A new change coming for 529 plans
We saw a wave of laws in 2020-2021 intended to help Americans cope with the financial fallout from the pandemic. While many provisions of the CARES Act, the Consolidates Appropriations Act, and the American Rescue Plan focused on immediate help with stimulus payments and mortgage and student loan relief, the bills also included long-standing financial assumptions. As an example, the Consolidated Appropriation Act included an update on how financial assistance is determined and administered. This includes the simplification of the Free Federal Student Aid Application (FAFSA) from the 2023-2024 academic year. In addition to shortening the duration of the FAFSA, this simplification includes several provisions to make it easier to calculate and obtain financial aid.
A big change for 529 accounts owned by non-parents
An important change concerns the way contributions to education are handled by non-parental figures like grandparents. Today, 529 account balances held by grandparents are not counted as an asset on the FAFSA, but distributions to pay for education for the beneficiary are counted as untaxed student income. Non-taxed student income can offset financial aid by 50%, meaning that a $ 5,000 distribution from a grandparent’s 529 could reduce aid by $ 2,500.
This concern about reducing financial aid has been a planning issue for many years. Several workaround strategies have been used to help grandparents support education through a 529 plan. Examples include waiting in late college years for grandparents to make a distribution to prevent income from falling. either included in the FAFSA or using the 529 account to pay off student loans once the student is finished.
So how has this changed?
According to SavingforCollege.com, the updated FAFSA does not require students to manually report cash support. This means that a 529 account opened by a grandparent, aunt, uncle, or family friend and its distributions will have no impact on eligibility for need-based financial aid. With the removal of the “grandparent trap”, Plan 529 becomes even more appealing to grandparents interested in contributing to the education of their grandchildren. The advantages include:
Tax deferral on investment growth and tax-free distributions if used for qualifying educational expenses (including $ 10,000 per year in K-12 tuition and $ 10,000 in total student loan payments for the recipient and each of their siblings)
Much higher contribution limits and more flexibility than Coverdell education savings accounts
An income tax deduction in many states for contributions
The ability to change beneficiaries if needed, making the 529 account very flexible for account holders with multiple grandchildren
Contributions to a 529 plan being considered a full gift while the owner retains control, which is a unique opportunity for those concerned with paying estate taxes
The ability for grandparents to contribute up to the donation limit in a 529 regardless of generation by skipping transfer rights
Be able to carry out up to 5 years of exemptions from the tax on donations
Availability in many age-based investment portfolio plans that offer one-stop diversification and automatically become more conservative as the beneficiary approaches college age
A whole new set of strategies
The current 529 savings landscape includes several strategies to maximize benefits while minimizing any negative effects on financial assistance. Since distributions from non-parental 529 plans are not counted, would it now make sense for parents to contribute to the grandparents plan instead? Be careful when creating new strategies on a rule change that is not yet in use. Since this change is in a few years, we might see some additional guidance on how these rules will be enforced.
For generous families and friends who would like to donate to education after 2023, this is great news. Just keep in mind that this can always be changed again as the rule should go into effect in a few years. For those who want to distribute before 2023, the above workarounds can help you avoid wasting help in the meantime.
Want to know more about planning education spending? Consider consulting a qualified and impartial financial planner. Your employer may even give you one for free as part of a workplace financial wellness program.