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Why Your Grandparents Could be Your Meal Ticket to College

This sheltering of grandparent-owned college savings plans applies only to federal student aid. Approximately 300 colleges use the CSS Financial Aid PROFILE form for awarding their own aid. This form requires the reporting of all college savings plans that name the student as a beneficiary.

An additional benefit of a 529 college savings plan is the value of the plan is excluded from the grandparent’s estate. It becomes an asset of the beneficiary upon death of the account owner. The only exception is for five-year gift-tax averaging for lump sum contributions, which is included in the estate on a prorated basis if the grandparent dies during the five-year period.

Grandparents can also contribute directly to a 529 college savings plan owned by a grandchild’s parent. This will be treated as a parent asset on the FAFSA.

CollegeInvest, the Colorado state 529 college savings plan, has an annual Grandparents Scholarship promotion where they give away 10 $2,500 college savings plans to Colorado grandparents.

Gifts to the Parents and Students

If a grandparent gives a gift to a parent, it is not reported as income (taxed or untaxed) on the FAFSA. If the grandparent gives the money to the grandchild, however, it is treated as untaxed income and affects aid eligibility (by as much as 50%).

One workaround is to wait until after the grandchild graduates and then give a graduation present to help pay off the grandchild’s education loans. Since this gift occurs after college graduation, it will not affect the grandchild’s eligibility for need-based aid.

Giving Directly to the College

Many personal finance and tax experts recommend giving money directly to the college to avoid gift taxes. This is bad advice for most families because it hurts eligibility for need-based financial aid. It should only be considered if the family does not qualify for need-based financial aid and the annual gift tax exclusion is insufficient.

Section 2503(e) of the Internal Revenue Code provides a gift tax exclusion for money paid directly to an education institution to pay for tuition on behalf of a student. However, the exclusion is limited to amounts paid for tuition (not room and board or other expenses) and the payment does not count as a charitable contribution. The potential gift tax savings will also be much less than the negative impact on need-based aid, yielding no net benefit to the student. Moreover, with the annual gift tax exclusion at $13,000 ($26,000 joint) in 2009, it doesn’t seem like it is really necessary to make the payment directly to the college.

Direct payments to the college will be treated unfavorably by federal need analysis. It cannot be treated as just a payment on the student’s account because eligibility for the gift tax exclusion is dependent on the amount being paid for tuition. There are two possible approaches based on the statute and regulations. One approach treats the payment as untaxed income to the child (i.e., cash support within the scope of section 480(b) of the Higher Education Act of 1965). This reduces need-based aid by 50% of the amount of the direct payment. Another approach treats the payment as a resource (i.e., estimated financial assistance within the scope of the regulations at 34 CFR 673.5©(1)(xiii)). This reduces need-based aid by 100% of the amount of the direct payment, dollar for dollar.

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