Estate PlanninG

New FAFSA Rules Give Grandparents Greater Incentive to Start a 529 Plan

A 529 plan is an investment account that offers tax benefits when used to pay for qualified education expenses for a designated beneficiary. 529 plans get their name from Section 529 of the Internal Revenue Code, but they are established and maintained at the state level. Every state except Wyoming has a version of the 529 plan.

529 plans have been a great option for grandparents who want to leave money to their grandchildren for college. Not only can a 529 plan account help a grandchild with educational expenses, but it can also help grandparents with their estate planning goals.

However, in the past, grandparent 529 plans had the potential to reduce a student’s ability to receive federal aid. But recent changes to student aid application rules mean that soon, distributions from a 529 account won’t count toward a student’s income on the most-used financial aid form (FAFSA). This is great news for grandparents who want to help cover the ever-increasing costs of higher education without impacting their grandchild’s need-based financial aid eligibility.

Why would someone want to start a 529 plan?

Student debt has long passed a crisis point in the United States. Student debt in the U.S. is approaching $2 trillion and is growing six times faster than the national economy. The average annual cost of a private four-year college is more than $32,000—not including expenses such as housing, food, books, and supplies. Between 2005 and 2020, the average per-student debt level nearly doubled, from $17,000 to $30,000.

This debt can be crippling and can limit opportunities long after graduation.

Grandparent-Owned 529 Plans

A 529 plan is the most popular way for Americans to save for a child’s education. Grandparents may contribute to a 529 plan that has already been established by the parents, or they can open a separate plan.

Until these recent changes, there wasn’t a huge incentive for grandparents to open a 529 plan because when their grandchild received funds from it, they were required to report the funds as untaxed income on their FAFSA form. As a result, the income from the plan could reduce the amount of financial aid the student qualified for. This was true for parent-owned 529 plans too, but the maximum reduction amount was significantly lower than the one from grandparent-owned plans.

FAFSA Changes and Grandparents

Several changes to the FAFSA form came as a result of the FAFSA Simplification Act signed into law in late 2020. One of these changes is that students no longer have to disclose cash support on their FAFSA form.

The good news for grandparents is they no longer have to worry about the financial aid trap that used to come with grandparent-owned 529 accounts. They can now use a 529 account to help pay for their grandchild’s education without worrying about it potentially affecting financial aid eligibility.

An important note: income reporting changes are not yet in effect. Until they are, money from grandparent 529 plans may count as untaxed income on a student’s FAFSA form. The Department of Education announced in the summer of 2021 that full implementation of FAFSA changes, originally scheduled for the 2023–24 school year, will be delayed until the 2024–25 school year.

This delay should not affect plans to fund a grandchild’s education, because the funds in a grandparent-owned 529 plan come into play only when they are released. Therefore, grandparents can continue to put money into a 529 plan without affecting student aid eligibility.

In the meantime, plan to keep an eye out for when these new FAFSA changes take effect. Also, keep in mind that a grandparent 529 plan will still be considered on the College Scholarship Service Profile—an additional financial aid form used by a small number of private colleges.

What other benefits does a 529 plan offer?

A 529 plan can fund more than just tuition. Students can use the funds to pay for various fees, books, supplies, equipment such as computers and printers, software, and internet access. In addition, students living off-campus can use the money for rent, utilities, and food.

A 529 plan doesn’t have to be for higher education, either. Tuition for primary or secondary school qualifies as well.

Leaving a legacy in the form of education funding is its own reward, but 529 plans provide financial benefits to both grandkids and grandparents, including the following:

  • Investment earnings and withdrawals from a 529 plan are tax-free if they go towards qualified educational expenses.

  • The money from a 529 plan can be used for non–education-related expenses. The money withdrawn is subject to a 10 percent penalty and taxes on the investment gain but the money can be tapped in an emergency.

  • If the beneficiary (i.e., the grandchild) decides not to attend college, the grandparent owner can change the beneficiary. In fact, the beneficiary and the ownership can be changed at any time.

  • Contributions to a 529 plan are removed from the owner’s taxable estate, lowering estate tax liability.

  • While 529 contributions are considered gifts to the beneficiary and could be subject to the federal gift (and generation-skipping transfer) tax, this tax can be avoided by spreading a lump-sum contribution over a five-year period, a strategy known as “superfunding” a 529 plan. Superfunding can be done for an unlimited number of beneficiaries.

  • Some states offer a tax break for contributing to a 529 plan.

  • State rules vary for 529 plans, including contribution limits, but you can pick a plan from any state. You are not limited to plans in the state where you live, and students can use the money to attend a qualified school in any state.

Whenever you’re dealing with the IRS, there are a number of rules and regulations that must be followed. 529 plans are no exception. Individual state rules also apply to 529 plans.

That’s why it’s a good idea to work with a knowledgeable professional to make sure you’re getting the most out of your 529 plan. We can help. Call Santaella Legal Group, serving San Ramon, Danville, Dublin, Pleasanton & the Tri-Valley area, at (925) 831-4840.