FAFSA Simplification Act

Congress recently made changes to the 529 rules that apply to outside contributions. 529 plans have become the predominant way most households save for a child’s college tuition. There are numerous reasons 529 plans have an edge ahead of the others as the most used saving vehicle, namely, tax-free growth and withdrawals if used for qualifying education expenses, higher maximum contribution limits, flexibility to change the intended beneficiary of the plan, and more no income limitations for contributions.

Anyone who has completed the FAFSA in the past is aware of how complicated and time consuming the form can be. Simplifying the FAFSA is expected to increase use of FAFSA funds for many who find it too difficult along with reducing confusions and errors. 

The ‘Grandparent Trap’

Today, 529 account balances owned by grandparents are not counted as an asset on the FAFSA, but distributions to pay for education for the student are counted as untaxed student income. Current 529 plan distributions from a grandparent’s 529 plan for their grandchild also reduce the recipient's eligibility for financial aid by 50% of the amount withdrawn for the student. This is the reason you may have heard us previously say that a grandparent-owned 529 plan should be the last money used for a grandchild's college tuition–generally in a junior or senior year–not to impact FAFSA eligibility. 

The current FAFSA asks the student and parents to report the amount of money they receive from anyone else outside the immediate family. Half of that amount impacts the Expected Family Contribution–effectively adding back half of that amount into what the student and family would be required to contribute. 

‍Removal of the ‘Grandparent Trap’

The new rules are set to take effect for the 2024-2025 school year. This Simplified FAFSA Act removes the question about outside contributions. So, other extended family members, godparents, friends, whoever, can contribute and use their 529 accounts to effectively support their student without negatively impacting the student’s financial aid. When those savings are used for education expenses in the future, the student will not need to report the funds. 

According to Federal Reserve data, 37% of families with students in college used a 529 plan in 2020. The average account holding is $25,664. Parents are unsurprisingly the biggest contributors to the plans, followed by grandparents.

Here is a brief recap of the current 529 plan benefits for savings for a student’s education:

529 plan benefits:

• Tax deferral on investment growth and tax-free distributions if funds are used for qualifying education expenses 
• The ability to withdraw up to $10K per year for K-12 tuition and $10k in total student loans payments for the beneficiary and each of their siblings
• The ability to change the beneficiary if needed, which makes the 529 account flexible for account owners with multiple grandchildren
• Contributions to a 529 plan are considered a completed gift while the owner still maintains control, providing a unique opportunity for families concerned with estate taxes
• The ability for grandparents to contribute up to the $16,000 in annual gift tax exclusions without having to file a gift tax return or hit the generation skipping transfer tax
• The ability to front-load up to 5 years’ worth of gift tax exemptions–up to $80,000 into a 529 plan in one year

As with most rules, the simplified FAFSA particulars are still subject to change, and each individual should make decisions based in the current laws. Until the new rules taxes effect, it is still a good idea for parents or students in college to consider waiting to use funds from a grandparent owned 529 plan until the student’s junior or senior year, or consider paying down a student loan with a grandparent owned 529 plan after the student graduates.

California 529 plan update

There is talk in Sacramento to revisit allowing some contributions to California 529 plans to receive a tax deduction. A similar bill was previously vetoed by Govenor Newsom in 2019, however there is a plan to re-introduce a bi-partisan bill for 529 plan deductibility for California residents during the 2023 legislative session. We will be sure to keep you updated as to how this bill may progress. 

If you are preparing for a child’s or grandchild’s college education, please feel welcome to contact your Highline advisor for more information on how you can optimize education planning. 

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