Grandparents + 529 College Savings Plans = Loophole?

There was a discussion on Bogleheads recently about giving money to grandparents so that could invest in a 529 college savings plan for their grandchildren. While it brought more light on what I think is a flawed financial aid system, it also presented a learning opportunity for me and any parent with college-bound kids.

The idea was that if a 529 plan is owned by someone other than the parent or child (e.g. aunt/uncle, grandparent), the plan will not be considered as an asset for financial aid purposes. It won’t be a parental asset, and it won’t be a student asset. This, in turn, will lower your “expected family contribution” and increase the possibility of receiving financial aid. Loophole! Note that this holds for the popular FAFSA, but not schools that use the CSS Profile, which requires you to list all 529 plans with the student as beneficiary.

However, there is a catch. If a qualified education benefit such as a 529 plan distribution is not reported as an asset on the FAFSA, then those distributions are reported as untaxed income to the beneficiary on the subsequent year’s FAFSA. (You must fill out a new one every year.) As a result, next year’s financial aid eligibility for the student can be significantly affected.

Still a loophole, just smaller. So what can you do? If a grandparent has money in a 529 plan for your child, they should delay taking a distribution until the student’s senior year in college, so next year’s financial aid picture won’t matter. (Assuming no graduate school or that you won’t need aid there.) According to Finaid.org, technically you can take the distribution any time after January 1st of the junior year in college.

Theoretically, the grandparents could fund a quarter of the undergraduate education this way, without the assets in their 529 plan ever counting against any financial aid eligibility. I never knew this, but it’s true unless future legislation changes it.

Sources: FinAid.org, The Guide to Federal Student Aid

Comments

  1. Ben Johnsen says:

    I found this out when I went to college in 2000. As I grew up my parents put money in an investment account for my college education. It seems that 529 plans didn’t have tax advantages until 2001 so the money was just in a regular investment account with my name on it.

    When I turned 18 and graduated from high school the money was put over into my name. FASFA preceded to not give me any money until I had used all of the money out of the account. So 2 years after I started college the money was gone and FASFA started giving be $5000 a year in need based grants.

    Once I graduated and looked back on my money situation in college I realized I should have taken all of the money out of my account and given it to my grandparents. I could trust my grandparents to not spend the money on themselves. The biggest risk I would run is if they died it would have been considered as part if their estate.

    If my grandparents had the money it wouldn’t have appeared on my FASFA and any time I needed money I would have asked my grandparents to write me a check. Now days I wouldn’t even have to ask them to write me a check they could just do a balance transfer to my bank account or better yet they just give me the login and password to the account where the money is kept under their name and I can login and do the balance transfer anytime I want.

    I my case it could have netted me $10,000. In fact having the money in a non-529 so that is doesn’t show up at all on the FASFA maybe worth more than the tax saving on the 529. When I was in college the max gift allowed to an individual was $10,000 and then $11,000. So my grandparents could have given me $10,000 or $11,000 a year before taxes would have come into play.

    If the money was split up across grandparents, aunts and uncles you could distribute larger amounts of money to your child. This is assuming you can trust multiple grandparents, aunts and uncles to not use the money for themselves.

  2. You’d have to trust the grandparents to do the right thing with the money. Sadly thats not a given for everyone.

  3. Dangerman says:

    “you can take the distribution any time after January 1 of the junior year in college.”

    Doesn’t that mean you can also pay the Spring junior year tuition with the 529 money and not be affected?

    Last time I looked, a semester’s tuition isn’t finally due until a few weeks into the semester.

  4. Do you think that taking advantage of that loophole is moral?

    As flawed as the financial aid system may be, it is designed to allow those children who come from financially challenged families an opportunity to attend college. If those of us who would normally be ineligible for financial aid were to exploit this loophole, would that not leave less financial aid money for those who need it more?

    Is this different than finding a loophole which would allow individuals who can afford to take care of themselves to utilize soup kitchens? If there is only so much soup to go around, is your genius move leaving others hungry?

  5. “would that not leave less financial aid money for those who need it more?”
    Steve, do you think it would? I’m not so sure about it. The budget might just be increased according to demand. After all, this is how this country is living, by borrowing money.

  6. Vlad,

    I am not an expert, but I found this information about Federal Pell Grants:
    2010: Amount of Aid Available: $32,295,226,000
    http://www2.ed.gov/programs/fpg/funding.html

    Also, much of the grant money/financial aid comes from the colleges and universities themselves. Obviously, the institutions play a game in overcharging and then providing massive financial aid awards. That said, the institutions need to balance their budget. Receiving financial aid is a zero sum game…someone gets more, so someone else has to get less.

  7. For the most part, I’ll leave morality up to the reader.

    If you as a parent are giving money to grandparents to fund the 529 for the explicit reason to dodge financial aid reduction, I can see how some people may disagree with that.

    However, if grandparents are saving money on their own, and wish to help out the grandkids with college tuition, then deferring that help until the senior year just seems more like good sense to me. Otherwise, you are actually harming the student with your help. I think that’s important information to know.

  8. Steve,

    It’s probably best that nobody save for college – and just spend down all thier money on cars and vacations. That way everybody would be deserving of financial aid.

  9. steve:

    I think that its your duty to yourself, to make your money go as far as you can. If you get a better bang for your buck legally doing it one way over another, you would be silly not to use that to your advantage.

    it would similar to not trying to get every penny you can (legally) get back on your tax returns.

  10. There’s no workaround when your parental income is over 300k. It doesn’t matter what’s in anybody’s name, they look at the income and you automatically get nothing. The same thing will happen to Mr. MMB’s kids with his high income.

  11. I get a state tax deduction for contributions to my child’s 529 up to $x per year. I actually contribute more like $2x to the account per year. I recently discovered that by opening another 529 in my wife’s name with my child as beneficiary I can actually double the amount of the state tax deduction. I wish I had known this sooner!

  12. Can you pay off college loans with 529 assets? (This is a real question. I don’t know.)

  13. I was not under the impression that this is how 529 plans work. In fact, I just watched something with suze orman (i know) explicitly having her say, 529′s in parents names do not affect finaid eligibility. It was some money show on pbs…

    second, i have to agree with steve. my first thought was, huh? if you dont need financial aid you dont get it.

    third, ‘if’ legislation is changed? 18 years, 16 for my daughter, and record debt makes me think ‘if’ is ‘when’

  14. I have to disagree with Steve and GT about financial aid “if you dont need financial aid you dont get it.” My father was in the military and was extremely frugal with money. He never drove a new car, did not believe in credit cards, we did not live in a nice area of town, but he did not have any debt. Now at college due mostly in part to his debt to earnings ratio I was not offered any grants, just student loans. The system is set up to reward those either a) are extremly poor or b) people (parents and kids)whom live way above thier means. Around campus and with talking with friends I see a lot more of the latter. So yes I have some resentment for the people whom have a drive car at school and are getting thier Tuition waived and getting grant money from FAFSA.

    To fix the problem I think FAFSA money should be contingent on maintaining a 3.0GPA

  15. @ Matt: Putting a 3.0 GPA requirement on financial aid would just cause grade inflation by Universities to make sure their students can maintain the tuition payments.

  16. Chuck Said:
    Can you pay off college loans with 529 assets? (This is a real question. I don’t know.)

    Yes, you can. However, it would be non-qualified distribution of 529 assets. The earnings portion of the withdrawal will be subject to income tax and an additional 10% penalty tax.

  17. Frank Blaha says:

    Having recently put 2 kids through USC I have some advice to offer:

    If you think your kids will go to college at a private school save nothing! Every $ you save for college will be one dollar that you won’t get in aid from the college’s endowment fund. That is because the money you save in your name, your kid’s name or in a 529 plan is considered by the college as first funds to be spent on tuition. This increases your expected family contribution and lowers the amount of aid the college may offer you.

    If you think your kids will go to college at a public school save like crazy! That is because you will get no aid at all. College tuition grants in aid at public colleges is for poor people. If you are reading this blog and planning ahead you are probably solid middle class and not poor.

    When you save for either public or private college you need to beat the system. You should set aside as much money as you can and give it to a trusted friend or relative to hold and invest in their name. Take all of the subsidized loans you can get and apply for aid and scholarships from all sources. When your kids graduate from college, get the money back from the trusted friend or relative and pay off the loans.

    I did not know this and paid nearly sticker price for my kids to go to USC.

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