Saving for College: A Guide for Grandparents

Christine Benz: Hi, I'm Christine Benz for Morningstar.com. Given the high cost of college, many families need all hands on deck when it comes to paying for it. Assistant site editor Adam Zoll has received many questions from grandparents who are hoping to aid in college funding. He is here to answer some of them for us today.

Adam, thank you so much for being here.

Adam Zoll: Thanks for having me.

Benz: So, Adam, I think a lot of grandparents struggle with college funding. First of all, figuring out what type of vehicle to use for college savings--whether they should use a [529 college-savings plan] or some other vehicle. And if they are using a 529, which 529? Their home state's [plan] or maybe one that the parents are funding? How do grandparents figure out whether the 529 is the best option for them and also which 529?

Zoll: Well, 529 is certainly a viable option for grandparents. Anyone can open a 529 for the benefit of anyone else, so that certainly qualifies in this case. Also, I should mention aunts, uncles, cousins, relatives, friends--

Benz: All hands on deck.

Zoll: All hands on deck, yes. Exactly. I'm sure most parents wouldn't turn away the offer for help. So, yes, a 529 is an attractive vehicle because it does offer these tax advantages. Your money grows tax-free, and as long as it's withdrawn for qualified college expenses, there are no taxes paid upon distribution either.

One of the attractive features of a 529 is that many states also offer an upfront tax break on contributions. So, a grandparent, for example, who lives in a state that offers such an upfront tax break might consider using his or her state's 529 to save for the grandchild's college even if the grandchild doesn't live in that state and even if the grandchild isn't going to go to college in that state. Geography is largely irrelevant except for this issue of whether you're going to get this upfront tax break. Aside from that, if you live in a state that does not offer a tax break, then you are free to look for 529s elsewhere.

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Benz: So, if your state does offer a state tax break and it's a decent plan, in many cases, you're better off sticking with that plan versus going out of state and forgoing that tax deduction.

Zoll: Right.

Benz: Are there any reasons that a grandparent shouldn't use a 529 to save for a grandchild's college education?

Zoll: There are a couple of things to keep in mind: One is that having a separate grandparent-owned 529 in addition to a parent-owned 529 can complicate recordkeeping when it comes time to take distributions and pay for expenses. You need to really be careful that you are not both taking distributions that cover the same expenses. But the larger concern really is with regard to financial aid--and, in particular, need-based financial aid. Keep in mind that there is both merit-based and need-based financial aid. With merit-based, your income, your family's income, and the student's income are irrelevant; but with need-based financial aid, the way that 529 assets are treated comes into play.

In particular, with a family-owned or student-owned 529, that's considered a family asset and will reduce the amount of a need-based financial aid award somewhat. With a grandparent-owned 529, it's not considered a family asset. That's the good thing. It doesn't factor into the equation. However, when it comes time to take a distribution from a grandparent-owned 529, that counts actually--believe it or not--as student income on the following year's financial aid application. So, therefore, if a student is using assets from a grandparent-owned 529 account to pay for some expenses, that's going to be assessed at a much higher rate--a rate closer to 50% of the value--whereas a family-owned 529 is only assessed at a maximum of about 6%.

Benz: Are there any workarounds for this, because that seems like a pretty big problem for grandparents looking to fund college through a 529?

Zoll: One workaround is simply to wait until the student's final year in school, where the following year's financial aid is no longer an issue. So, for example, if the student is in his or her senior year of college and does not plan to attend grad school--at least not in the following year--then maybe save those grandparent 529 assets until that final year. That way, you don't have to worry about the distribution having an impact.

Benz: What about direct cash contributions? If you wanted to write a check, write to the bursar of the college and forgo the 529 altogether, how would that affect the student's financial aid picture and everything else? Would that be, in some cases, maybe a better route for certain grandparents?

Zoll: There are a couple of different ways to look at the issue of cash gift. One would be a direct cash gift to the student, which unfortunately does count in the financial aid formula as student income. So, that's going to have a negative impact. You also have to think of the gift-tax ramifications. Under current law, you're allowed to gift $14,000 to an individual or a married couple, for example, could gift $28,000 to an individual without there being any tax implications down the road with regard to estate taxes. However, that will be, as I said, assessed as student income on the financial aid formula, so it will have that negative impact. A direct payment to the college--so if you say that you want to pay your grandchild's tuition payment for a given year--does not have any gift-tax implications. That's the good thing; but it still does count as student income with regard to financial aid the following year. So, once again, that's something that you might want to put off until the student's final year in the school.

Benz: Do you have any other ideas for grandparents, because this is a lot to take in and, unfortunately, a lot of rules that you might inadvertently trigger? Are there any other ideas that you have for grandparents attempting to be helpful and also make sure that the child is able to qualify for any other type of aid that he or she might otherwise.

Zoll: One strategy that I like is, actually, if the grandchild ends up taking out student loans, help that grandchild pay off the student loans once the student is out of school and no longer has to worry about financial aid. You are free to give money to the student for the purpose of paying off the loan. That's a pretty low-impact strategy. You also might consider--if you do want to help before the student is in school--giving the money to the parents for them to make a contribution to their 529. That would be another avenue; but again, you have to keep the gift-tax implications in mind.

Benz: From that standpoint, because you would be giving the money to the parents, it wouldn't have such a negative impact on the financial aid calculations.

Zoll: Right. And another point to remember is that there are some states that will give you a tax break on contributions made to a 529 plan that you don't own. Not all states, but some do allow for this. So, you may be forfeiting that upfront tax break on your 529 contribution, but the upside for the student's family is that there is going to be a lower financial aid impact.

Benz: Adam, this is complicated stuff. Paying for college is expensive. We appreciate you being here with us.

Zoll: Thanks for having me.

Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.