Some of your clients may be heartbroken watching their children and grandchildren struggle to pay for college. They’ve always been able to chip in, but any funds they provided had to be reported by the student as “money received or paid on your behalf” on their application for financial aid.
Why, they may be wondering, did I bother to set up 529 accounts for my grandkids if it’s only going to hurt their chances for aid?
That’s changing, thank goodness. This December, we expect to see the long-awaited changes under the FAFSA Simplification Act when the U.S. Department of Education releases the FAFSA (Free Application for Federal Student Aid) for the 2024-2025 academic year.
Currently, students and parents are required to report all income, whether or not it was reported on a 1040, with few exceptions. Under upcoming changes, income reported on the FAFSA will be linked to the student’s and parent’s federal tax returns. If something wasn’t reported as income on the 2022 return, it won’t be included as income for the purposes of the 2024-25 FAFSA.
So, your client can write a check, give cash or provide a distribution from a 529 account without it affecting their granchild’s federal aid eligibility or, potentially, need-based institutional aid.
Under another, less welcome FAFSA rule change, families will no longer get a break if they have more than one child in college, so the additional help may come in handy.
As you know, 529 accounts are tax-advantaged. Contributions are not federally tax-deductible, but many states offer a state tax deduction. Earnings grow tax-free and are not taxed when withdrawn to pay for qualified education expenses.
When the owner of a 529 is a dependent student or custodial parent, the account’s total value is reported as an investment asset on the FAFSA. Investment assets are assessed at 5.64% on the FAFSA, thereby slightly reducing a student’s eligibility for financial aid. For example, if the parent has $50,000 of assets saved in a 529 plan, this could reduce their student’s aid by a maximum of $2,820 (5.64%).
Clients may not realize that any third party — grandparents, aunts, uncles — can establish a 529 college saving account for the benefit of a future college student. And since third-party 529 accounts are not reported on the FAFSA, they are not considered parental or student assets. There is no annual cap on contributions, but they are considered completed gifts, subject to the annual $17,000 gift tax exclusion ($34,000 for couples).
Qualified education expenses
It’s good news that a grandparent can soon withdraw 529 funds to help pay for college, but it’s important to remember that this money can be used only for qualified education expenses. These expenses include tuition, room and board, books and supplies, laptops and internet access. Student loans can also be repaid up to a lifetime maximum of $10,000 per student.
Unqualified expenses include insurance, student health fees, transportation and extracurriculars. Paying unqualified expenses out of a 529 incurs a 10% penalty.
Should clients pay the school directly?
While distributions from third-party-owned 529 accounts paid directly to the school should not affect aid eligibility, the final rules have not yet been published. In general, it’s best to reimburse the student. Sending the money to the school simply announces that somebody is helping with college expenses — something you don’t want to draw attention to.
When can money be withdrawn?
Very important: Funds should be withdrawn during the same tax year that the educational expenses will be paid. A client might be tempted to withdraw money in December to pay for second-semester tuition in January, but don’t let them.
How much can be withdrawn?
The amount of money withdrawn from all 529s — whether owned by the student, a parent or a third party — cannot exceed the cost of the qualified educational expenses being billed by the school. If too much is withdrawn, it has to be repaid to the account within 60 days to avoid a penalty.
If the student receives a scholarship that offsets part of the 529 distributions, taxes would be owed but the funds can be used for any purpose penalty-free.
If the parents want to take the American Opportunity Tax Credit (AOTC) for qualified education expenses, non-529 funds must be used for up to $4,000 of those expenses. They can’t double-dip by getting the tax credit while paying with 529 money.
A note of caution
If the student is planning to attend one of the 200 or so schools that use the CSS (College Scholarship Service) Profile to award federal and institutional aid, it’s possible that a grandparent’s contributions could still be classified as student income. CSS Profile schools are mostly private colleges and universities, along with a few “public ivies” such as the University of Michigan, William & Mary and the University of Virginia. The full list is on the College Board website.
The CSS Profile assesses student and parental assets at 5%. So going back to the example of a parent with $50,000 in a 529 plan account, their child’s aid could be reduced by a maximum of $2,500 (5%).
Many changes are coming to the FAFSA, and we won’t know the impact of all of them until later this year. Paying attention to the upcoming rules may benefit your clients who have college-bound grandchildren or college-bound children.
Billie Jo Weis is vice president of client services for My College Planning Team and is a FAFSA and CSS Profile specialist. She has more than 20 years of experience in accounting and finance at a variety of companies and, as the mother of three boys in high school, knows first-hand the challenges and concerns of preparing for the cost of college. www.CollegePlanningTeam.com