One question I get a lot in my financial planning practice is “How should I help with my grandchildren’s college costs?” There are many options: opening a 529 account on your own, gifting into the parents’ 529 accounts, UTMAs, direct payment of tuition, just to name a few. The answer, as is so often the case, is It Depends.
First, is the grandchild likely to be a candidate for need-based aid? Then, how much financial support are you planning to give? For a student eligible for need-based aid, the main thing to avoid is creating student income because student income is the biggest liability in the FAFSA calculation. On the FAFSA, the student is required to report as income any cash gifts they receive or distributions from non-parental 529 accounts. Of course, now that the student’s last FAFSA will be filed in fall of junior year instead of spring, non-reportable gifts can be made earlier. This means gift amounts can be spent over a longer timeframe. In some cases, it may make sense for the student or the parents to take out loans which the grandparents will repay after the last FAFSA is filed.
For students who are not likely to be eligible for need-based aid, the calculation is a little different. Grandparents who would benefit from an in-state tax deduction can open their own 529 account. Many states also allow any in-state contributor to take a tax deduction for a 529 contribution, regardless of the account owner. This means that grandparents can contribute directly to the parents’ 529 account and still get the tax deduction.
Grandparents should be aware that qualified distributions from 529 accounts receive the same tax treatment as distributions from Roth IRAs. Nonqualified distributions, though, are subject to income tax and a 10% penalty. So if contributions don’t get any state tax benefit, simply saving in a Roth IRA and using those funds to help with college adds flexibility and reduces potential tax exposure.
Given that there are limits to qualified distributions from 529 accounts, grandparents who are considering opening their own accounts on behalf of grandchildren should coordinate with the parents to ensure they are not overfunding accounts and to determine the best timing for each party’s withdrawals to ensure that withdrawals are qualified.