Does a 529 plan mean less financial aid?

When our son was born 11 years ago, my husband's parents set up and began contributing to a 529 plan for him. It was a wildly kind and useful thing to do.

A 529 plan is a tax-free way to save for college. Parents, grandparents or other interested adults put after-tax money — as much as $300,000 — into a 529 account.

Then they name a beneficiary. In this case, the people who started the fund are my in-laws, and the beneficiary is our son.

Professional money managers invest that money. Withdrawals of both principal and income are tax-free, as long as the money is used to fund the beneficiary's education at an accredited college or graduate school.

I've written about 529 plans many times, and I thought I knew all there was to know. I was wrong. Recently, my mother-in-law emailed me:

"I read somewhere recently that 529s held by grandparents reduce eligibility for financial assistance. I’m wondering if ownership should be transferred to you, as funds held by parents evidently do not affect eligibility, oddly."

As strange as this sounded, I had to check it out. My brilliant mother-in-law is right.

What's so great about a 529?

There are no income limitations. No matter how rich you are, you can take advantage of the tax savings.
The money is a tax-advantaged source of tuition, whether the beneficiary earns a degree or not.
Typically, a plan owner is a parent or grandparent, and that person controls the money. This comes in handy if you have teenagers who would cheerfully spend big sums on a new car instead of college tuition, if the decision were left up to them.
If the beneficiary doesn't go to college or graduate school, or goes but doesn't use all the money in the account, it's a simple (and free) matter to change the plan beneficiary. Other children and grandchildren are all eligible beneficiaries, as are adults.
Nearly every U.S. state sponsors at least one 529 plan; some have more than one, each with its own investment team and philosophy. All of them have the same federal benefits. Families might get state tax benefits as well, if they choose a 529 plan sponsored by the state where they live, but they are also free to choose any other plan.

When grandparents withdraw money from a 529 plan and use that cash to fund college or graduate school expenses, the money they pay counts as income to the beneficiary. Apply for financial aid for the second year of schooling, and you'll report the contribution from the grandparent-owned 529 plan as untaxed student income.

The Free Application for Federal Student Aid (FAFSA) includes a variety of shelters for parent assets, but no such shelters for student income. Colleges expect that parents have additional fish to fry — other kids to educate, retirements to fund, maybe a business to operate and so forth — but assume that students will spend most of their money on educational expenses.

The FAFSA assumes that between 5% and 6% of parental assets are available for paying college costs. Students, by contrast, get to pay 20% of their assets toward college.

There are two ways around this. The first, as my mother-in-law suggested, is to transfer ownership of our son's 529 account. The asset would still count against financial aid eligibility, but at the 5% percent to 6% parental rate, not the 20% student rate.

This might be a hassle.

Depending on the state, some 529 plans charge a modest fee to transfer ownership. That's not a problem.

However, some states' plans report an ownership transfer as a taxable distribution of funds. That could mean a substantial tax bill, though we could potentially avoid that by transferring funds from the current 529 plan into a plan that does not consider ownership transfers as taxable distributions.

The second solution is simpler. We could use the money in our son's 529 account to pay for his last year of school. We wouldn't have to report it as student income on the next year's financial aid application, because there would be no financial aid application for the next year.

For now, the 529 plan will stay with our son's grandparents.