Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / How 529 Plans Protect Grandparent Assets
Transcript
- Lucas: The most common assumption parents make about grandparent-funded college is that it’s a straightforward gift. They think if Grandma puts money into a 529 plan, it just works. But we are seeing a massive structural shift where wealthy families are actively avoiding 529 accounts for grandchildren, not because they dislike the tax benefits, but because of how those assets sit on the balance sheet. Luna: Right, and I have seen clients panic when they realized that even a dormant 529 could wipe out their child’s need-based grants. The mechanics of that calculation are brutal. Lucas: Exactly. Under the current FAFSA framework, which remains largely stable as of October twenty-three, two thousand twenty-six, any assets held in a grandparent’s name are treated as student income in the following year. That means if a grandparent has a five hundred thousand dollar 529, up to sixty-four percent of that distribution is counted as untaxed student income. That directly reduces federal aid eligibility by nearly half the account value. Luna: Sixty-four percent is staggering. It essentially turns a gift into a tax on the child’s future aid. Lucas: It does. And this is where the strategy gets interesting. Instead of putting that cash into a 529, many high-net-worth families are shifting those assets into taxable brokerage accounts or even holding them in their own retirement IRAs. Why? Because distributions from retirement accounts do not count as untaxed income on the FAFSA form at all. So the money stays liquid, it grows, and when it’s time for college, you can withdraw it without triggering a penalty on the aid calculation. Luna: So you are prioritizing aid eligibility over the specific tax shelter of the 529 structure. That feels like a counterintuitive move for most people. Lucas: It is counterintuitive until you run the numbers. Let’s say the grandparent has three hundred thousand dollars. If it sits in a 529, the potential aid reduction could be one hundred ninety thousand dollars. If it sits in a taxable brokerage account, and they distribute it strategically, the aid hit is zero. You lose the state tax deduction on the 529, sure, but you gain back hundreds of thousands in federal Pell Grants and subsidized loans. The math favors liquidity and neutrality over the dedicated wrapper. Luna: But doesn’t withdrawing from a taxable account trigger capital gains taxes immediately? That seems like a hidden cost. Lucas: It triggers capital gains, yes. But compare that to losing sixty-four percent of your aid. A ten percent capital gains tax is far cheaper than a sixty-four percent aid reduction. Plus, you can manage the timing. You don’t have to dump the whole portfolio in one year. You can stagger distributions to stay under certain thresholds, or hold long-term assets to minimize the hit. The flexibility of a brokerage account actually gives you more control over the tax event than the rigid rules of a 529. Luna: I see. So the 529 becomes a liability rather than an asset in this specific context. Is this only relevant for families near the aid cutoff? Lucas: No, it is relevant for almost everyone who cares about net price. Even middle-class families often fall into the gap where a large grandparent contribution pushes them from full need to partial need. We saw a case last month where a grandmother had eighty thousand in a 529 for her grandson. She withdrew it right before the second year of college, thinking she was helping. Instead, it slashed his institutional grant by forty thousand. She literally paid for the same tuition twice. Luna: That is a painful lesson. Did she recover from that? Lucas: She did, but it required a professional appeal to the financial aid office. And that brings us to the second part of this shift: the power of direct payment. Some families are now skipping the account entirely. The grandparent pays the university bursar directly. Since the money never touches the student’s name, it doesn’t appear on the FAFSA as student income. It is effectively invisible to the needs analysis formula. Luna: Direct payment sounds simple, but isn’t there a risk if the family dynamics change? Like if the grandparent passes away or the relationship sours? Lucas: Those are valid concerns. Direct payment lacks the legal protection of a trust or a custodial account. If you pay the school directly, you cannot get that cash back. It is a true gift. However, many families use a hybrid approach. They keep the bulk of the wealth in their own names, perhaps in a revocable living trust, and only draw down what is needed for tuition each year. This keeps the assets off the student’s radar while maintaining control for the grandparents. Luna: So control is the key word here. You want to preserve the ability to step back if things go wrong. Lucas: Precisely. In a 529, once the money is in, it is very hard to take out for non-qualified expenses without penalties. In a brokerage account or trust, you have discretion. You can decide to fund a study abroad semester, or you can decide to let the money stay invested for a later grandchild. That optionality is valuable. It turns the savings vehicle into a strategic tool rather than a static piggy bank. Luna: I am curious about the graduate school angle. Does this logic hold up for masters degrees too? Lucas: It holds even stronger. Graduate students often face stricter aid limits because they are considered independent. But the FAFSA still looks at parental assets for undergraduates. For grad school, it’s mostly about the student’s own resources. If a grandparent has funds designated for grad school, keeping them in a taxable account avoids the complexity entirely. You just pay the tuition. No forms, no calculations, no surprises. Luna: It feels like we are moving away from branded products toward pure service. Paying the bill instead of buying the box. Lucas: That is a great way to put it. The 529 is a branded box with nice tax features. But if the box itself disqualifies you from the main prize—the federal aid—then the box is worthless. We are seeing a generation of planners who are willing to give up the state tax deduction to save the federal aid. It is a trade-off that used to be unthinkable, but with tuition rising, every dollar of aid matters more. Luna: And what about the state tax deduction? Isn’t that a significant chunk for some states? Lucas: For some states, it is. In New Jersey or Massachusetts, the deduction can be substantial. But remember, that deduction saves you maybe four or five percent on your annual contributions. Losing sixty-four percent of your aid is a much larger number. Most families find that the aid loss dwarfs the tax benefit. Unless you are in a state with a massive deduction and you are contributing at the very top limit, the math usually points away from the 529 for grandparent assets. Luna: So the advice flips depending on whose name is on the account. Parents should use 529s, but grandparents should probably avoid them. Lucas: Correct. Parent assets are capped at five point six percent of their value in the needs formula. That is manageable. Grandparent assets are treated as student income, which is uncapped and highly punitive. The asymmetry is the problem. It forces grandparents to act differently than parents, even though they are trying to help the same person. Luna: This feels like a loophole that policymakers might close eventually. Do you think the rules will change? Lucas: There have been proposals to treat grandparent assets like parent assets, but nothing has passed yet. As of today, the distinction remains. Until it changes, families have to navigate it themselves. It adds a layer of complexity to estate planning that didn’t exist ten years ago. You can’t just set up a college fund anymore. You have to design a liquidity strategy. Luna: Liquidity strategy. That sounds like corporate speak for making sure you have cash when you need it. Lucas: It is exactly that. In finance, liquidity is king. When you lock money into a 529, you sacrifice liquidity for tax breaks. When you keep it in a brokerage account, you retain liquidity at the cost of higher ongoing taxes. In the college funding world, liquidity buys you aid eligibility. It is a premium feature. Luna: I wonder if this trend will push more families toward private loans or scholarships instead of family support. Lucas: Unlikely. Families are incredibly committed to funding college. They just want to do it efficiently. If the 529 path is blocked by aid rules, they will find another path. Direct payment, taxable accounts, trusts. They will adapt. The demand for funding is inelastic. The supply side is just getting more sophisticated. Luna: Sophisticated families winning the game. What about the average family who doesn’t have a lawyer to set up a trust? Lucas: For the average family, the advice is simpler. If you have less than fifty thousand dollars in assets, the aid impact is minimal anyway. The sixty-four percent rule hits harder when the base is larger. If you are a modest saver, a 529 is still fine. The complexity only matters when the stakes are high. Don’t over-engineer a solution for a small problem. Luna: Scale matters. Small problems get simple solutions. Big problems get complex structures. Lucas: Exactly. Complexity is the tax you pay for managing large sums. If you have enough money to worry about aid cliffs, you also have enough money to hire someone to figure it out. But the principle remains: know where your assets live. If they live in a grandparent’s 529, you are likely paying a hidden tax to the government in lost aid. Luna: So the takeaway is to check the ownership structure before you contribute. Who holds the bag? Lucas: Always check. And if it is a grandparent, consider moving it. Or better yet, start fresh with a taxable account. It is never too late to restructure. Many families discover this issue in junior year, which is too late. Start the conversation in senior year of high school, or even earlier. Timing is everything. Luna: Timing is everything. I guess we should remind our listeners that silence is not golden when it comes to financial aid forms. Lucas: Silence is expensive. Ask questions. Verify the calculations. Don’t assume the default product is the best product. Especially when it involves your future. Luna: We deliberately don't run ads on these. If you want to support that choice, the link is buy me a coffee dot com slash fexingo — that's F. E. X. I. N. G. O. Lucas: Thank you for keeping the signal clean. Now, back to the question of whether you should pay the school directly or save in an account. Luna: It really comes down to control versus convenience. Which do you value more when the tuition bill arrives? Lucas: Most families I talk to realize they value control. They want to know they can pivot if the market shifts or the family needs change. Convenience is nice, but control is survival. Luna: Survival mode in college funding. I hope we never have to use that term, but the pressure is real. Lucas: It is real. And navigating it requires looking past the shiny boxes and understanding the underlying mechanics. That is the only way to win.