College Savings Plans and Financial Aid

on February 24, 2017

Prepaid tuition plans, 529 college savings plans and Coverdell education savings accounts are collectively known as qualified education benefits. Qualified education benefits are treated the same from a financial aid perspective on the Free Application for Federal Student Aid (FAFSA).

 

Reporting of College Savings Plan Depends on Account Owner

 

The financial aid treatment of a qualified education benefit depends on the account owner. Ownership affects whether the net worth of the account is reported as an asset on the FAFSA.

  • If the account is owned by dependent student (e.g., a custodial 529 plan), the qualified education benefit is reported as a parent asset on the FAFSA
     
  • If the account is owned by a dependent student’s custodial parent, the qualified education benefit is reported as a parent asset on the FAFSA
     
  • If the account is owned by anybody else, including a grandparent, aunt, uncle, cousin, non-custodial parent or complete stranger, the qualified education benefit is not reported as an asset on the FAFSA

Whether an account is reported as an asset on the FAFSA affects whether distributions are reported as income on the FAFSA.

 

If a qualified education benefit is reported as an asset on the FAFSA, distributions are ignored. However, if a qualified education benefit is not reported as an asset on the FAFSA, distributions are reported as untaxed income to the beneficiary on the FAFSA.

 

Financial Aid Impact Depends on Reporting of College Savings Plan

 

Thus, whether a qualified education benefit is reported as an asset on the FAFSA and whether distributions are reported as income can have a significant impact on eligibility for need-based financial aid.

  • If a qualified education benefit is reported as an asset on the FAFSA, the student’s eligibility for need-based financial aid may be reduced by up to 5.64 percent of the asset value. For example, $10,000 in a parent-owned 529 plan will reduce aid eligibility by at most $564.
     
  • If a qualified education benefit is not reported as an asset on the FAFSA, the student’s eligibility for need-based financial aid can be reduced by up to half of the amount of any distribution. For example, $10,000 in a grandparent-owned 529 plan will reduce aid eligibility by up to $5,000.

Non-Reported College Savings Plans Can Hurt Aid Eligibility

 

College savings plans can hurt aid eligibility when anybody other than the student or a dependent student’s custodial parent is the account owner of the college savings plan. Even though such college savings plans are not reported as assets on the FAFSA, distributions are reported as income.

 

When grandparents create 529 plans for their grandchildren, they sometimes decide to create a 529 plan with themselves as the account owner, instead of contributing to a parent-owned 529 plan. This can significantly reduce the grandchild’s eligibility for need-based financial aid. Sometimes grandparents set up 529 plans this way for the state income tax benefits, since some states require the taxpayer to be the account owner to claim the state income tax deduction on contributions.

 

Sometimes they do it because they don’t trust the grandchild’s parents to manage the 529 plan responsibly. After all, nothing stops the account owner from taking a nonqualified distribution to buy a big screen TV or sports car. A potential workaround is to open a custodial 529 plan, with the grandchild as the account owner and the grandparent as the custodian.

 

Similarly, problems arise when a child’s parents get divorced and the noncustodial parent is the 529 plan’s account owner. Although such a 529 plan is not reported as an asset on the FAFSA, distributions count as untaxed income to the child on the child’s FAFSA. This can have a very harsh impact on eligibility for need-based financial aid. It is important to consider this as part of the financial settlement and to change the account owner to the custodial parent.

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