Watch Out for Grandparent-Owned 529 Plans

Unlike medicines and pesticides, financial products do not come with warning labels. But they should.  Grandparents and other relatives interested in helping pay for college may actually do more harm unless you follow this advice.

Help from Grandparents and Family

It’s been said that it takes a village to raise a child.  And nowadays paying for college may also be a team effort as well. More grandparents are getting involved with paying for college.  But this can be tricky and the impact on financial aid may have unintended consequences. So watch out for grandparent-owned 529 plans or you may put your grandchild’s financial aid eligibility at risk potentially costing thousands more in the long run.

According to a survey of more than 1,000 adults over age 45, more than 53% of grandparents have indicated that they are saving for or will be saving for college for their grandchildren. For those who are saving for college now, the median amount saved is about $25,000 but more than 35% of those surveyed indicated that they expect the amount to be at least $50,000.

Also noted in Fidelity’s 2014 Grandparents and College Savings Study, more grandparents are getting involved.  More than 70% of grandparents think that it’s important to help pay for college.  That’s probably because of the ballooning costs for college which have made it outrageously expensive.  Gone are the days when you could work part-time and walk out of school debt-free (like I did at a UMass school).

More than half of those surveyed are familiar with or are using 529 Plans to help save for college.  More than 15% of Fidelity’s retail accounts are owned by grandparents.  Considering the current costs and trends in college costs, every little bit helps though the help may not be going far.  Right now the average is $18,391 per year to attend a public four-year school as an in-state student for the 2013-14 academic year, and $40,917 per year to attend a private non-profit four-year school, according to the College Board’s Trends in College Pricing. (Imagine yourself buying a brand new luxury car every year for four or more years – for cash – and you get the picture).

Grandparent-Owned 529s: The Problem

So what’s wrong with a grandparent or other relative saving for college with a 529 Plan?  What’s not to like about a plan that provides for tax-free accumulation and withdrawals for qualified education expenses? Well, there’s nothing wrong with the plan but used incorrectly you may be in danger or at least putting someone else in danger – of paying more for college.  You may be blowing your favored student’s chances for getting more financial aid.

Grandparent-owned 529s are a very good thing indeed.  Assets held in a grandparent’s name are not reported on the Free Application for Federal Student Aid (FAFSA).  So the assets are not counted in the financial aid eligibility formulas or in calculating the Expected Family Contribution (EFC).

But once a qualified withdrawal is made, the distribution needs to be reported on the following year’s FAFSA as student income.  And student income is assessed even higher than student-held assets.  The financial aid formulas count fifty percent of a student’s income and 20% of a student’s assets as their contribution to paying for college. Weird? Yep, but them’s the rules.

The Workarounds

So, how do you work around this potential problem?  In general, you should not tap grandparent or other family-owned 529s until the last year in college.  Used after the last FAFSA is filed for the student’s last year in school means that the funds don’t need to be reported as student income.

Another option is to consider transferring the 529 account to a parent. Some plans allow this (but Fidelity is not one of them).  Here the asset is assessed at 5.64% (above the applicable asset protection exemption) but the distributions aren’t counted as income.

The final option is to simply contribute to the plan already set up by the parents. Getting family and friends to do that is hard, I know, but it is worth trying.  Many 529 plans now offer a link using UGift. With a few simple keystrokes, Ugift lets you invite family and friends to celebrate a child’s or student’s milestones with a gift contribution to your 529 plan account.

No Choice for Some

If your student will not likely be a candidate for needs-based financial aid, then all of this may not matter.  Or if you’re late to the party and you haven’t set up a funding plan ahead of time, you may have no choice but to tap into the grandparent-owned 529 as soon as the first year.

Recently, I had a couple come into my office who were looking at how to fund their son’s college costs.  The first tuition bill was due in less than four weeks.  They had some savings, lots of home equity and a 529 Plan owned by a grandparent.  Given the timing and their reluctance (as well as mine) for using a PLUS loan, it made the most sense to tap the 529 for the first year.

Sure, this will add about $10,000 to the “income” of the student on next year’s FAFSA but it was the most ready source of funds.  But these folks already had an EFC north of $48,000.  The impact of the ‘student income’ next year will likely increase that by about $2,000.  With a college cost of $35,000 per year, they were not eligible for any needs-based aid so the timing of the 529 withdrawals would not have made a difference.  And now with more than a year’s lead time, they can arrange for that home equity line and work on the budget with me to determine how much discretionary cash flow may be redirected to college funding.

The bottom line:  It may take a village to help pay for college.  But it sure helps to have a plan – and not just a 529 Plan.