Is it better for a grandparent or the parents to set up and own a 529 college savings plan?

Question:

Is it better for a grandparent to set up and own a 529 college savings plan or for the parents to set up and own the 529 plan? If the parents own the 529 plan, should the grandparent give the parents money to deposit into the 529 plan or should the grandparent deposit the money directly?

Answer:

Generally, a grandparent-owned 529 college savings plan will reduce the grandchild’s eligibility for need-based financial aid much more so than a parent-owned 529 plan. If the student expects to be eligible for need-based financial aid, it is better for the 529 plan to be owned by a parent, not the grandparent. The grandparents can then contribute directly to the parent-owned 529 plan.

These rules apply to all qualified education benefits, including prepaid tuition plans and Coverdell education savings accounts, not just 529 college savings plans.

The impact of a 529 plan or other qualified education benefits on eligibility for need-based financial aid depends on whether the 529 plan is reported as an asset and whether distributions from the 529 plan are reported as income on the FAFSA (Free Application for Federal Student Aid).

  • If a 529 plan is reported as an asset on the FAFSA, qualified distributions from the 529 plan are disregarded on the FAFSA.
  • If a 529 plan is not reported as an asset on the FAFSA, qualified distributions from the 529 plan are reported as untaxed income to the beneficiary.

In both cases, non-qualified distributions are included in the student's adjusted gross income (AGI).

Only 529 plans owned by the student or a dependent student’s custodial parent are reported as assets on the FAFSA. College savings plans owned by anybody else, including grandparents, aunts and uncles, are not reported as assets on the FAFSA. If a dependent student’s parents are divorced, 529 plans owned by the custodial parent (the parent responsible for completing the FAFSA) are reported as assets on the FAFSA, but not 529 plans owned by the non-custodial parent.

On the FAFSA, income, including untaxed income, has a more severe impact on eligibility for need-based financial aid than assets.

  • Parent assets reduce aid eligibility by at most 5.64% of the net asset value. A portion of parent assets, typically $30,000 to $60,000, are sheltered based on the age of the older custodial parent. Assets may also be disregarded entirely if the parents qualify for the simplified needs test. The remaining assets contribute to the expected family contribution (EFC) based on a bracketed scale from 2.64% to 5.64% of the net asset value. (Student assets are assessed at a flat 20% rate, but a 529-plan owned by a dependent student is treated as though it were a parent asset.)
  • Student income reduces aid eligibility by as much as half of the amount of income. Untaxed income has the same impact on aid eligibility as taxable income. Both are part of total income. A portion of student income is sheltered from need analysis on the FAFSA. Half of any income above this income protection allowance will reduce eligibility for need-based financial aid.

Accordingly, grandparent-owned 529 plans will have a much more severe impact on the grandchild’s eligibility for need-based financial aid than parent-owned 529 plans. Distributions from a grandparent-owned 529 plan, which are not reported as assets on the FAFSA, will reduce aid eligibility by as much as half of the amount distributed. Parent-owned 529 plans are reported as assets on the FAFSA, yielding a small impact on aid eligibility, but distributions from such 529 plans are disregarded. For example, a $10,000 distribution from a grandparent-owned 529 plan may reduce eligibility for need-based financial aid by as much as $5,000, while $10,000 in a parent-owned 529 plan may reduce eligibility for need-based financial aid by, at most, $564.

Contributions to a 529 college savings plan may also have an impact on federal and state tax liability.

In some cases, the grandparents may lose state income tax benefits by contributing to a parent-owned 529 plan. Thirty-four states and Washington, D.C., provide a state income-tax deduction or tax credit for contributions to the state’s 529 college savings plan. Of these, 11 states require the taxpayer to be the account owner to claim the state income-tax deduction.

It is better if the grandparent contributes money directly to the parent-owned 529 plan for each grandchild. Contributions to a parent-owned 529 college savings plan have the same impact on aid eligibility, regardless of whether the grandparent contributes the money directly or indirectly through a gift to the parents. There are, however, differences in the gift-tax treatment. If the grandparent contributes directly to a parent-owned 529 plan, the grandparent can give up to the annual gift-tax exclusion ($14,000 per recipient in 2013, 2014 and 2015) to each grandchild’s 529 plan. (Grandparents can give up to twice the annual gift-tax exclusion to each grandchild’s 529 plan if they are contributing as a couple.) If the grandparent gives the money to the parents, however, the grandparent is limited to a single gift-tax exclusion per parent since the gift is given to the parent, not each grandchild. This may limit the amount that can be contributed to each grandchild’s 529 plan if there are multiple grandchildren. Also, direct contributions to a grandchild’s 529 plan are eligible for five-year gift-tax averaging, while gifts to the parents are not.