In this reader mailbag, we explore how grandparents can ensure they are doing more good than harm when putting money in 529 plans.
By Karen Wallace | 01-31-17 | 05:00 AM | Email Article

We receive lots of questions from readers who want to help pay for their grandchildren's college educations. It's an admirable goal, and one of the most valuable gifts for grandchildren--especially considering the steep (and rising) costs of college

Karen Wallace is a senior editor with Morningstar.com. Follow her on Twitter @KarenW60602.

But before you reach for your checkbook, it's always wise to make sure you have saved enough for your own retirement. Safeguard the assets that will be needed in case of a very long life or pricey health complications. Though it can be hard to watch loved ones struggle to fund college on their own, they have many ways to borrow money for college if they need to. It would be much harder to borrow money in later years of retirement.

That said, if you are financially secure enough to help defray your grandchildren's college costs, being strategic about how and when to help can be beneficial, because in the case of students seeking financial aid, contributions from grandparents can come at a price.

Q: I've heard experts advise not withdrawing money from a grandparent-owned 529 until the student is a junior or senior because it's "penalized." Should grandparents not open 529s for their grandchildren at all?

A: The Free Application for Federal Student Aid must be filled out every year by students seeking aid. Information reported on the form is then used to compute the expected family contribution, which is then used to determine the amount of need-based aid the student is eligible to receive. Assets in 529s owned by the custodial parent(s) are assessed at a maximum of 5.64%; meanwhile, assets that are owned by a grandparent, aunt/uncle, noncustodial parent, etc., are not counted at all, until two years after they are used. 

As the money is withdrawn from these noncustodial-parent accounts and used to pay for college, it appears as student income, and that figures much more heavily into the expected family contribution calculation (as much as 50%, as opposed to 5.64%.) This difference is significant because a higher expected family contribution means less financial aid.

That's not to say that it's a bad idea for grandparents to open 529 accounts for the benefit of grandchildren. It's just wise to be tactical about how and when you use this money. By not using that higher-counted 529 withdrawal in earlier years of college, you will maximize the student's overall aid package.

As Christine Benz points out in this video, a lot of 529 plans offer a state tax benefit for contributing to an in-state plan. 

"Even if you have the money on hand and plan to pay for college next semester ... it can still make sense to run it through your home state's 529, pocket the tax break on the money that you've invested, and you can then pay for college straightaway," she said.   

It may make sense to open a 529 account for the benefit of your grandchildren, especially if you are looking to take advantage of that state tax benefit. A workaround for the financial aid penalty is not using the funds until later years of college (ideally until after the financial aid form is filled out for the senior year, if possible). 

Another possible solution would be changing the account owner to the parents, but not all plans permit changing account owners. And in some cases if you roll the assets to an out-of-state plan you would be on the hook for repaying the income tax benefit you received for contributing to your state plan. Check the details of your plan before going this route. 

Q: Grandparents can use the gift tax exclusion to help grandchildren pay for college expenses, if they pay college tuition and dorm costs directly to the university, correct?

A: Your understanding is correct, at least as far as tuition goes. Under Section 2503(e) of the Internal Revenue Code, direct payment of tuition to the institution will constitute a qualified transfer excluded from the gift tax. So potentially, a grandparent could pay a student's entire tuition directly to the university and it would be exempt from gift tax consequences. (Room and board, books, and supplies are not covered under this exclusion.)

But you may want to consider the implications not only on your own tax situation, but on the student's financial aid eligibility as well. Direct tuition payments could end up limiting the amount of need-based aid that a student is qualified to receive. Therefore, if the student is seeking financial aid, a better solution may be to contribute to the parent-owned 529 plan (which is assessed at a lower percentage in terms of the expected family contribution calculation and therefore has a lower impact on aid reduction). 

Alternatively, you could open an in-state 529 account(s) for the benefit of your grandchildren, which would allow you to take advantage of your home state's state tax benefit. Just be mindful of the order in which you withdraw the funds if the student is seeking financial aid. (Custodial parent-owned accounts should be used before noncustodial parent-owned accounts. See the previous answer for more on this.)

Q: I've heard there is some new legislation allowing you to use 529s to repay student loans. How would this work?

A: There is some relatively new legislation that would make 529s a little more flexible. If it were to become law, student loan repayment would be treated as a qualified educational expense. 

Why would you need to take out student loans in the first place if you had extra money in a 529 account, you ask? It's a logical question, but I can foresee a few circumstances in which this might happen. Say a family has two daughters who are planning to attend college, and the parents have saved $200,000--$100,000 in two 529 accounts.

The costs of college can differ dramatically from one child to the next. Say the older daughter attends a private college, and $100,000 doesn't cover the whole bill; she takes out student loans to cover the balance. The younger daughter attends a state school and is awarded a scholarship. The parents end up with some additional money in their younger daughter's 529 after paying for her education. If this bill were to become law, the parents could can change the beneficiary on the younger daughter's account to the older daughter, and then withdraw the funds tax-free to help her pay down her student loans. 

In the context of grandparents, this legislation (if passed) could help alleviate the issue of noncustodial assets "counting against" students who are applying for financial aid. If grandparents saved in a 529 account, they could take advantage of the state tax benefit, then (theoretically) wait until the student graduates and use the money in the 529 account to help pay down loans. That way, the student could get a larger financial aid package and then minimize the impact of interest on the student loans (especially helpful in the case of federal subsidized loans, which don't accrue interest until the student graduates). 

Of course, whether this legislation passes or not, a grandparent can help a student pay off loans by gifting the money directly after she graduates. Gift tax rules allow any individual to give another individual up to $14,000 per year ($28,000 from a couple) without the gift counting against the lifetime estate tax exemption (which for most individuals, is a nonissue anyway: For 2017, the lifetime gift tax exclusion is $5.49 million). 

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