It’s summer. While this traditionally means kids in their late teens and early twenties are looking forward to weeks of sun and fun, it’s also the time when tens of thousands of young men and women across our country apply for financial aid to attend college.
In the mounds of financial information that you’ll need to gather, there’s one area of college funding that often gets overlooked — distributions from Section 529 plansi owned by a child’s grandparents, aunts, uncles and family friends.
If your son or daughter is heading off to college, and their grandparents, aunts, uncles or others have a 529 plan to help pay for some of the education, should your student take their 529 distributions outright? Or, should you investigate the matter? Our advice: Continue reading.
The rising cost of college education
The financial aid application season officially begins on October 1. That’s when FAFSA, the Free Application for Federal Student Aid, becomes available for the 2018-2019 school year.ii (The application deadline for the 2017-2018 school year was June 30.)
Some families can afford to pay for college. Others rely on government aid, and maximizing their student’s eligibility is important.
The cost of college education keeps increasing. In-state tuition and fees for four-year public universities for the past 10 years increased 3.5% per year beyond inflation, says the College Board. For the 2016-17 school year, the College Board says the cost to attend college (tuition, room and board) totaled …
- $20,090 per year for in-state institutions
- $35,370 per year for out-of-state institutions
- $45,370 per year for private institutions
A college student who started in 2016 will spend $80,360 to $181,480 for his education.
529 plans and financial aid
It’s great when grandparents, aunts, uncles and family friends want to help defray college costs. The problem is, their efforts might compromise a student’s financial aid eligibility.
“Failing to consider how 529 college savings plans impact financial aid can result in a student missing out on valuable financial assistance,” says Investopedia.
So, before grandparents, aunts, uncles and others hand out money or take distributions from Section 529 plans they own, consider how such steps might reduce your child’s eligibility to receive financial aid for college. Such handouts and distributions are viewed as prior-year income by the federal government, and are reported on the FAFSA in Section 45, “Student’s Untaxed Income,” line 45j.iii
In other words, a grandparent’s 529 distribution to a student this year could lower the student’s financial aid eligibility next year. Why is that?
A student’s financial aid eligibility is determined by the (1) assets and (2) income he and his parents have at their disposal. The more assets and income, the lower the student’s eligibility for needs-based aid.
- Assets include 529 college savings plans, Coverdell savings accounts, trust funds, and UGMA and UTMA accounts.
- Income includes both the student’s income, the spouse’s income (if married) and the parents’ income. It also includes qualified distributions from a 529 plan owned by a grandparent , aunt, uncle or family friend. Such distributions count as “untaxed income” the next time the student applies for aid.
But, “untaxed income” lowers a student’s financial aid eligibility far more than his asset balances. Fastweb.com notes that untaxed income reduces aid eligibility the following year by 50% of the distribution amount. “A similar treatment also applies to other qualified education benefits, such as prepaid tuition plans and Coverdell education savings accounts,” Fastweb says.
In contrast, the assets held directly by the student reduce the aid eligibility by 20% of the asset amount. Assets held by the student’s parents reduce aid eligibility by only 5.64% of the asset amount.
All this means the “untaxed income” from a grandparent’s 529 distribution might lose more aid than the distribution itself provides.
We advise readers to get qualified advice. Some Internet articles suggest that a grandparent-owned 529 account is excluded by the federal government financial aid formula. True, the FAFSA has no question related directly to grandparent-owned 529 plans. But, it does state unequivocally that “money received, or paid on [the student’s] behalf” from “grandparents, aunts, uncles, and non-custodial parents” must be included in question 45j.
Workaround for grandparents and others
So, what should grandparents, aunts, uncles and friends do if they own 529 plans (and prepaid tuition plans, a Coverdell education savings accounts, or some other assets) and want to make funds available to a college student? They should consider (1) the timing of the distributions and (2) changing the ownership of the assets.
1. Timing:
Wait until the student’s junior or senior year in college to take the distribution. FAFSA used to ask for prior year income, but a recent change requires income reported from a year earlier. So, a student filing for the 2017-18 school year will report income from 2015. This means, by waiting to the junior year the student will already have received his financial aid, and your 529 plan distribution (or other plan distribution) won’t affect his aid eligibility.
Another idea is to wait until after graduation to take a non-qualified distribution to help the student pay down student loan debt. The tax obligation may be far less than the loss of the need-based aid eligibility through“untaxed income” distributions.
2. Ownership:
Change the account owner to the student or the student’s parents — if the state you live in allows it. Then, the 529 plan may be treated as an asset by the student or by his parents, and assets reduce aid eligibility calculation less than income.
Of course, you will need to get sound financial and tax planning advice.iv
Time to act
On October 1, students and their parents will want to download the FAFSA and begin filling it out as soon as they can.
Why the urgency? Because many states — AK, IL, KY, NC, NC, OR, SC, TV and VA — dole out non-federal aid on a first-come, first-served basis until their funding programs run out.v It’s always best to submit your FAFSA as close to October 1 as you can to qualify for the best federal and state aid package.
You might consider crowd-sourced funding options for 529 plans. Grandparents, aunts, uncles and family friends often want to help and may be just waiting to be asked. This short Franklin Templeton Investments video shows how grandparents, aunts, uncles and friends can get involved.vi
Think as a family of what’s in the best interests of the student qualifying for needs-based aid. Anything that lowers aid eligibility could be a problem down the road.
Don’t wait to get the advice that you need. Remember, we’re here to help.
i. Section 529 college savings plans, sponsored by states, provide a tax-advantaged pathway for families to set aside funds to pay for future college education. Parents, grandparents and others often start a 529 savings plan when a child or grandchild enters the picture. However, “many families fail to consider the complex relationship between 529 plans and financial aid,” says Investopedia.
The investment return and principal value of 529 plan investments will fluctuate with market conditions. You may have a gain or a loss upon sale. Past performance does not guarantee future results. The 529 Plan interests are municipal securities issued by a state agency, and not shares in a mutual fund, although plan portfolios may invest in mutual funds. If you pay state taxes in states other than those offering the 529 plans, you should consider whether your state offers a plan with alternative tax advantages for its residents. Before investing in a 529 plan, consult with your financial advisor.
ii. To emphasize why you should begin organizing your student’s financial aid application process as soon as possible consider that the FAFSA is currently 10 pages long and has 105 questions related to a student and his family’s financial strength.
iii. This is based on the 2017-2018 FAFSA. The 2018-2019 FAFSA will be available October 1, 2017 and is expected to be a similar application.
iv. Securities America and its representatives do not provide tax or legal advice. Readers should consult their tax advisor, or legal counsel, for advice concerning their particular situation.
v. This list of states is for informational purposes only and is derived from the 2017-2018 FAFSA. South Bay Asset Strategies is licensed do business in some of these states, but not all of them. Readers should consult an advisor or student guidance counselor knowledgable about the particular state they reside in.
vi. Mention of specific investment companies should not be construed as a recommendation, by us or any third party, to acquire or dispose of any investment or security, or to engage in any investment strategy or transaction. Please consult with your financial advisor.