Rules unclear for grandparents' 529 plan



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


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.

Popular Questions


Two kids, two 529 plans?

Dear Big Bill,
While it's possible to maintain a 529 plan in just one child's name, even when you intend to send more than one child to college, I generally recommend that families open a separate 529 account for each child.

That's assuming there is no additional cost to maintaining multiple accounts. If your 529 plan charges an annual or quarterly account maintenance fee, check to see if you can avoid the fee by signing up for automatic contributions through payroll deduction or electronic funds transfer)

With a separate 529 plan for each child, it becomes easier for you to tailor the mix of stocks, bonds and stable-principal investments (e.g., stable value, guaranteed principal and money market funds) to the particular ages of your children. When your older child is nearing high school graduation, you may want to ratchet down the level of market risk in her 529 plan. At the same time, you could keep a more-aggressive asset allocation in your younger child's 529 plan, accepting more risk for a potentially higher return. Many 529 plans offer "age-based" investment options that automatically make these adjustments as the beneficiary ages.

Separate accounts for your children also offer more gift-tax leeway. Since your 529 contributions are treated as gifts from you to the account beneficiary, your $15,000 (in 2018) annual gift exclusion will go twice as far with two accounts -- one for each child -- than with just one account.

Financial aid is another reason to recommend maintaining separate accounts. You wouldn't want the investments reserved for your younger child's future college expenses to count against your older child's financial aid eligibility. Be warned: The rules here are rather murky, and the impact of a sibling's 529 account may depend on the college's own policies as well on as the type of aid -- federal or institutional -- being sought.

Finally, I believe that separate 529 accounts allow for better family bookkeeping. There will never be any doubt as to your intention to help send all of your children to college. You'll avoid the uncomfortable position of being asked to explain to a curious 8th-grader why account statements are showing up in the mail with only a brother or sister's name on them. And in the event of your death or divorce, no matter how unlikely, your legal representatives and other family members will have less reason to question your actions in setting up and funding the 529 plans.

Even with separate accounts, you'll continue to have the flexibility to shift the money around in the future. You simply need to make sure that whenever funds are withdrawn from the 529 plan to pay for college they are coming from an account in the name of the child incurring the costs. It's a simple matter to change the beneficiary designation among family members at any time, transfer 529 funds between different family members' accounts or split one 529 account into two. The ability to move assets around the family is a key advantage of 529 plans when comparing other college-savings alternatives, such as Uniform Transfers to Minors Act, or UTMA, accounts.

Original Post: 2005-10-13
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Coverdell ESA vs. 529 Plan: Which to choose? (Script)

The Coverdell ESA and the 529 plan are both excellent college savings vehicles because they are both tax-free when used for college. But many families face a choice: do they use a 529 plan for all of their child's college savings, or do they use a Coverdell for the maximum amount of $2,000 each year and put any any extra savings above $2,000 into a 529 plan? In spite of its low annual contribution cap, Coverdell's are now attracting quite a few families. There are two major reasons for that. One is that only the Coverdell allows you to self-direct your investments, just like you might self-direct the investments in your IRA. The other is that in addition to college expenses, Coverdells can be withdrawn tax-free to pay for a broad range of K-12 expenses, while 529 plans are limited to K-12 tuition. This feature is appreciated most in families planning to send their children to private grade schools, which may include additional costs such as room and board or uniforms. A 529 plan, on the other hand, does not impose age limits or income limits like the Coverdell does and so overall we see a lot more money going into 529 plans than into Coverdells. Plus many savers are happy with the investment choices offered by the 529 plans and don't necessarily want to self-direct their investments. And don’t forget this: your state may be giving you a state tax deduction for using a 529 plan, but there are no states offering a state tax deduction for investing with a Coverdell ESA.

Learn more about Coverdell ESAs.

Original post date 2013-07-15
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Top 529 Plan Withdrawal Tips. (Script)

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Top 529 Plan Withdrawal Tips. (Video)

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