Grandparent Savings and Financial Aid

It’s always wonderful when grandparents can help with college costs.

Grandparents, however, have to be careful about how they pitch in if their grandchildren have a shot at receiving need-based financial aid.

Friends of mine experienced first hand how grandparent generosity can backfire. Their story is an extreme example, but there are lessons here for other families as well.

When the three children of my friends were young, the grandparents gave each of their grandchildren a significant amount of money in trusts. The grandparents intended each of the children to eventually use the money to help buy a house in San Diego, one of the nation’s most expensive real estate markets.

The dad and mom are middle class, but the money in the children’s names eliminated their chances of receiving financial aid. The children were bright and probably would have been admitted to some excellent private schools that offered strong aid packages if the grandparents hadn’t made those early gifts.

If the children had attended private colleges, it would have come out of their house funds that no one in the family considered tenable.

All three children ended up attending state universities in California and paying full fare.

If the grandparents had kept the money until the children graduated from college, their school choices would have expanded greatly.

What You Need to Know When Grandparents Want to Help

1. If you won’t qualify for need-based aid, there is no issue.

If your family is too affluent to be eligible for need-based financial aid, it doesn’t matter how grandparents save for college or how they help pay the tab.

Grandparent contributions only jeopardize need-based aid and not merit scholarships. Schools award merit scholarships regardless of need.

2. Grandparent savings won’t hurt as long as the money isn’t used.

Grandparents, aunts, uncles or other relatives or family friends can save for college without jeopardizing a child’s chances for financial aid as long as the money stays in their accounts. These can be 529 college savings plans or other investment accounts.

The Free Application for Federal Student Aid does not inquire about third parties saving for a child’s college education.

Except in rare cases, schools that use the CSS/Financial Aid PROFILE also do not ask about non-parents holding money for a student. Those schools that do ask about outside accounts intended for the child can decide to assess that money any way they wish.

3. Withdrawn money does count against a child.

When grandparents eventually withdraw money from an investment account to use for their grandchild, parents must report this money as the child’s untaxed income on the FAFSA and PROFILE (if applicable). They are expected to originally report this money on the child’s income tax return.

This income can reduce aid eligibility by as much as half of the cash withdrawn from the college account.

Let’s say a grandmother contributed $10,000 to help defray her granddaughter’s tuition cost. When the family was completing the FAFSA, the parents would have to declare this gift.

This contribution would be treated as the child’s income and be assessed at 50%.

$10,000 X 50% = $5,000

Based on the formula, the child’s financial aid eligibility would drop by $5,000. Put another way, the child’s EFC would rise by $5,000.

The FAFSA does provide a way to help blunt or eliminate the penalty triggered by a grandparent’s largesse. The FAFSA gives each student an automatic income allowance that is adjusted annually. For the 2017-2018 school year, the allowance is $6,420. A student can earn $6,420 without having his or her income subject to the 50% assessment.

Consequently, in this example the student’s income allowance would help blunt the impact of the grandparent’s $10,000 gift to help pay her college costs.

4. Grandparents should be strategic when withdrawing money.

If financial aid is at stake, grandparents should be strategic about when they help. Federal regulations implemented in 2016 has made it easier for grandparents to help earlier and not jeopardize a grandchild’s chances for financial aid, which is great news for families.

Here’s why timing is important. The FAFSA and PROFILE asks if anyone beyond the parents has contributed to a child’s college costs in the base year. Traditionally, the base year had been the calendar year before the child starts the new school year. For a student who was enrolled in college in the fall of 2016, for example, the base year was 2015. Consequently, if a grandparent helped with college costs in 2015, that would have been reported on the FAFSA for the 2016-2017 school year. And this money, as you’ve already learned, would have been treated as the child’s income.

Because of this rule, grandparents had traditionally been told to ideally hold off on helping until the last financial aid form has been filed. This has typically been in the late winter or spring of a child’s junior year in college. After that form was completed for the child’s senior year aid package, a college would no longer ask about a family’s finances.

The base-year rule, however, has now changed that allows grandparents to help out earlier than in the past. Parents and students are now using their prior-prior IRS returns when applying for financial aid. This means the base year is not  the most recent calendar year completed prior to the start of the school year, but two calendar years prior.

Because the parents and students are using two-year-old tax returns, grandparents could safely start helping with college costs after the family has filed for financial aid for the upcoming junior year. Parents can now file for aid for the third year of college as early as October 1 of the child’s sophomore year in college.

PROFILE schools are also using two-year-old tax returns and allowing families to file for aid as early as Oct. 1.

5. Give parents money.

Another way to avoid the draconian grandparent penalty is for grandparents to simply give their adult children a cash gift, but this strategy is only recommended if applying to FAFSA-only schools.

The FAFSA formula doesn’t treat gifts to parents as untaxed income. In fact, the financial aid form doesn’t even ask if the parents received money from outside people or have had bills paid on their behalf.

Instead, the FAFSA just wants to know how much nonretirement assets that parents have on the day the aid application is filed. So if the grandparents give parents money after the aid application is filed and the parents spend it on college before the next FAFSA is filed, there will be no financial-aid hit since the money is gone.

This method won’t work with the PROFILE because the aid application asks parents this question each year:

Enter the amount of cash your parents received and any money paid on their behalf (e.g. bills). (Don’t include child support or any other amounts reported elsewhere on this application.)

If grandparents gave money to parents, this amount is supposed to be divulged on the PROFILE. As a practical matter, most parents won’t even know to share any money they received from grandparents or other generous sources.

6. Move money to the child’s parents.

A grandparent with a 529 plan could transfer the ownership of the account to a 529 account controlled by one of the parents of the child. Once the transfer is made, the money is treated as a parent asset which is assessed at no more than 5.64%.

About a half dozen states, however, only allow a change in 529 account ownership if there’s a court order or the owner dies. This restriction, by the way, is different from a change in beneficiaries which you can do in any state. For instance, if money is remaining in a 529 account when a student graduates, the owner (parent, grandparent or someone else) can change the beneficiary to someone else.

7. Lend money to the parents.

If parents borrow money from grandparents to pay for college, the debt won’t hurt financial aid chances. The loan, however, has to represent a legitimate lending arrangement and the grandparents need to charge interest. Once the parents are done paying for college, the grandparents do have the option of forgiving the loan. Parents should contact their tax professional regarding how any forgiven loan balance would be treated for tax purposes.