Question: Our daughter is the beneficiary of her grandfather’s 529 college-savings account. We’re paying the college bills, but can he reimburse us for those paid qualified education expenses?
Answer: Yes, he can reimburse you for qualified expenses, such as tuition, textbooks and fees, that you paid on your daughter’s behalf. The withdrawals should be made in the same calendar year that the expense is incurred, and you should keep receipts, canceled checks and other paperwork for your records in case the IRS asks for evidence that the money was used for a qualified expense.
Before making a withdrawal from a grandparent-owned 529 account, review the impact it will have on your student’s financial aid award. Money in a grandparent-owned 529 account is not reported as an asset on the Free Application for Federal Student Aid (FAFSA). But withdrawals from the account are reported as untaxed income to the student, reducing aid eligibility by as much as 50% of the distribution amount. (Students are allowed up to $6,600 in annual income before aid is reduced.)
To minimize the impact on financial aid, grandparents can take distributions after the last tax year that counts for financial aid. After some recent changes, the FAFSA is now based on a two-year lookback period. Families filing beginning on October 1, 2019, for the 2020-21 academic year, for example, will use 2018 income and other financial information. Distributions made after January 1 of the sophomore year of college won’t show up on the FAFSA, assuming the student graduates in four years.
There are several other workarounds to limit a grandparent-owned 529’s impact on financial aid, says Mark Kantrowitz, publisher of SavingforCollege.com. The grandparent can name the student’s parent as the account owner before the money is withdrawn. That way, distributions will not count against financial aid. Instead, the account will be reported as a parent asset on future FAFSAs, reducing aid eligibility by as much as 5.6% of the account’s value. However, not all 529 plans let you switch account owners. And some states will reverse state income tax benefits the previous owner received if the account owner is changed. See SavingforCollege.com for information about each state’s rules.
Another strategy: The grandparent can roll over a year’s worth of funds at a time to a parent-owned 529 plan. If the rollover occurs after the FAFSA is filed and if the funds are spent before the next FAFSA is submitted, the money won’t show up as an asset on the FAFSA. And distributions won’t affect aid eligibility because the 529 is owned by the parent. To avoid unexpected tax penalties, the parent-owned 529 plan should be in the same state as the grandparent-owned account, says Kantrowitz.