Top strategies to help grandchildren with college

With the holiday season approaching, there is a terrific way grandparents may want to consider spoiling their grandchildren.

Today’s retirees have accumulated wealth at unprecedented levels and combined with the rising cost of college, many now are taking advantage of an opportunity to provide a legacy of education to their grandchildren.

However, without understanding the proper strategies, many well-intended grandparents can unnecessarily cost their grandkids money or at the very least, not maximize the dollars they are giving.

529 Plans

One of the best vehicles for grandparents are 529 plans, which allow investment for future education expenses with any earnings accumulating tax-free. And depending on where you live, many states provide a tax write-off for at least a portion of the contribution.

But it is important that grandparents set these up and distribute the funds properly to maximize the value.

First, determine whether it is best for the grandparents to open the 529 in their name or contribute to one on the parents name. If grandparents set up themselves as the owner of the 529 plan, they will name the grandchild as the beneficiary. If the grandchild doesn’t end up going to college, the money can be kept in the account and the beneficiary can be changed.

Since the grandparent owns the account, the asset does not have to be reported on the FAFSA, which is used to determine eligibility for need-based aid and only asks for the assets of the parents and child.

While that is the tremendous strategic advantage of grandparents owning the account, it also causes many to overlook the back-end of how the money is distributed.

The FAFSA has to be completed each year a student is in college in order to qualify for need-based financial aid each year, and it uses tax return information from 2 years prior to the fall of whatever school year the student is applying for aid in. For example, a family completing the FAFSA for the school year beginning in Fall 2021 would use their tax information from 2 years prior, or 2019.

When a grandchild receives money from a 529 plan, it appears as income in their name and thus needs to be reported on the FAFSA. When that happens, those dollars will be assessed at a rate of 50 percent, compared to only 5.64 percent if they were a parental asset. 529 distributions could reduce aid by 50 percent, meaning if a grandparent distributes $20,000 to a grandchild, it could reduce his or her aid by $10,000.

But there is a strategy to get around that major issue: Because the FAFSA looks back 2 years, postponing grandparent 529 distributions until the student’s junior year means they will not need to be disclosed on the FAFSA. 

If a grandparent distributes $20,000 to a granddaughter in the Fall of 2023, which is her junior year, the FAFSA she and her parents would have completed for that school year would use 2021 tax return info. And her senior year, Fall of 2024, will use 2022 tax return info, so neither the $20,000 distributed in 2023 nor any additional dollars distributed in 2024 would ever show up on the FAFSA and be assessed at the much higher student rate.

One of the few downsides to 529 plans is that the dollars must be used for educational purposes. Grandparents still can withdraw the funds if they need to, but then have to pay a penalty and income taxes.

Direct gifting

If that restriction is too much of a turnoff, an alternate strategy is for grandparents to give money directly to the parents with the intent that they be used for their grandchild’s education.  Those dollars would have to be reported on the FAFSA as a parent asset at 5.64 percent — more than using the delayed distribution 529 strategy but less than if it were in the name of the student and assessed at 50 percent.

Because those dollars are reported on the FAFSA, there is a chance that they could greatly reduce or eliminate the family’s ability to qualify for need-based aid.

If the family is unlikely to qualify for need-based aid anyway (check out the quick reference table to get an estimate) sending money directly to the grandchild, not delaying 529 plan distributions or directly paying tuition are all viable strategies. Grandparents can gift up to $30,000 per year as a couple ($15,000 per grandparent) before facing any gift taxes, but directly paying college tuition can exceed the annual gifting limit without penalty.

Families considering those options would be wise to consult with a certified financial planner along with an expert in college financial aid consulting to identify the best strategy for all of the financial goals the grandparents wish to achieve.

Spoil away, grandpa and grandma.