Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / How Grandparents Can Fund a 529 Plan Without Losing Financial Aid
Transcript
- Lucas: If you're a grandparent who wants to help pay for college, the instinct is to open a 529 plan in your own name, put money in, and hand it to the grandchild when the time comes. That instinct can cost a family thousands of dollars in lost financial aid. Luna: Wait — how? I thought 529 money was always treated favorably on the FAFSA. Lucas: That's the common assumption, and it's true for parent-owned 529 plans. But grandparent-owned 529s are a different animal entirely. When the grandparent takes a distribution to pay for the grandchild's college expenses, that money is counted as untaxed student income on the FAFSA. And student income is assessed much more harshly than parent assets. Luna: So let me guess — the student ends up losing aid dollar for dollar? Lucas: Almost. For the 2026-2027 academic year, the FAFSA formula applies a 50 percent assessment rate on student income above a small allowance. So if a grandparent sends a $10,000 distribution, up to $5,000 of that can be counted against the student's aid package. It's often called the 'grandparent 529 trap.' Luna: That's rough. And this is a recent change, right? I remember the old rules were different. Lucas: Exactly. Before 2024, the FAFSA only asked about parent assets and income, not student assets — so grandparent 529s went unreported. But the FAFSA Simplification Act changed that starting with the 2024-2025 form. Now, any cash support paid directly to the student, including grandparent 529 distributions, must be reported as student income. And that's a big deal for families near the aid threshold. Luna: So what's the workaround? Just tell grandparents not to open their own 529? Lucas: That's one option. The cleanest strategy is for the parent to open the 529 plan and let the grandparent contribute to it. In that case, the money is treated as a parent asset, which is assessed at a much lower rate — up to 5.64 percent on the FAFSA. So a $10,000 contribution would only reduce aid by about $564, compared to $5,000 if it's a grandparent distribution. Luna: But some grandparents want control. They don't want to just hand over money to the parents. Lucas: Right, and that's a real concern. There's a middle ground: the grandparent can own the 529 but delay distributions until after the student's final FAFSA is filed. For a typical four-year degree, that means the last FAFSA is filed for the student's junior year — so distributions in senior year and beyond won't affect aid. But that's a narrow window. Luna: And what about the SECURE Act's 529-to-Roth rollover? Could that help? Lucas: That's actually a really interesting angle. Starting in 2024, the SECURE 2.0 Act allows unused 529 funds to be rolled over into a Roth IRA for the beneficiary, up to a lifetime limit of $35,000, subject to Roth contribution limits. So if a grandparent opens a 529 and the grandchild doesn't use all the money, the remainder can become a retirement nest egg. But it doesn't solve the aid issue for the years the distributions are actually taken. Luna: So the rollover is more of a safety valve if the kid doesn't go to college or gets scholarships? Lucas: Exactly. And there's a five-year holding period before the rollover can happen, so you can't use it as a quick tax dodge. But for grandparents worried about overfunding, it's a nice backstop. Luna: Let's talk about the 'kiddie tax' for a second. I've heard that can complicate things when grandparents fund 529s. Lucas: The kiddie tax applies to unearned income of children under 19, or under 24 if they're full-time students. For 2026, the first $1,250 of unearned income is tax-free, the next $1,250 is taxed at the child's rate, and anything above $2,500 is taxed at the parent's marginal rate. But 529 plan earnings grow tax-deferred, and distributions for qualified education expenses are tax-free — so the kiddie tax doesn't apply to the 529 itself. The trap is when grandparents make a direct cash gift to the student instead of using the 529. That cash could be subject to the kiddie tax if the student invests it. Luna: So the 529 actually avoids the kiddie tax problem — as long as the money stays inside the plan. Lucas: Precisely. And the annual gift tax exclusion for 2026 is $18,000 per person per beneficiary. So a grandparent can contribute up to $18,000 to a 529 plan without filing a gift tax return. They can even front-load five years' worth — $90,000 — in a single year, as long as they elect that treatment on their tax return. Luna: That's a lot of money to front-load. But is that smart if the kid is still young? Because you're tying up that money in a 529, and if the kid doesn't go to college, you're stuck. Lucas: That's the trade-off. The front-loading strategy makes sense when grandparents are confident the grandchild will pursue higher education. And now with the Roth rollover, there's more flexibility than there used to be. But for a lot of families, the simpler approach is just to contribute annually to a parent-owned 529 and avoid the aid complications altogether. Luna: I want to zoom in on a concrete example. Say a grandparent wants to contribute $50,000 over four years. What's the difference in aid impact between a grandparent-owned plan and a parent-owned plan? Lucas: Great question. With a grandparent-owned 529, if distributions are taken each year, they count as student income. For a $12,500 distribution per year — assuming a $2,500 student income allowance — the assessed amount would be about $5,000 per year, totaling $20,000 over four years. With a parent-owned 529, the $50,000 asset is assessed at a maximum of 5.64%, so about $2,820 over four years. That's a difference of over $17,000 in potential aid loss. Luna: Seventeen thousand dollars — that's a semester at a state school. So the parent-owned plan wins dramatically. Lucas: On pure aid impact, absolutely. But again, control is a factor. Some grandparents want the legal protection of owning the account — for example, in case of a divorce or bankruptcy in the parent's household. In those situations, a grandparent-owned 529 is safer because it's not considered a parental asset. Luna: So the strategy really depends on the family's specific circumstances. If both parents are stable and the grandparent trusts them, parent-owned is the way to go. If there's concern about the parents' financial situation, grandparent-owned might be worth the aid hit. Lucas: Exactly. And there's a middle path: the grandparent can own the 529, but only take distributions in the student's senior year, after the final FAFSA is filed. That way, the aid impact is limited to one year. It's not perfect, but it's a compromise. Luna: I think this is a good moment to note that listener support is what keeps this show ad-free and accessible. If today's episode helped you think through your own family's strategy, buy me a coffee dot com slash fexingo is the place. Even a small contribution makes a difference. Lucas: Yeah, and we mean that sincerely — it's what allows us to do deep dives like this without sponsors. So, back to the 529 trap: one more thing to watch out for is the timing of distributions relative to the FAFSA filing date. Luna: Right, because the FAFSA looks at the prior-prior year's tax return. So distributions taken in 2026 would affect aid for the 2027-2028 academic year. Lucas: That's right. So if a grandparent plans to take a distribution for freshman year, they need to check whether that distribution will fall into the student's income for the correct FAFSA filing year. It gets complicated fast. That's why many advisors recommend working with a tax professional or college funding specialist. Luna: We should also mention that some states offer tax deductions for 529 contributions. Does that change the calculus? Lucas: It does. Over 30 states offer a state income tax deduction or credit for 529 contributions. But here's the catch: many of those deductions are only available to the account owner. So if the grandparent owns the account, they get the state tax benefit. If the parent owns it, the parent gets the deduction. That can be a significant factor in high-tax states like New York or California. Luna: So if the grandparent is in a high-tax state and the parent is in a no-tax state, the grandparent might want to own the account just for the deduction. Lucas: Exactly. But then they're back to the aid trap. It's a balancing act. The best approach is to run the numbers — compare the state tax savings against the potential loss of financial aid. For a family with high income and no aid eligibility, the aid impact is moot, so the grandparent-owned plan with the tax deduction wins. For a family that's likely to qualify for need-based aid, the parent-owned plan is usually better. Luna: Let's talk about the new FAFSA's treatment of small businesses. Does that affect grandparent contributions? Lucas: Not directly. The simplified FAFSA eliminated the small business asset question, so that's one less complication. But it also made the student income question more prominent. So the grandparent 529 trap is actually more significant now than under the old rules. Luna: So the message is clear: grandparents should think twice before opening their own 529, and if they do, they need a distribution strategy. Lucas: That's the takeaway. And if they can coordinate with the parents, the simplest and most effective approach is to contribute to a parent-owned 529. It avoids the trap, preserves financial aid, and still lets the grandparent benefit from gift tax exclusions. Luna: One last thing — what about 529 plans owned by other relatives, like aunts or uncles? Same trap? Lucas: Same trap. Any non-parent-owned 529 distribution that goes to the student is treated as student income on the FAFSA. So the advice applies to any relative who's not the parent. Luna: Good to know. So if you're planning to help a grandchild, niece, or nephew with college, think about the account ownership structure first. Lucas: Exactly. A little planning upfront can save thousands in lost aid. And with the new FAFSA rules, it's more important than ever.