The Free Application for Federal Student Aid (FAFSA) has introduced changes that provide a significant advantage for grandparents willing to support their grandchild’s higher education. Traditionally, grandparent-owned 529 plans were a financial dilemma due to their potential impact on the student’s aid eligibility. However, recent updates to FAFSA rules have shifted this landscape, creating what’s been dubbed the “Grandparent Loophole.”
Understanding the Grandparent Loophole
Under old FAFSA regulations, withdrawals from grandparent-owned 529 plans were treated as untaxed income for the student, potentially reducing their eligibility for financial aid significantly. Now, with the new FAFSA changes, these distributions no longer need to be reported, thus not affecting the student’s aid calculation.
Grandparents can now contribute to a 529 plan, with the funds being used for qualified education expenses without fearing the reduction in financial aid eligibility for their grandchildren. This is particularly appealing given the escalating costs of college education and the increasing student debt crisis, where student debt in the U.S. is nearing $2 trillion.
Benefits of a 529 Plan
A 529 plan offers various advantages beyond just aiding in college tuition. Contributions grow tax-deferred, and distributions for educational expenses are tax-free. These plans are flexible; if the original beneficiary does not need the funds (for example, they choose not to attend college), the beneficiary can be changed to another family member. Additionally, there are estate planning benefits, as contributions to a 529 plan can significantly reduce the taxable estate of the grandparents.
However, it’s crucial to note that while FAFSA requirements have eased, the College Scholarship Service (CSS) Profile, used by approximately 200 private colleges for awarding their own aid, might still consider grandparent-owned 529 plans as part of the student’s resources.
Operational Guidelines
Grandparents considering opening a 529 plan should be aware of the following:
- Qualified Expenses: Funds from a 529 plan can be used for tuition, room and board, books, supplies, and even laptops and internet access. There’s a distinction between qualified and unqualified expenses, with unqualified expenses incurring penalties.
- Gift Tax Exclusions: Contributions to 529 plans are considered gifts and thus are subject to the federal annual gift exclusion limits. However, there is a provision for front-loading five years’ worth of contributions without triggering the gift tax.
- Timing and Amount of Distributions: To avoid penalties, it’s important to withdraw funds in the same tax year they are used for educational expenses. Moreover, the total withdrawals must not exceed the cost of the qualified educational expenses billed by the school.
- Impact on Other Aid and Benefits: Grandparents should also be aware of how these contributions might affect the American Opportunity Tax Credit (AOTC) and be mindful of the timing of withdrawals to optimize tax benefits.
Conclusion
The introduction of the Grandparent Loophole under the new FAFSA rules marks a significant shift in how grandparents can contribute to their grandchildren’s education. It alleviates previous concerns over financial aid reduction due to their contributions.
However, while it offers a new avenue for supporting educational expenses, careful planning and understanding of the rules are essential to maximize benefits while avoiding pitfalls. This change underscores the evolving landscape of college financing, reflecting a broader recognition of the diverse sources families may draw upon to manage educational costs.