says. “The more you save, however, the better prepared you will be for whatever shifts in policy and priorities occur.”

A good place to start:

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