There is a loophole in the law concerning the treatment of a section 529 college savings plan that is owned by someone other than the parent or student.

Assets of Third Party Account Owner

Only section 529 college savings plans that are owned by the parent or student are reported as assets on the FAFSA. They are reported as assets of the account owner, and not the beneficiary, because the account owner has the power to change the beneficiary. If the section 529 college savings plan is owned by a third party (say, a grandparent), it is not reported on the FAFSA because only assets owned by the student and parents are reported on the FAFSA.

This loophole applies only to the FAFSA. The CSS Profile asks the family to list all 529 college savings plans that name the student as a beneficiary, so plans owned by a grandparent but with the student named as a beneficiary would have to be reported.

Are Distributions from a College Savings Plan Income?

Some people have argued that distributions from a 529 college savings plan owned by a grandparent should be counted as untaxed income to the student (i.e., as cash support or other untaxed income on Worksheet B). They argue that it is no different than a grandparent paying for college costs using funds from a different type of investment account. After all, section 480(a)(2) of the Higher Education Act (the section that prevents student aid funds, national service educational awards, the Hope Scholarship and Lifetime Learning Tax Credits from being counted as income or assets) does not include section 529 college savings plans. They also note that section 26 USC 529(c)(3)(B)(iv) treats distributions from a 529 college savings plan as distributions to the beneficiary, meaning that such distributions are (currently untaxed) income to the student. Treating such distributions as income to the student in need analysis would have a severe negative impact on need-based aid eligbility in the subsequent year.

This argument is flawed for several reasons. When a grandparent pays money directly to the school, it is not treated as cash support to the student or parent. Instead, it is treated as a resource, and also is provided a special exemption from gift taxes. So if distributions from a grandparent's college savings plan paid directly to the school were to be counted at all, it would be as a resource. Only when the grandparent pays the money directly to the student is it considered cash support of the student.

Note that if the grandparent pays the money to the parent, it does not get reported on Worksheet B because cash support to the parents is not considered untaxed income and benefits. This is because the language defining untaxed income and benefits in Section 480(b) of the Higher Education Act specifically restricted the definition of cash support in Section 480(b)(7) to money paid on the student's behalf. (The cash support line in the parents' column of Worksheet B is XXXed out for this reason.) When the grandparents pay the student's educational expenses, it is technically cash support of the parents because higher education expenses of a dependent student are primarily the responsibility of the parents.

Guidance from the US Department of Education

But we do not have to rely in interpretation to reach this conclusion. The US Department of Education has given clear guidance indicating that distributions from section 529 College Savings Plans and Coverdell Education Savings Accounts are not counted as income, regardless of who owns the account.

Page AVG-21 of the 2004-05 Application and Verification Guide states:

The value of a college savings plan should be treated as an asset of the owner (not the beneficiary because the owner can change the beneficiary at any time) and will be reported on the FAFSA if the owner’s assets are reported. Distributions from college savings plans are not considered taxable income, so they will not appear in the next year’s AGI. They also should not be treated as untaxed income or as resources.

Similar guidance has been published by the US Department of Education in Dear Colleague Letter GEN-04-02 which states:

Distributions from Coverdell Education Savings Accounts and 529 College Savings Plans that are not subject to federal income tax are not counted as parent or student income in the determination of federal financial aid eligibility. Distributions for qualified educational expenses therefore do not reduce financial aid eligibility.

Private informal conversations with staff from the US Department of Education and members of Congress have indicated that this loophole was intentional. The reasoning was that grandparents can avoid having their support count at all by waiting until after the student graduates to help the student and parents pay off their education loans or by giving the money to the parents. Moreover, few in Congress would want to establish public policy that could be seen as taking money out of the pockets of grandparents.

Caveat

That being said, this loophole is based on guidance and is not encoded in the law or regulations. Such guidance is subject to change, and families should exercise caution before relying on it for a long-term investment in their children's education.