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COLLEGE SAVINGS 101

Rules unclear for grandparents' 529 plan

03/27/2006

QUESTION:
Dear Joe,

I just read your column about a parent saving for a child's education using a 529. What if it is a grandparent that opens the account? My parents want to open a 529 account for my son with $100,000. I am a single mom; the father has not seen my son since 1996. My sole source of income is Social Security disability because of multiple sclerosis. How will this affect the financial aid situation for college for my son if they open a 529?

-- Kim

ANSWER:
Dear Kim,
I can understand your concern. Based on your limited income, and assuming your nonretirement financial assets are modest, it is likely that your child will be eligible for federal grants, subsidized loans for college or both. The generous actions of grandparents or other relatives in helping to pay for college can cause a reduction in financial-aid awards.

The good news for you is that the federal student-aid application, or FAFSA, does not ask about assets belonging to anyone other than yourself and your child, even when those assets are set aside to help pay for your child's college. This means that grandparents can open 529 accounts without being concerned about how the value of those accounts will impact federal-aid eligibility.

There is some uncertainty, however, surrounding the treatment of a grandparent's withdrawal of 529 funds when those funds are actually used to pay for college. Some experts feel that when a grandparent hands over the money to the student or to the parent on behalf of the student, it must be included on the FAFSA as base-year income, just like any other cash support provided by the grandparent to the student. The base-year income reduces financial-aid eligibility for the following school year. The consequences would be even more severe if the grandparent were to direct the 529 plan to make payments directly to the educational institution, as these payments would reduce financial aid on a dollar-for-dollar basis.

The counterargument is that Congress and the U.S. Department of Education did not intend that financial-aid eligibility be reduced by tax-free withdrawals from 529 plans, regardless of account ownership and method of payment. The support for this argument comes from a poorly worded letter issued by the U.S. Department of Education in 2004.

So what should you and your parents do in light of this uncertainty? To avoid the income issue, they could put their money into a 529 plan naming you as the account owner. The problem with this approach is that it then gets included in the eligibility formula as a parental asset, albeit at a low rate of 5.64 percent or less of the account value. Perhaps a bigger problem for your parents is that they would be turning over control of their 529 money to you and would no longer have the option of taking it back or redirecting it to other grandchildren in the future.

An alternative approach would be for your parents to take withdrawals from their 529 accounts in the years during which your child is attending school on a financial-aid package but wait until after his last FAFSA is filed entering his senior year before handing the funds over to you or your son. The 529 account withdrawals should still qualify for the preferable income-tax treatment, and the money can be used to pay down student loans or for other purposes. Check with your tax advisers to make sure they concur with this strategy.

Note that I have been describing the federal financial-aid rules. Many private colleges (and some public colleges) dispense their own aid to students based on alternative needs-assessment formulas. Colleges may inquire about any 529 accounts held for the benefit of the student and may consider those accounts when awarding institutional aid.

Finally, ask yourself if this financial-aid discussion is even necessary. If your parents have the means, and the desire, to fully fund your child's college education, why even worry about the financial-aid consequences? Most financial aid comes in the form of loans, not grants. You may not want to look into this gift horse's mouth too closely.

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