How Grandparents Can Help Their Grandchildren Pay for College
Grandparents want to leave a legacy by helping their grandchildren get a college education. But, if they help in the wrong way, it can hurt their grandchildren’s eligibility for need-based financial aid for college.
Give Gifts to the Parent, Not the Student
The expected family contribution (EFC) is based on student and parent income, including untaxed income, received during the second prior tax year before the academic year. This use of two-year-old tax data is known as prior-prior year (PPY). For example, the 2017-18 Free Application for Federal Student Aid (FAFSA) was based on adjusted gross income (AGI) and untaxed income from 2015. The EFC also is based on assets as of the date the FAFSA is filed.
Thus, gifts received by the student during the base year may be double counted on the FAFSA, once as income and once as an asset, if the gift remains unspent as of the date the FAFSA is filed.
Gifts received by the student’s parents, however, will be counted as an asset and not as income because of a loophole in the Higher Education Act of 1965. The same loophole also excludes gifts from a dependent student’s parents to the student from being considered as income to the student.
Student assets also are assessed more than parent assets. The FAFSA reduces eligibility for need-based financial aid by 20 percent of student assets and at most 5.64 percent of parent assets.
Tip: Grandparents should give gifts to the student’s parents instead of gifts to the student. Each grandparent can give up to the annual gift tax exclusion to each parent without triggering gift taxes.
Contribute to a Parent-Owned 529 College Savings Plan
If a 529 college savings plan is owned by a student or a dependent student’s custodial parent, it is reported as a parent asset on the FAFSA. This reduces eligibility for need-based aid by up to 5.64 percent of the asset value. Distributions from such a 529 plan, however, are ignored.
If a 529 plan is owned by a grandparent, aunt, uncle, non-custodial parent or anybody else, it is not reported as an asset on the FAFSA. Distributions from such a 529 plan, however, count as untaxed income to the beneficiary (the student), reducing aid eligibility by as much as half of the distribution amount.
Total student income, including AGI and untaxed income, is reduced by allowances for federal and state income taxes and FICA taxes, plus an income protection allowance ($6,570 for the 2018-19 FAFSA). This is referred to as the student’s available income. Half of the student’s available income reduces eligibility for need-based financial aid.
529 plans provide a five-year gift tax averaging option, which allows grandparents to each make a lump sum contribution of up to five times the annual gift tax exclusion to each child’s 529 plan without incurring gift taxes. The contribution is treated as occurring and prorates during the next five years.
Some grandparents worry that the parents will take a nonqualified distribution from the 529 plans and spend it on a flat-screen TV or an expensive vacation. One work-around is to contribute to a custodial 529 plan account, where the grandchild is both beneficiary and account owner. Since the grandchild is a minor, the grandparents can serve as custodian of the account until the grandchild reaches the age of majority. Such a custodial 529 plan account will still be reported as a parent asset on the FAFSA, yielding a more favorable impact on eligibility for need-based financial aid.
Tip: Grandparents should contribute to a parent-owned 529 plan or a custodial 529 plan instead of a grandparent-owned 529 plan.
Wait until January 1 of the Sophomore Year in College
Due to the timing of the FAFSA’s base year, taxable income and untaxed income received on or after January 1 of the sophomore year in college will not affect eligibility for need-based financial aid, unless the student will be going to graduate school after graduating from college.
Tip: Wait until after January 1 of the student’s sophomore year in college to take distributions from a grandparent-owned 529 college savings plan.
Rollover Grandparent-owned 529 Plans into Parent-Owned 529 Plans
Another workaround is to rollover one year’s funds from a grandparent-owned 529 plan into a parent-owned 529 plan each year. If the rollover occurs after the FAFSA is filed, it will not be reported as an asset on the FAFSA. Since distributions to pay for college costs will come from a parent-owned 529 plan, they will not be counted as untaxed income on the FAFSA either.
There is one caveat. Some states have recapture rules that will require the taxpayer to repay any tax benefits received if the 529 plan account is rolled over into another state’s 529 plan.
Tip: Rollover one year’s 529 plan funding from the grandparent-owned 529 plan to a parent-owned 529 plan in the same state as the grandparent-owned 529 plan after filing the FAFSA.
Wait until after Graduation
Although grandparents can give gifts to the grandchild as early as January 1 of the sophomore year in college, some grandparents find it convenient to wait until after the student graduates from college. Then there will be no risk of the gift reducing the grandchild’s eligibility for need-based financial aid.
Tip: Wait until the grandchild graduates from college and help them pay off their student loans as a graduation present.
Do Not Pay the College Directly
Section 2503(e) of the Internal Revenue Code of 1986 specifies that there is no gift tax on direct payments of tuition to an educational institution. However, payments of a student’s tuition are considered to be cash support, which is treated as untaxed income to the student, reducing aid eligibility by as much as half of the total cash support. Some colleges treat such payments as a resource, which reduces financial aid eligibility dollar for dollar.
Help the Grandchild Find College Scholarships
Grandparents can help their grandchildren search for scholarships using free scholarship matching services, such as Cappex.com/scholarships.
Grandchildren also could be eligible for scholarships based on the grandparent’s heritage and affiliations.
- Scholarships based on a student’s race/heritage usually require the student to have at least one grandparent from the particular race/heritage. For example, scholarships from the U.S. Bureau of Indian Affairs require the student to have more than one-quarter Indian blood.
- Some colleges provide special scholarships for students whose grandparents worked for or attended the college. Examples include scholarships from the San Diego State University Retirement Association and legacy scholarships from the University of Pittsburgh Alumni Association.
- Some fraternal organizations award scholarships to grandchildren of their members. The Elks National Foundation, for example, awards scholarships to children and grandchildren of Elks members.
- Grandparents also should ask their employers and unions whether they award scholarships to grandchildren of employees. A few do.
Do Not Borrow on Behalf of a Grandchild
Grandparents are not eligible for the Federal Parent PLUS Loan unless they have legally adopted a grandchild.
Grandparents can cosign a private student loan for a grandchild. This is not recommended, especially if the grandparent is on fixed income. A cosigner is a co-borrower, equally obligated to repay the debt.
Name the Grandchild as a Beneficiary on a Roth IRA
Naming a grandchild as a beneficiary on a Roth IRA is a good way of passing retirement assets outside of probate. The beneficiary also will not pay income taxes on distributions from an inherited Roth IRA, although it can be counted as part of the grandparent’s taxable estate and subject to the estate tax exemption.
A Roth IRA, as a qualified retirement plan, will not affect the student’s eligibility for need-based financial aid.