Avoiding the financial-aid trap with grandparent 529s

http://www.savingforcollege.com/articles/avoiding-the-financial-aid-trap-with-grandparent-529s

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Numerous articles have warned families about the potentially devastating effect that grandparent-owned 529 plans can have on financial-aid eligibility. The story goes like this: The grandparent-owned 529 account is not reportable on the student’s FAFSA, which is good for aid eligibility. However, any distributions to the student or to the student’s school from a grandparent-owned 529 must be added to student income on the following year’s FAFSA, which can be very bad.

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Several strategies may be employed for mitigating this negative effect—including a couple of ideas that will surprise you—suggesting that grandparents may use 529s with less to worry about. Here are four strategies:

1. Take distributions from a grandparent-owned 529 only after the student has filed her final FAFSA.

January 1 of the student’s junior year in college is Liberation Day for the grandparent’s 529 account. Distributions from a grandparent-owned 529 occurring on or after that day will have no impact on federal financial-aid eligibility. This represents the best of both worlds: the account value never gets reported on the FAFSA as an asset, and use of the account never gets reported as student income.

Of course, this strategy only works if the grandparent’s 529 is not needed for the first 2 ½ years of college, and is not so large as to result in a leftover balance if used for only the last 1 ½ years of college.

2. Change owners on the 529 account

If the 529 plan allows for a change in ownership—some 529s do not—the grandparent can simply turn over the account ownership to the student, or to the student’s parent. Qualified (i.e. tax-free) distributions from a student-owned or parent-owned 529 are not includable in the student’s income on the FAFSA.

The downside to this approach is that the 529 account value now becomes reportable on the FAFSA thus reducing aid eligibility by as much as 5.64% of the account value. (It is reportable as a parent asset whether the account is owned by the student, by the parent, or by a custodian for the student under the Uniform Transfers to Minors Act.)

Even this modest negative impact can be avoided through a timing strategy involving a transfer of this year’s college funds into a separate 529 account via partial rollover. Ownership of this separate account is then transferred from the grandparent to the student or parent, but only after student has submitted this year’s FAFSA. The funds in this 529 account are spent before next year’s FAFSA is filed and thus never get reported.

3. Gift any distributions from a grandparent 529 to the student’s parents and let them use the money for their child’s college expenses.

This strategy is adapted from financial-aid texts advising grandparents with non-529 funds to simply make gifts to the parents rather than pay student expenses directly. Because they are not directly supporting the student, an argument is made that these gifts do not get added to the student’s income on the FAFSA.

If it works for non-529 funds, it should work for 529 distributions as well. But if the distributions are not used directly for college expenses, you may question whether the distributions will still be qualified and tax-free.

The tax code does not require that 529 distributions be paid directly for college expenses, or somehow be traced to the payment of college expenses. The only requirement is that the account beneficiary incur qualified expenses during the same year the distributions are taken from a 529 plan.

4. Retain any distributed funds from a grandparent 529 in the grandparent’s checking or investment account until Liberation Day (see Strategy 1 above), and then gift the money to the student to repay college loans.

Similar to Strategy 3, this is a 529 version of traditional financial-aid planning for grandparents. Assume the grandparent withdraws $10,000 from his 529 account to cover the student’s first-semester expenses. Instead of actually turning the 529 money over to the student or to the school, the student takes out loans to pay for first-semester costs. In a later year, after the student has filed her last FAFSA, the grandparent transfers the money to the student to repay the loans.

The 529 withdrawal in Year 1 is tax-free even when the funds are used in a later year to repay student debt, owing to the fact that the account beneficiary incurred sufficient qualified expenses in Year 1.

Important disclaimer: Strategies such as the ones described here are not immune from challenges by financial-aid administrators or the IRS, and even if not challenged can raise ethical concerns. They can also give rise to other consequences. For example, the gifts made under Strategies 3 and 4 are effectively double-counted for gift-tax purposes, first upon original contribution to the 529 plan and again later on when funds that had been distributed to the account owner from the 529 plan are gifted to the parent or grandchild. Your clients should seek and rely on the advice of their own professional advisers.