Options include cash gifts and funding a 529, but beware the financial aid impact.
Question: I want to help my grandchildren pay for college, but I don't want to affect financial aid eligibility. What's the best way to help?
Answer: Helping pay for a grandchild's college education is an admirable goal, especially given the financial strain college can put on families. But before your clients start writing checks to help out their grandkids, make sure they have taken care of their own financial needs. If there's any question about whether they've saved enough for their own retirement, they're better off letting the grandkids and their parents fund college on their own. After all, they'll have plenty of opportunities to borrow money for college if they need to, but no financial institution will loan your clients money for their retirement.
Once they've determined they're financially secure enough to help, it's time to think about what strategy best suits not only their situation but also that of their kids and grandkids. There are several different ways grandparents, aunts, uncles, friends--pretty much anyone--can help students with college costs, but don't decide on any one path until you've considered all the implications.
The Complications of a Cash Gift
The easiest, most straightforward way for a nonparent to help a student pay for college is with a cash gift to the student or to his or her parents. Gift tax rules allow any individual to give another individual up to $13,000 per year ($26,000 from a couple) without the gift counting against the lifetime estate tax exemption. But there's a problem with this approach--aside from the fact that there's no guarantee the recipient will use the money for the purpose you intend--and it comes into play for students applying for need-based financial aid.
On the Free Application for Federal Student Aid, or FAFSA, the most widely used financial aid application, cash given directly to a student the year before he or she applies may be considered student income, reducing need-based aid by as much as 50% of the amount given. (For dependent students, the first $6,130 in income received does not affect aid, but anything beyond that is subject to the 50% reduction.) To make matters worse, money held in the student's name is treated as a student asset, reducing aid by another 20%. So that gift of $13,000 could end up costing the student up to $9,100 in financial aid. Cash given to the parents counts as a parental asset, though not as parental income, and also counts against financial aid, but at a much lower rate of up to 5.64%. That means a $13,000 gift made to the parents would potentially cost the student just $733 in financial aid. Much better, but still not ideal.
To avoid any financial aid impact with a cash gift, keep in mind that the FAFSA takes into account income from the prior year in determining need-based aid. So cash given to a student the year before he or she enters college--as a high school graduation present, for example--could reduce the amount of need-based aid the student receives the following year. To avoid this, your clients may consider giving the money when they know the student will not be applying for aid the next year. That could mean giving money before Jan. 1 of the student's junior year of high school or after Jan. 1 of the student's final year of college. (If the latter, be sure the student will not be applying for aid for further studies the following year.)
Lending a Hand With Loans
Another approach that is even cleaner is for grandparents to offer to help pay back the student's loans. By waiting until the student is done with school, they avoid financial aid concerns and help ease the student's debt burden as the student enters the workforce. Mark Kantrowitz, publisher of financial aid website FinAid.org, says that for many grandparents, this option makes the most sense.
"When deciding how to contribute to a grandchild's college education, grandparents should consider the impact of their contributions on the student's eligibility for need-based financial aid, the impact on gift taxes, and the impact on estate planning. Often the best option is to wait until after the student graduates and then help the student pay off his or her student loans as a graduation present," Kantrowitz said.
This strategy might be particularly useful for students with subsidized loans, which don't begin to accrue interest until after graduation.
529 Tax Break Could Come at a Price for the Student
Cash gifts and loan repayment aren't the only options, of course. Grandparents may open a 529 college-savings account in the name of a student as a way to provide tax-free growth and distributions of funds set aside for college. One of the advantages of this approach for the account owner, in this case the grandparent, is that many states offer income tax deductions on 529 contributions, though investors must typically make the contribution to their home state's plan in order to earn the deduction. An added benefit of contributing to a 529 is that the Internal Revenue Service allows a five-year acceleration of the gift tax exclusion for such contributions, meaning that an individual may contribute as much as $65,000 in a single year to a 529 in a student's name provided the individual does not give the student any additional gifts during the next four years.
But there's a downside to this approach for the student. Although a 529 account owned by a grandparent (or anyone other than the student or his or her parents) is not counted as an available asset in financial aid calculations, distributions from a 529 owned by someone other than the student or his or her parents are counted as student income and may reduce the amount of need-based financial aid available by $0.50 for every dollar distributed (with the $6,130 income allowance for dependent students again applying).
So the impact of these distributions on the following year's need-based aid allocation could be significant. Here again, waiting to use 529 distributions from a grandparent-owned account until the student's final year in school is one way to avoid this problem. (Assets in a 529 plan owned by the parents could be tapped earlier because those distributions don't affect need-based financial aid eligibility.) Another option is for grandparents to contribute funds to a 529 account owned by the parents or by a dependent student. Those assets count just 5.64% against financial aid. If the account is owned by an independent student, assets count 20% against financial aid. Bear in mind, however, that in contributing to a 529 owned by someone else, the grandparents would not receive a tax break.
Another college-savings vehicle, the Coverdell Educational Savings Account, is treated similarly to a 529 from a tax and financial aid standpoint. Distributions from a grandparent-owned Coverdell plan count as income for the student and could reduce aid by up to 50%. But if the account is owned by the parent or a dependent student, it is treated as their asset and the impact is reduced. Another drawback to Coverdell accounts is that the current $2,000 annual contribution limit per student is set to drop to just $500 next year unless Congress makes changes.
Direct Tuition Payment a Good Option Only if Financial Aid Isn't Needed
One final option that some grandparents might consider is paying tuition directly to the university on the student's behalf. This has special appeal for those who want to give large amounts but who are worried about gift tax consequences. The good news is that payments made directly to the university to cover tuition are exempt from the gift tax, though additional costs such as room and board are not. So grandparents could potentially pay a student's full tuition without a gift tax penalty.
This approach has a serious drawback, however, if the student requires need-based financial aid to cover part of his or her tuition costs. That's because direct tuition payments may be counted as income against the student's financial aid allocation, reducing it by 50%. Or the payments could be treated as a financial resource available to the student, resulting in financial aid being reduced dollar-for-dollar. So this approach only makes sense for students who are not concerned about need-based aid or if the payment is made during the final year of school, when the student will not need to apply for aid for the following year.
Helping a grandchild with college costs is a great thing to do, but the when and how should be carefully considered by you and your clients, especially if the student will require need-based financial aid to help cover costs. Giving a gift more than a year in advance of the start of school, or at the tail end, can help minimize the potential drawbacks of your clients' kind gesture.