What grandparents need to know about the new FAFSA rules

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As grandparents watch their own children struggle to pay down student loan debt, many want to help their grandchildren avoid a similar situation. According to Fidelity Investment's 2016 College Savings Indicator Study, 74 percent of high-net-worth individuals surveyed said they would be willing to help save for their grandchildren's future college education, and 39 percent were actively doing so. That number might not seem like a lot, but recent changes to the Free Application for Federal Student Aid (FAFSA) could encourage more grandparents to chip in.

Here's how grandparents can take advantage of these changes and utilize some of the unique benefits offered by 529 plans.

Prior-prior year as base year income

One of the biggest drawbacks to helping a grandchild pay for college is that your generosity could end up hurting the student's financial aid eligibility. Assets held in a grandparent-owned 529 account don't have to be reported on the FASFA, but things change once the funds are withdrawn to help pay for college. Any monetary gift from a grandparent or other relative, including money from a 529 plan, is considered untaxed income and must be added to the student's adjusted gross income on the FASFA. What grandparents may not realize is that up to 50 percent of the student's income (including their gift) will be added to the Expected Family Contribution (EFC) figure that's used to determine financial aid eligibility. Simply put: higher EFC equals less financial aid.

Under the old rules, it was suggested that grandparents wait until the calendar year in which their grandchild begins their last year of college to help pay tuition. This way the grandchild would avoid having to report any income since the last FASFA would have already been filed. But beginning with the 2017-18 school year, families will fill out the FAFSA using their income from the calendar year two years prior to the start of their school year. That means if a student were going to be a freshman in the fall of 2017, they would have to report income from 2015 on the FASFA. With this new “prior-prior” year requirement, grandparents can now help pay for an additional year of college without impacting the student's financial aid eligibility.

RELATED: What the new FAFSA rules mean for you

529 plan gifting

A great way to grow a grandchild's college fund is to make contributions to a 529 college savings plan in lieu of gifts for birthdays and holidays. Unlike an UGMA/UTMA custodial account, the account owner, not the beneficiary, retains control of the assets in a 529 plan. That means if you change your mind about the gift or need the money for medical issues or any other reason, you can take the money back. However, distributions from a 529 plan that aren't spent on college expenses for the beneficiary will incur income tax as well as a 10 percent penalty tax on the earnings portion of the withdrawal.

Grandparents who are concerned about the possibility of their grandchild deciding not to go to college or getting a scholarship need not worry. 529 plan savings can be withdrawn tax-free to pay for more than just traditional four-year schools. In fact, eligible post-secondary institutions include many community colleges, online programs, international schools and vocational schools. And if the student gets a scholarship non-qualified withdrawals can be taken penalty-free up to the amount of the award. The earnings portion of the withdrawal, however, will still incur income tax. The same applies to students who attend a U.S. Military Academy.

State tax deductions or credits for 529 plan contributions are sometimes another perk for grandparents who help save for college. Over thirty states, including the District of Columbia, currently offer a tax benefit, but different plans have different requirements as far as who can receive it. In Iowa, for example, only 529 contributions made by the account owner are deductible in computing state tax income. And while a few states offer a deduction for contributions to any 529 plan, most require that residents use their home state's option.

RELATED: How much is your state's 529 state tax benefit really worth?

Tax planning

Soon after the holiday season comes tax-planning season, and many affluent grandparents will be looking to reduce estate tax exposure. 529 plans can serve double-duty as a college savings vehicle and an estate-planning tool. Contributions are considered gifts for tax purposes, and up to $14,000 per individual will qualify for the annual exclusion in 2016. What's more, 529 plans allow account owners to treat contributions of up to $70,000 ($140,000 if married and filing jointly) per grandchild as if they were made over a five-year period for gift tax purposes. So if grandma and grandpa have 10 grandchildren, they would be able to contribute up to $1.4 million in a single day. These funds would be removed from their estate, but the account owner would retain control of the assets over the life of the account.

Grandparents should keep in mind, however, that if they have already exhausted their gift-tax exclusions with life insurance trusts, family limited partnerships or other vehicles, their 529 plan contributions will be considered a taxable gift and will count against their lifetime exclusion – currently $5.45 million in 2016. Another option for grandparents who want to avoid the gift tax all together is to pay the tuition bill directly to the school. Direct tuition payments are considered gifts under the Section 2503(e) exclusion. However, this exclusion only applies to tuition and does not include other qualified expenses (e.g. books, supplies, room and board, etc.)

RELATED: 8 reasons why grandparents love 529 plans