Distributions from a Grandparent or 3rd Party Owned College Savings 529 Plan May Negatively Impact Student College Aid Eligibility

With rising tuition costs, 529 plans have become a popular way for family members to help fund a student’s college education.  However, distributions from such plans may actually decrease a student’s eligibility for federal financial aid.

When a student applies for federal aid, he or she must fill out the Free Application for Federal Student Aid (FAFSA). Eligibility is determined based on the assets and income of a student and their parents, with income being more heavily weighted.  Although, 529 plans owned by grandparents or other third parties, such as aunts or uncles, are not included as assets for FAFSA purposes, any qualified distributions to the student is counted as untaxed income received by the student, thereby decreasing the student’s federal aid eligibility.

Below is a reproduction of a chart created by Mark Kantrowitz (see his article here) that shows the treatment of 529 plan funds for FAFSA purposes:

529 Plan Owner	Treatment of Asset	Treatment of Qualified Distributions	Treatment of Non-Qualified Distributions
Dependent Student	Parent Asset	Ignored	Taxable Income to Beneficiary
Parent of Dependent Student	Parent Asset	Ignored	Taxable Income to Beneficiary
Independent Student	Student Asset	Ignored	Taxable Income to Beneficiary
Grandparent, Noncustodial Parent or other third party	Ignored	Untaxed Income to Beneficiary	Taxable Income to Beneficiary

Strategies

Funds from plans owned by the student’s parents should be used first, and funds from the grandparent owned 529 should be reserved until the student’s final year of college when the student will no longer be applying for future aid.  Since eligibility is based on the previous year’s income and assets, funds used for a student’s final year of college will not negatively impact a student’s eligibility for aid.  Those funds can also be used after graduation to pay off student loans.  Delaying distributions from the grandparent’s 529 plan will not only avoid requiring the student to report additional income, but using the parent’s 529 plan first will result in lower assets being reported in subsequent years, which may increase federal aid for a student’s sophomore or junior year of college.

Some states allow 529 plan funds to be transferred from one plan to another.  If grandparents or other relatives have 529 plans, they can transfer those funds to a plan owned by the parent. The assets of the plan would still be counted in the financial aid calculation, but distributions from the 529 plan would not be counted as income to the student.  The state of Utah allows a transfer between plans, however, such transfers may not be eligible for state income tax benefits and any tax credits or deductions previously claimed must be recaptured.