Welcome to MainStreet's newest series. Each week, we will answer a real question from readers on education costs and how to pay for college. If you have a question, feel free to send it to firstname.lastname@example.org
Q: “What’s the best way for grandparents and other relatives to help us pay for our kids’ college educations?” – Mark, Houston
A: There are many ways to give money, and student aid is extremely complicated, as the impact of a gift on financial aid eligibility depends on the timing of the gift as well as on whether the money is paid to the student, to the student's parents or directly to the college. The mechanism used to convey the gift also matters, since different college savings vehicles are treated differently by need analysis formulas.
Here are the best options and how to get the most out of them.
Option 1: Give to the student, but give early.
Financial aid formulas consider first the student's income and assets. If the student is a dependent (defined not by who claims him or her on a tax return, but by criteria like age, or whether the student is married, an orphan, a veteran or a graduate student), the income and assets of the parents are also considered. If not, the income and assets of the student's spouse are included in addition to the student’s resources.
In general, student income and assets are treated much less favorably than parents’: Half of the student's discretionary income is counted as his or her contribution to college costs, compared with 22% to 47% of parent income. Students are also expected to contribute a flat 20% of their assets every year, compared with a yearly maximum of 5.64% of parent assets.
If you do want the money to go directly to the student, remember that the amount of yearly aid the student will receive is based on the previous year’s income, often referred to as the base year. Thus the income received the year before a student enrolls in college – starting in the spring of the junior year of high school – affects the amount of financial aid available to the student.
Assets are evaluated as of the application date, so if a gift from a grandparent is received during the base year but the funds have not yet been spent when the student applies for financial aid, the gift is counted twice: once as income (because it came in during the base year) and once as an asset (because it is sitting in the student’s bank account). The only way to avoid this double-counting is to give the gift before the base year, making the money count only as an asset.
Option 2: Give to the student, but give after graduation.
Of course, if the grandparents wait until after the student graduates, the gift will have no impact on financial aid eligibility at all. Grandparents could help their grandchild pay off all or part of his or her student loans as a graduation present. Technically, the gift could come just after the student submits the FAFSA for his or her last year in college, but that is not without risk: The student's financial aid application could be selected for verification, which sometimes looks at a fresh snapshot of the student's assets to determine if the awarded aid was appropriate.
Option 3: Give to the parents.
A gift to the student will be treated as untaxed income on the Free Application for Federal Student Aid (FAFSA), and if the gift occurs during the base year, as much as 70% of the amount will work against aid eligibility: 50% considered as income and 20% considered as an asset.
A gift to the parents is not reported as income on the FAFSA at all, but is rather treated as an asset and will reduce aid eligibility by only up to 5.64% of the gift.
Option 4: Give straight to the college.
Financial planners and accountants sometimes recommend giving the money directly to the college. Per section 2503(e) of the Internal Revenue Code of 1986, amounts paid directly to a college for tuition expenses avoid gift taxes for the giver. But in most cases the college will treat this not as a payment on the account but as a resource for the student, reducing need-based aid dollar for dollar.
This approach is only beneficial when the student is not eligible for any need-based student aid anyway, or if the student is enrolled at a very expensive college and the maximum allowable gift that qualifies for the gift tax exclusion (currently $13,000 per contributor per recipient) is insufficient to cover costs.
Option 5: Contribute to a 529 plan.
If the grandparents may not be around when the grandchild graduates from college, they can contribute to a section 529 college savings plan, as the funds are immediately removed from the grandparents' estate. The 529 plan should be owned by the student or the student's parents, not the grandparents or a third party. If the student is a dependent, such a 529 plan is treated as though it were a parent asset on the FAFSA, so it will only reduce eligibility by at most 5.64% of the value of the plan.
529 plans that are owned by a grandparent or other third party are not reported as an asset on the FAFSA, which might seem like it should yield a more favorable treatment, but the yearly distributions from such a plan will be treated as untaxed income to the beneficiary on the subsequent year's FAFSA, reducing the student’s aid eligibility by half of the distribution. Qualified distributions are ignored when the 529 is reported as an asset on the FAFSA.
There are two approaches to minimizing the negative impact of a grandparent-owned 529 plan. One is to change the account ownership to the student or parents. The other is to delay taking any distributions until after January 1 of the student's junior year in college (i.e., after the end of the base year for the senior year of college), to avoid any effect on financial aid. Of course, this assumes that the student will not be enrolling in graduate or professional school the next year.
Option 6: Split the gift between cash and a 529 plan.
When saving for college with a 529 plan, the family should plan on reserving $4,000 in tuition and fee expenses every year to qualify for the maximum Hope Scholarship tax credit. You can’t double-dip and use the same education expenses to qualify for both a tax-free distribution from a 529 plan and the Hope Scholarship tax credit, so pay $4,000 in cash or through student loans, and pay the remainder from the 529. That way you get the maximum Hope Scholarship credit, which easily outweighs the tax savings from a qualified 529 plan distribution.
If the child ends up not going to college, parents can change the 529 plan's beneficiary to a sibling or another family member with college costs. If nobody in the family is a student, parents can take a nonqualified distribution, subject to normal income taxes plus a 10% penalty on the earnings.
Option 7: Give through a Roth IRA
Many financial planners also recommend that grandparents save for their grandchildren's education using a Roth IRA. Assuming that the grandparents are over age 59½ when the child is in college and the Roth IRA has existed for at least five years, distributions from the Roth IRA will be tax-free.
But qualified distributions from a 529 plan are tax-free without any waiting period or age threshold, and many states provide a full or partial state income tax deduction for contributions to the state's 529 plan. What a Roth IRA will give you is flexibility: These funds can be used for any purpose without incurring any income taxes or a 10% tax penalty as long as the account owner is over 59½. Contributions to a Roth IRA can be withdrawn without tax or penalties at any time.
Grandparents can name their grandchildren as primary beneficiaries on a Roth IRA, who will then avoid income tax and the 10% tax penalty on distributions after they inherit the IRA. However, a Roth IRA is included in the account owner's estate, while 529 plan funds are not, so estate taxes can significantly reduce the value of an inherited Roth IRA.
A Roth IRA is not reported as an asset on the FAFSA regardless of who owns it, but distributions are treated as income to the beneficiary, similar to the treatment of a 529 plan when the grandparent is the account owner. The taxable portion of the distribution will be included in adjusted gross income and the untaxed portion will be reported as untaxed income on the FAFSA. As before, one could wait until the child graduates and use the Roth IRA to pay off the student loans as a graduation present to avoid any of the red tape.
Option 8: Give in small amounts through rebate programs.
If the grandparents are of limited means, they can still help through programs like Upromise, owned by lender Sallie Mae. Upromise tracks purchases from credit cards (or through its own credit card that Upromise issues and that carries extra benefits) and awards rebates on those purchases to 529 plans. Grandparents can join and have the rebates distributed to their grandchildren’s accounts. Some people work hard to maximize the rebates, but even someone who doesn't change their buying behavior can still accumulate a lot of money for their children's or grandchildren's education.
Option 9: Instead of a gift, help the student access new scholarships.
Grandparents should ask their employer, union and other groups they may be a part of whether they provide tuition assistance or scholarships for grandchildren. Some scholarships depend on a grandparent's status as an alumnus, military service, or ancestry and ethnicity. Fastweb.com and other free scholarship matching services are a good place to start looking for these opportunities.
The federal government’s Silver Scholars program provides education awards of $1,000 to people 55 and over for volunteering 350 or more hours a year. This award is transferrable to children and grandchildren. Grandparents can volunteer together with their grandchildren, who are also eligible for education awards from AmeriCorps.gov equal to as much as the maximum Pell Grant for each year of full time volunteering.
—Mark Kantrowitz is president of MK Consulting Inc. and publisher of theFinAid.org and FastWeb.com. He has testified before Congress about student aid on several occasions and is on the editorial board of the Council on Law in Higher Education.