Don’t Let Your Parents Start a 529 for your Kids
If you have parents who are offering to help you with college planning for your kids…lucky you! With college tuition increasing 7-8% every year, most of us can use all the help we can get.
However, there is a right way and a wrong way to accept this assistance. While your parents might want to jump in and open a college savings account on your kids’ behalf, it really should be the parent who creates the account.
Before we get into why grandparents creating the account could be an issue, let’s discuss the ways your child’s education might be funded.
Let’s Start with the FAFSA®
If you’re a parent with a young child, this might be a new term for you. The FAFSA® (Free Application for Federal Student Aid) opens every year on October 1st and is used to calculate a student’s expected family contribution (EFC) – the amount of a family’s income and assets a college/university will expect to contribute towards the child’s education. 66% of students apply for federal financial aid using the Federal Application for Student Financial Aid (FAFSA). (Source)
Funding Options
In addition to student loans (federal and private), common sources of education funding include regular cash flow, (i.e., from your paycheck), 529s and UTMAs (the Uniform Transfer to Minor Act). Other sources might include:
- IRAs
- Taxable accounts
- Rental properties or home equity
The Ups and Downs of UTMAs
Minors can’t legally hold (have custody of) assets in their name. As a result, accounts for minors are often setup as UTMA (Uniform Transfer to Minor) or UGMA (Uniform Gift to Minor) accounts, depending on the state.
There are two primary issues with UTMAs, one related to college funding and the other has to do with trying to keep your 21-year-old who just found out they have $200K in an account from buying a corvette! We’ll focus on the first.
Other Funding Sources
Lesser-known methods include a provision to withdrawal from your traditional IRA without the usual 10% penalty applied (though taxes on earnings would apply) or Roth IRA contributions (not earnings) which are post-tax and always eligible to be withdrawn, regardless of purpose or timing.
Additionally, though not well known, grandparents with the resources can bypass gift taxes by paying the school directly, versus giving the money to the parent or student.
Here’s What You Should Know About Grandparent Contributions
Grandparents in a position to help their children and grandchildren fund their education often contribute to a 529 account, correctly citing tax deferment and in some cases, state tax deductions as reasons for choosing this method.
Once they’ve decided on the vehicle, the question becomes whether to fund a new/existing 529 with the owner as the parent and beneficiary as the grandchild. Alternatively they may decide they wish to take the state tax deduction, or in some cases, not want the parent to know they’re setting aside the funds earmarked for their grandchild.
Remember the FAFSA at the beginning of this blog? A separate 529 becomes a problem when it’s time to use the funds; income (withdrawals) coming from the grandparents 529 will be assessed at roughly 50% EFC because it’s considered income to the child. (Please see upcoming changes to this rule at the end of this blog.)
And that could become a major issue when accessing federal tuition assistance.
If you think your child’s grandparent is considering contributing to their college education, it’s important to have conversations about the best way to go about it. You don’t want anything to get in the way of the funds your student might be able to access free and clear in the form of federal student aid.
It might also help to bring a professional into the conversation. By talking about your options, we can determine how to help your student with their tuition in the most tax-efficient way for your parents.
PLEASE NOTE THIS UPCOMING CHANGE: The latest version of the federal form for college aid will be available on Oct. 1 for the 2022-23 academic year. But a planned major overhaul of the form may not take effect for several years. (Source)