How might a 529 plan impact eligibility for need-based financial aid?

Question

My grandparents started a 529 college savings plan for me several years ago. They’d like me to be able to use the funds in the 529 plan to help pay for college. How might this potentially impact my eligibility for need-based financial aid?

Answer

The most common scenarios in which a college savings plan will be owned by someone other than the student or a dependent student’s custodial parent include 529 plans owned by a grandparent, another relative or a non-custodial parent. Since such 529 plans can significantly reduce eligibility for need-based aid, the family will want to find a workaround that reduces the harmful impact on aid eligibility.

While a grandparent-owned 529 plan will not be reported as an asset on the Free Application for Federal Student Aid (FAFSA), distributions from such a 529 plan will be reported as untaxed income to the beneficiary (the student). This can have a severe impact on the student’s eligibility for need-based financial aid.

There are several possible ways to avoid this situation:

Change the account owner. The simplest solution is to change the account owner to be the student or the parent. Nothing prevents a grandparent or other relative from contributing to a 529 plan owned by the student or parent. Changing the account owner, however, may affect the former account owner’s eligibility for state income tax deductions on contributions to the 529 plan, since some states (e.g., Maryland) require the taxpayer to be the account owner in order to claim the deduction.

If the grandparent or non-custodial parent is concerned that the custodial parent might take a non-qualified distribution, they could change the account owner to the student, with themselves as custodian in the custodial version of the 529 plan account.

It is best to wait until after the FAFSA has been filed to change the account owner, so that the 529 plan is not reported as an asset on the FAFSA. After the account owner is changed, the distributions will not be reported as untaxed income on the subsequent year’s FAFSA.

Wait to take qualified distributions. If the student is not planning on enrolling in graduate or professional school, the family could wait until after the FAFSA is filed for the student’s senior year in college to take distributions from the 529 plan, when there’s no subsequent year’s FAFSA to be affected.

Take non-qualified distributions after graduation. The family could also wait until after the student graduates to take non-qualified distributions to pay down any debt the student might have incurred.