Many grandparents want to help their grandchildren achieve their dreams of college. Unfortunately, how grandparents save or offer assistance can unintentionally reduce a student’s eligibility for financial aid. Knowing some of the rules in advance will ensure that a grandparent’s good intentions are fulfilled without penalizing the student.
If you are a grandparent (or soon to be one) here are a few things to consider when planning to help save for college.
Starting early helps
Saving for college is a great example of patiently investing for a known future event. Starting to save early gives more time for money to grow. For investments in tax-advantaged accounts, starting to save early can pile up into a good-sized nest egg. To understand this better, consider the Rule of 70, a rule of thumb for understanding how long it could take to double an investment: the number of years it takes to double your money is 70 divided by the annual interest rate.
So, starting a savings program early and not delaying is key. If you have a lump-sum of $1,000 and earn 4%, it will take 17.5 years to double your money. This investment made at your grandchild’s first birthday will grow to approximately $1,972 when they turn 18. If you wait four years and make that investment at age five, you will have saved $1,681. If you are able to add $100/month, the savings program started at age one will mushroom to over $30,000. The investment at age five will be worth approximately $22,000.
When is it too late to start saving?
Never. If your grandchild is in high school or college, whatever savings you have for them will likely help reduce their student loans. Saving a dollar today is better than borrowing one tomorrow®.
Options to save for college
Grandparents can choose from college savings options available to anyone wishing to help a student:
- Savings Bonds
- Traditional savings accounts
- Brokerage accounts
- Education trusts or UGMA/UGTA
- Tax-advantaged accounts including 529 Savings Plans and Coverdell Education Savings Account
Each of these has pros and cons depending on your financial goals and means. The Congress established the Coverdell ESAs and 529 Savings Plans to make saving for college possible on a tax-advantaged basis. These tax benefits make them particularly attractive for college savers.
Coverdell Education Savings Accounts
Savers with modified adjusted gross incomes of less than $110,000 ($220,000 for joint filers) are eligible to set up a Coverdell ESA and contribute up to $2,000 per year to pay for college and K-12 expenses. Withdrawals for Qualified Education Expenses for k-12 and college are tax-free at the federal and some state levels. The account must be used by the beneficiary before they are 30. Here is a link to more information for Coverdell ESAs.
529 College Savings Plans
529 College Savings Plans have become a very popular way to save for college. According to ISS Market Intelligence, there are more than 13.7 million 529 College Savings accounts in the U.S. with more than $360 billion invested in assets. In addition to tax-free growth and tax-free distributions for college, K-12 and apprenticeship Qualified Education Expenses, 529 Plans have other benefits.
Benefits of 529 Savings Plans
Account owners may change the beneficiary at any time and may exclude the asset from their estates. There are no restrictions on the type of college or the location of the college. Saving through a state plan can be used for out of state schooling.
And, if a student does not go to college, or there is money left in the account, the account owner may change the beneficiary or close the account after paying taxes and a 10% penalty.
The drawbacks for saving in 529 plans include their perceived complexity, the ability to only change investment options twice per year, and the penalty and required tax payments for unqualified withdrawals. Although each drawback has a mitigant, they should be considered when making an investment decision.
Grandparents have the option of contributing to a grandchild’s existing 529 plan or setting up a 529 Plan of their own plan.
Utilize the special 5-year 529 gifting rule for estate planning purposes
Grandparents also use 529 College Savings in their estate plans. Contributions of up to $15,000/year do not trigger gift taxes. Under a special five-year accelerating gifting rule available to 529 savers, grandparents can each make a single lump-sum contribution of up to $75,000 to a 529 plan beneficiary in a single year. Grandparents who are able can therefore kick-start a 529 savings plan with a lump-sum contribution of $150,000 for each grandchild.
Be careful: grandparent-owned 529 accounts may reduce financial aid
Grandparent assets are not directly disclosed on the Free Application for Federal Student Aid (FAFSA) since they are neither an asset of the custodial parent nor the student. However, when distributions from grandparent 529s are made to the student, the money is treated as student “income” for financial aid purposes in the year it was received. This is how a grandparent funded 529 distribution could reduce need-based financial aid.
The federal financial aid formula considers 50% of student income to be available to pay for college. A $10,000 distribution from a grandparent-owned 529 account would be considered student income in the FAFSA calculation. This could potentially reduce a student’s aid package by as much as $5,000.
This free Financial Aid Estimator will show you how that works.
How to use a grandparent 529 savings plan without reducing financial aid
Federal financial aid eligibility is calculated using income and asset information from tax returns going back two years, aka “prior-prior” year tax returns. For example, students applying for financial aid in the coming academic year, 2021, will use tax returns from 2019. For example, “income” they received from a distribution from the grandparent’s 529 in their freshman or sophomore year would show-up as student income when they file for financial aid in the junior and senior years. If a grandparent distributes money in the student’s junior or senior year, the “income” will not show on the tax returns used to determine need-based eligibility for their junior and senior years.
Grandparents who hold off 529 distributions until at least their grandchild’s junior year, will not affect the student’s financial aid. Students will still be eligible for their maximum need-based financial aid and then use their grandparent’s 529 for expenses in their last two years of college.
529 funding can also help pay for Graduate School where financial aid is primarily loans.
A Final Thought
Grandparents who help their grandchildren pay for college afford them an opportunity to graduate from college with as little student debt as possible. With proper planning, this can be an be accomplished using 529 or other college savings vehicles. There is some devil in the detail. Consulting a financial planner or college funding expert will help ensure everyone’s good intentions are met and students are well served.