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Contributing to a College-Savings Account When You're Not the Parent

Rules for tax deductions and the effect on financial aid can be tricky.

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I'd like to contribute to a 529 account for my niece. Will I get an income tax break for my contributions, and how will the account affect her financial aid prospects when she goes to college?

Among the 34 states (and the District of Columbia) that offer an income tax deduction for contributions to 529 college-savings accounts, some permit anyone who contributes to a 529 to take a tax deduction, but others let you deduct your contributions only if you are the account owner—regardless of whether you're the parent, uncle, aunt, grandparent or anyone else. Most states require you to contribute to your own state's plan to get the break, although Arizona, Kansas, Maine, Missouri and Pennsylvania allow deductions for contributions to any state's plan. See SavingforCollege.com for details about each state's rules. Also see our Find the Best 529 Plan for You map.

See Also: How to Help Your Grandkids Pay for College

You might have to open a separate account in your own state to qualify for a deduction. A few states have trickier rules. In Virginia, for example, if you don't own the account, you can't take a tax deduction—but the account owner can deduct contributions made to the account by others. There's no limit on the number of accounts that can be opened for a single beneficiary.

A 529 account not owned by the parent or child isn't considered to be an asset on the Free Application for Federal Student Aid (FAFSA), but distributions from the 529 must be reported as student income on the following year's FAFSA. Students are expected to contribute 50 cents of every dollar of income toward college bills (after an allowance of about $6,300).

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There are ways to minimize the impact of the withdrawals on financial aid, says Joe Hurley, founder of Savingforcollege.com. You could wait to withdraw the money from your 529 until the last financial aid form has been filed, after January 1 of your niece's junior year of college. In that case, the account is never reported as an asset on the financial aid form and the income isn't reported on the FAFSA, either.

If your niece needs the money before then, you may be able to switch the account ownership to the parent. The FAFSA calculation counts up to 5.6% of the parents' assets (after an allowance) as being available to pay for college, but withdrawals are not reported as income. Some 529 administrators let you switch account owners; others do not. If your 529 administrator doesn't let you switch ownership to the parents, you could transfer the money to another state's plan that does let you switch ownership.

Got a question? Ask Kim at askkim@kiplinger.com.