(This article previously appeared on NerdWallet.com.)
Grandparents are often willing to help with college expenses when possible. I remember my own grandmother chipping in a bit for my freshman year at school. Knowing what I know now, though, it’s likely that the gift had a negative impact on my future financial aid.
The rules surrounding need-based financial aid can be confusing and overwhelming. Here’s how grandparents can help pay for college without negatively impacting their grandchildren’s eligibility for need-based aid:
Who owns the 529 account and when distributions are taken are very important factors for financial aid purposes.
529 Accounts — 529 accounts are one of my favorite college savings vehicles. The combination of tax benefits and flexibility make them very appealing. However, who owns the 529 account and when distributions are taken are very important factors for financial aid purposes.
Some grandparents will contribute to a 529 account in a parent’s or grandchild’s name. Because 529 accounts count as parental assets under the guidelines of the Free Application for Federal Student Aid (or FAFSA), those monies may reduce the amount of aid the student is eligible for. It has a similar effect under guidelines for the College Board’s CSS Profile for financial aid.
It’s usually best for a grandparent to establish the 529 plan in his or her own name, so it won’t impact need-based aid eligibility on the FAFSA.
Special care should also be taken when 529 distributions are made. Although parent-owned 529 plans are included in aid calculations, qualified distributions used to pay for the student’s education expenses are not included for the following year. However, grandparent-owned 529 distributions are considered “untaxed income” and can reduce a student’s aid award.
The best solution for grandchildren who won’t attend graduate school would be to take the distributions when they are in their junior or senior year of college. This is due to the new “Prior-Prior” rules that use the student’s sophomore year as the final “base” year for assessing aid eligibility.
Gifts — When it comes to financial aid, grandparents need to be careful here. Gifts given to the grandchildren or directly to the school will count as “unearned income” and could reduce the award amount.
Following the “Prior-Prior” rules, the best time to make gifts is in the grandchildren’s junior or senior year of college. As long as graduate school is not planned, gifts received in the last two years of college will be excluded from the aid calculations.
If the student needs money for freshman- or sophomore-year expenses, then the best option would be to make a gift to the parents, which would count less in financial aid calculations.
Hiring Your Grandchild — If any of the grandparents own a business, it might make sense to hire a grandchild in lieu of making a gift. The federal aid formula allows students to shelter $6,300 of income (for 2016) from their aid calculation. The student could use the proceeds to pay college expenses, pay off student loans or fund a Roth IRA.
Of course the job should be legitimate, meaning the work must be necessary for the business, and the pay must be appropriate.
Both parties benefit. The grandparents not only help their grandchildren pay for college, they receive a tax deduction on the salary they pay. This replaces a gift that they had planned on making anyway. The student receives tax-free income up to $6,300 thanks to the standard deduction, without any negative impact to aid eligibility.
One of the first steps in the college-planning process should be to determine if a child qualifies for need-based aid at the schools of his or her choice. If the answer is no, then it doesn’t matter who owns the assets, receives the income or when the gifts are made for aid purposes.
At that point, your focus should shift toward merit aid, tax aid such as the American Opportunity Tax Credit and how to best use your personal resources to pay your share of the cost.
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