Grandparents love to spoil their grandchildren. They buy them toys, they let them eat candy, and they let them stay up late—things that the grandchildren’s parents would normally not allow. One way that grandparents could spoil their grandchildren and make everyone in the family happy would be to help fund their college education.
Going to college is expensive. The rise of college costs has outpaced the costs of other goods and services since the 1990s, and the trend is likely to continue. For grandparents, helping fund a grandchild’s college education not only benefits the grandchild but also may benefit themselves. Contributing to a 529 college savings plan, gifting appreciated assets or paying for college directly may help grandparents take advantage of favorable income and estate tax opportunities.
For example, a grandparent can contribute up to the annual gift tax exclusion of $14,000 to a 529 plan or as much as $70,000 ($140,000 for joint gifts) in one lump sum using the five-year gift tax averaging rule without incurring any gift taxes and shifting assets out of their estate if they have estate tax issues.
However, grandparents should think strategically when contributing to the financing of their grandchildren’s college education. The rules for the Free Application for Federal Student Aid (FAFSA) can get complex, and if a strategic plan to fund college education is not put in place, it can significantly affect the chances of the grandchildren receiving their own financial aid whether it be in the form of grants, scholarships or federal loans.
Why Who Owns the 529 Plan Matters
Contributing to a 529 college savings plan is a smart way for grandparents to contribute to their grandchild’s education especially if the grandchild has many years before college. The investments grow and compound tax-free for a long period of time, and the distributions are tax-free when used to pay for qualified education expenses. Some states even let you deduct all or part of your contributions to the plan. With that said, who owns the 529 plan plays a significant role when it comes to financial aid eligibility.
Parent-owned and child-owned 529 plans (given the child is a dependent) have a minimal effect on the FAFSA. Only a percentage (5.64%) of the assets is counted toward the expected family contribution, and the qualified distributions from the plans are not counted as income of the student. On the other hand, grandparent-owned 529 plans can severely affect the student’s eligibility on the FAFSA. While the plan assets are not counted for financial aid planning purposes, the distributions made from grandparent-owned accounts are treated as the student’s income, potentially harming financial aid eligibility by as much as half of the distribution from the grandparent-owned 529 plan.
Two solutions for this problem are (1) to change the account owner to the student or student’s parents, or (2) delay taking a distribution from the grandparent-owned 529 plan until the student’s junior year in college when affecting next year’s financial aid eligibility is no longer a concern. For the latter, new prior-prior-year rules effective for the 2017 school year enable this to occur one year earlier than previously as the income from the prior-prior-year is used for financial aid eligibility instead of the prior year. Technically, one can take the distribution any time after January 1 of the sophomore year in college whereas before the PPY rule the distribution had to occur after January 1 of the junior year.
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Other Ways to Contribute
Grandparents can contribute in other ways as well. They can gift appreciated assets within the $14,000 annual gift tax exclusion to their student grandchild, thereby shifting the capital gains to the student’s lower tax bracket when the assets are sold. This will be beneficial only if the student can avoid the so called “kiddie tax,” by being married, by working part-time or by being age 24.
To sidestep the annual gift tax, grandparents can also pay for college tuition directly to the institution and are not limited to the $14,000 annual limit. Of course, this action would adversely affect the student’s ability to qualify for financial aid for upcoming years if financial aid is still an issue.
It’s All About Timing
With all of the above strategies available, timing is critical. In the early years of college, parent-owned and student-owned 529 plans should be used to fund the educational expenses. As these assets are drawn down, the eligibility for financial aid improves. In the later years of college, distributions from the grandparent-owned 529 should be used as they no longer adversely affect financial aid. Strategies such as gifting appreciated assets and paying tuition directly also work best in the later years of the student’s education especially if your grandchild decides to go to graduate school and beyond.
Grandparents can really soften the burden of the rising costs of college education. If done correctly and strategically, they can spoil their grandchildren without spoiling their grandchildren’s chances of financial aid eligibility.
Disclaimer: Consult your tax advisor before taking any action on topics discussed in the blog.