What is the 529 loophole?

The "529 loophole" refers to a beneficial change in federal financial aid rules that allows grandparents to contribute to a grandchild's education via a 529 college savings plan without negatively impacting the grandchild's eligibility for federal student aid. This effectively eliminates a previous penalty on aid.

Understanding the 529 Grandparent Loophole

The 529 grandparent loophole is a significant development stemming from recent legislative updates, particularly the FAFSA Simplification Act. Historically, distributions from 529 plans owned by grandparents could inadvertently reduce a student's eligibility for federal financial aid due to how these funds were reported on the Free Application for Federal Student Aid (FAFSA).

Thanks to these changes, grandparents who own a 529 account can now make significant contributions to their grandchild's education savings without necessarily affecting the grandchild's eligibility for federal student aid.

How the Loophole Works: Before and After FAFSA Simplification

To grasp the full impact of this change, it's crucial to understand the previous treatment of grandparent-owned 529s versus the new rules:

• Pre-FAFSA Simplification Act (Prior to the 2024-2025 Aid Year):

  • Asset Treatment: Grandparent-owned 529 plans were not considered an asset on the FAFSA because they were not owned by the student or their parents.
  • Distribution Treatment: When funds were withdrawn from a grandparent-owned 529 plan to pay for a grandchild's educational expenses, these distributions were counted as untaxed student income on the FAFSA for the following academic year.
  • Impact on Aid: Student income was assessed at a high rate, up to 50%. This meant that for every dollar withdrawn from a grandparent's 529, the student's federal aid eligibility could be reduced by up to 50 cents, potentially shrinking their grants, scholarships, or subsidized loans.

• Post-FAFSA Simplification Act (Effective for the 2024-2025 Aid Year and Beyond):

  • Simplified FAFSA: The updated FAFSA form has removed the requirement to report cash gifts or other untaxed income sources that previously included grandparent 529 distributions.
  • Asset Treatment: Grandparent-owned 529 plans continue to not be reported as assets on the FAFSA.
  • Distribution Treatment: Crucially, distributions from grandparent-owned 529 accounts are no longer considered income for the student.
  • Impact on Aid: This change completely eliminates the "penalty" that previously reduced a student's federal financial aid eligibility. Grandparents can now contribute substantially to their grandchild's education without fear of negatively impacting their federal aid package.

Key Benefits for Families

The 529 grandparent loophole offers several significant advantages:

• Increased Federal Aid Eligibility: Students are now more likely to qualify for a greater amount of need-based federal financial aid, as grandparent contributions no longer count against them.
• Encouraging Grandparent Contributions: Grandparents can contribute more confidently and generously, knowing their financial support will directly benefit their grandchild's education without hindering aid prospects.
• Optimized Education Savings: Families can strategically combine different college savings approaches, leveraging the tax advantages of 529 plans while maximizing opportunities for federal financial assistance.

Important Considerations

While highly beneficial, keep these points in mind:

• Federal Aid Specific: This loophole primarily impacts eligibility for federal student aid. State-specific aid programs or institutional scholarships may still have different rules or considerations. Always check with individual institutions or state aid agencies.
• Ownership Matters: The loophole specifically applies to 529 plans owned by grandparents. If a grandparent contributes funds to a 529 account owned by the student's parent, that account is treated as a parental asset on the FAFSA, which is assessed at a much lower rate (up to 5.64%) than student income historically was.
• Effective Date: The FAFSA Simplification Act changes are effective for the 2024-2025 academic year and subsequent years.

Navigating 529 Plans and Financial Aid

Here's a quick comparison of how different 529 ownership structures generally affect FAFSA:

By understanding these nuances, families can strategically plan for college funding and maximize their potential for federal financial aid.