Grandparents' 529 College Distributions Can Be a Ticking Time Bomb

Nov 19, 2013 | Updated Jan 25, 2014

Are you a grandparent thinking of helping out a grandchild fund their college expenses? Be aware of 529 plan structures to ensure that your gift doesn't turn into a bomb that destroys your grandchild's financial aid.

According to a recent Fidelity Investments survey, 65% of parents saving for college expect grandparents to contribute. In recent years, a growing number of grandparents have set up 529 college savings plans but before writing a check, grandparents must be aware of the potential pitfalls. Grandparents shouldn't have to worry about their 529 gift but many websites don't explain things clearly and many people are shocked when things go seriously wrong. Don't be left like tennis legend John McEnroe who famously stated "You can't be serious!"

So what's the story?

First, here's the good news. If a 529 plan is held in the grandparent's name, then there is no chance of the assets hurting the initial financial aid calculations. The Free Application for Federal Student Aid (FAFSA) doesn't even inquire about third parties saving for a child's education.

Grandparents may also benefit from reducing exposure to estate taxes, may be eligible for a state income tax break and as the account owner maintain complete control of the plan assets.

So what's the rub? Distribution Risk!

Students and families encounter problems when grandparents make distributions to pay for college expenses. The 529 withdrawals must be reported the following year on financial aid applications as the student's "untaxed income." The financial aid formula assesses student income at a stiff rate of 50 percent!!! This is the bomb to avoid at all costs.

For example, if a grandparent takes out $20,000 from a 529 that money would be assessed at 50 percent. The following year, the grandchild's need-based financial aid could be reduced by $10,000. This could be a devastating error.

Here are some tips to fix the problem

One way to diffuse the ticking time bomb is for the grandparent to transfer the ownership of the 529 plan to the parents. Assets in a 529 plan owned by the parents are assessed at a maximum of 5.64 percent for financial aid purposes. In our previous example, a potential financial aid award would only shrink by a maximum of $1,128, far better than the $10,000 lost. The only problem with this strategy is that a handful of states like New York do not allow account ownership changes.

Another way to avoid the financial aid bullet is by timing the withdrawals. Grandparents should coordinate with parents on the timing of payments. Ideally grandparents should wait until financial aid has been filed for the last time -- in the winter or early spring of the college student's junior year. This would be the last financial aid form the parents file covering the student's senior year, so the parents and child's finances after that filing wouldn't be affected by a grandparent's withdrawal.

The final solution is for grandparents to give cash to the parents letting them set up a 529 plan from the get go. This would avoid the hassles of timing withdrawals or looking for a state with liberal transfer rules. The only downside is that they lose control of the assets so there is no turning back.

Do you have additional college saving tips? Please share your thoughts and ideas in the comments section.

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