529 Plan? Be Careful Of The Grandparent Trap !

The 529 Plan Grandparent Trap!

Those that follow my blog know that I’m a big fan of the 529 plan. The 529 plan is the go-to instrument when saving for children’s education. Although they are funded with after tax money the funds grow tax-free and then, as long as the money is used for qualified educational expenses, no tax is paid when the money is withdrawn! In addition, in 30 states and the District of Columbia, some or all of the contribution to a 529 is deductible from state income tax. If you are not familiar with these plans you need to be. You can get more information here.

These plans are however, not a panacea. As I previously pointed out - there are some relatively minor pitfalls that that can generate significant penalties.  Perhaps the most under recognized is what I call the grandparent trap. To understand this trap lets look at what happens when parents hold a 529 for their child and the dependent child applies for financial aid. Essentially, assets in a parental 529 plan are used when calculating the Expected Family Contribution (EFC) (the amount that a family is expected to cover for higher education expenses). However its impact on financial aid is relatively minor because federal guidelines state that 529 accounts  used in EFC calculations are valued at just 5.64% of their actual worth. In addition, withdrawals are not counted as income to anyone. 

529 plans held by grandparents are totally different. The value of a 529 account held by grandparents (or anyone other than the beneficiary’s parent) are not used when calculating the students EFC; however, any monies withdrawn are counted as income to the  student. This income must be included on the Free Application for Federal Student Aid (FAFSA) application in the following year. Such income is assessed at 50% for purposes of the EFC. This can have a significant impact on financial aid eligibility. Something grandma and grandpa probably didn't even consider when they set up the account 18 years ago!

How can you avoid the grandparent trap? It’s not easy. One strategy is to use grandparent’s 529 money in the final year of higher education.  Since withdrawn are counted as income to the student in the following year, this should have no effect on FAFSA applications. However, as always, your best bet is to speak to a financial professional.