The Free Application for Federal Student Aid (FAFSA) rules are changing. One of the updates will significantly benefit grandparent owned 529 plans. Currently if a grandparent or others outside the immediate family help with college costs, the money is treated as untaxed income to the student. This untaxed income is assessed at up to 50% by the FAFSA formula. For instance, if Grandma and Grandpa give Suzy $10,000 from a 529 plan distribution, Suzy’s aid eligibility can be reduced by $5,000.
With the FAFSA revamp, grandparents can soon pay for college costs without jeopardizing aid. The updated FAFSA will no longer require students to manually report cash support. With the new form, the amount of a student’s “total income”, which includes untaxed income, will come directly from the federal income tax returns via the IRS Data Retrieval Tool (DRT). As a result, a student’s total income amount will only consist of data that comes from the federal income tax return.
The revamp of the FAFSA form comes as a result of the FAFSA Simplification Act passed by Congress in December 2020. The changes were originally planned to coincide with the release of a new FAFSA form on October 1, 2022, however, this has been pushed out. The Department of Education announced the provisions will happen in phases, beginning with the 2021-2022 award year and then full implementation is expected by the 2024-2025 award year.
Since a student’s FAFSA captures income and tax information on a prior-prior year basis, giving Suzy a distribution from a grandparent 529 plan can begin as early as the 2022 tax year if the 2024-2025 award year deadline remains intact.
529 plans have always been an attractive option for saving for college costs. With the new FAFSA rules, they are an even easier option for grandparents looking to give without interfering with financial aid support.
Prior to investing in a 529 Plan investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.