Currently, if a grandparent owns a 529 account and uses it to pay for a grandchild’s college, the amount distributed will count as student untaxed income in the year of the distribution (called the base year), reducing the amount of need-based federal aid the student is eligible to receive for the next school year. Right now, the FAFSA asks families to report student income from the prior calendar year.

Any financial support that doesn’t come from a parent can reduce a student’s need-based aid by up to 50% of the value of student income reported on the FAFSA form. To avoid this penalty, a grandparent may wait until the student’s final year of school (when there are no additional FAFSAs to complete) to make a 529 distribution.

New rules mean more time to help pay for college

Rule changes announced in late 2015 will allow a grandparent to use 529 assets a year earlier without impacting the student’s eligibility for financial aid. Under the new rules, which go into effect in the 2017–2018 school year, the base-year income on the FAFSA will reflect the student’s income from two years prior rather than one. If a student fills out the FAFSA for his or her senior year, base-year income will reflect income received during his or her sophomore—not junior—year. (Keep in mind that because the rules don’t go into effect until the 2017–2018 school year, 2015 will still be the base year for both the 2016–2017 and 2017–2018 FAFSA.)

Current FAFSA rule  
School yearWhen to report the income if student receives $10,000 from a grandparent-owned 529 during current school yearFinancial aid impact
FreshmanStudent must report $10,000 as income on sophomore-year FAFSA.Financial aid for sophomore year reduced by up to 50% of the value of student income reported on the FAFSA.
SophomoreStudent must report $10,000 as income on junior-year FAFSA.Financial aid for junior year reduced by up to 50% of the value of student income reported on the FAFSA.
JuniorStudent must report $10,000 as income on senior-year FAFSA.Financial aid for senior year reduced by up to 50% of the value of student income reported on the FAFSA.
SeniorGrandparent-owned 529 distributions made during senior year don’t need to be reported on the FAFSA form (assuming student graduates after senior year).No impact on financial aid (assuming student graduates after senior year). Note: Senior-year aid package is impacted by distributions made during junior year.

New FAFSA rule

School year When to report the income if student receives $10,000 from a grandparent-owned 529 during current school year Financial aid impact
Freshman Student must report $10,000 as income on junior-year FAFSA. Financial aid for junior year reduced by up to 50% of the value of student income reported on the FAFSA.
Sophomore Student must report $10,000 as income on senior-year FAFSA. Financial aid for senior year reduced by up to 50% of the value of student income reported on the FAFSA.
Junior Grandparent-owned 529 distributions made during junior year don’t need to be reported on the FAFSA form (assuming student graduates after senior year). No impact on financial aid (assuming student graduates after senior year). Note: Junior-year aid package is impacted by distributions made during freshman year.

 
Senior Grandparent-owned 529 distributions made during senior year don’t need to be reported on the FAFSA form (assuming student graduates after senior year). No impact on financial aid (assuming student graduates after senior year). Note: Senior-year aid package is impacted by distributions made during sophomore year.

Note: Assumes FAFSA is completed for school year that starts in the fall.

College savings accounts benefit grandparents and students

College savings accounts are a great way for you to help your grandchildren—and yourself. If you have significant assets, contributing to a 529 account allows you to “remove” those assets from your estate. You can contribute up to $14,000 annually ($28,000 if you’re married) in 2016 without triggering federal gift tax. You can also consider bundling up to five years of gifts into a one-time 529 plan contribution.

Jacklin Youssef
Jacklin Youssef
“A 529 account is a great option if you want to remove assets from your estate,” said Jacklin Youssef, a senior wealth planner in Vanguard Advice Services.The FAFSA rule changes are designed to simplify the annual application. “While the grandparent-owned 529 plan assets don’t count for calculating financial aid, it’s unfortunate that a grandparent’s 529 distributions can inadvertently reduce a student’s eligibility for financial aid,” Youssef said. “These new rules will make it easier for parents and grandparents to work together to help pay for a child’s college education.”

*Earnings on nonqualified withdrawals may be subject to federal income tax and a 10% federal penalty tax, as well as state and local income taxes. The availability of tax or other benefits may be contingent on meeting other requirements.


Note:
For more information about any 529 college savings plan, contact the plan provider to obtain a Program Description, which includes investment objectives, risks, charges, expenses, and other information; read and consider it carefully before investing. If you are not a taxpayer of the state offering the plan, consider before investing whether your or the designated beneficiary’s home state offers any state tax or other benefits that are only available for investments in such state’s qualified tuition program. Vanguard Marketing Corporation serves as distributor and underwriter for some 529 plans.