Financial Planning

Key Takeaways

1. Beginning in 2023, changes to FAFSA rules will create opportunities for extended family members to lend a hand with college costs without harming financial aid.
2. Gifts or 529 Plan distributions from non-parent accounts were previously considered income to the student, but with the FAFSA Simplification Act that is no longer the case.
3. Understand the power of 529 Plans and other custodial accounts when combined with estate and tax planning.

The legislation landscape has been unusually busy the last few years. One of the many pieces of legislation was the Consolidated Appropriations Act, 2021, a pandemic-era bill that may impact your financial plan, especially for those with college-bound family members.

Considered an ‘omnibus’ spending bill, it combined many different bills into one. Coming in at just over 2,000 pages, many of the provisions in the bill flew under the radar. One being the ‘FAFSA Simplification Act’ which overhauled the Free Application for Federal Student Aid (FAFSA) with the goal of simplifying the process. Whereas the old FAFSA formula focused on annual family cash flow, the new formula prioritizes total wealth.

For those with family members attending college in the fall of 2024 and beyond, these changes will impact them and may create opportunities for non-nuclear family members (e.g., grandparents) to help even more without hurting financial aid.

Changes to FAFSA

While the Act includes numerous provisions, here are the key changes:

1. Reducing the number of questions on the FAFSA form from 108 to 36.
2. Replacing the term ‘Expected Family Contribution’ with ‘Student Aid Index’ to reflect its purpose more accurately.
3. Expands access to Pell Grants.
4. Having two or more children with overlapping college years will no longer provide any benefit.
5. To offset the previous change, a greater portion of parent and student income is ‘protected’ or excluded from the formula. The Income Protection Allowance will increase by 20% for parents and 35% for students.
6. Gifts and 529 Plan distributions from anyone other than a student’s parents (e.g., grandparents) will no longer have to be reported as non-taxed income.

It is important to note that the Department of Education recently announced some of these changes will not go into effect until the 2024-2025 FAFSA award year, while others, like the question reduction, are now active.

A New Opportunity for Grandparents

Anyone who has filled out FAFSA is painfully aware how much higher student income is assessed than parent’s (i.e., 50% versus 5.64%!). For example, if a student had income of $10,000, like a gift, it would have reduced the Expected Family Contribution by $5,000, but only by $564 if reported as income by the parent.

Since gifts or distributions from a non-parent 529 Plan (or any other account) counted as student income, it was highly recommended delaying distributions until the spring semester of sophomore year. This is due to FAFSA’s practice of using information pulled from tax returns two years prior (i.e., prior-prior year). In other words, financial aid awarded for the student’s senior year was based on assets and income reported during the year that included their first-year spring semester and sophomore fall semester.

But due to the FAFSA Simplification Act, planning around gifts and distributions from non-parents won’t be necessary beginning in 2023. Not only does this increase the utility of 529 Plans and other custodial accounts, but there are many estate and tax planning benefits with using them.

Estate and Income Tax Benefits

529 Plans and other custodial accounts (like Roth IRAs) have always been powerful tools to leverage for estate planning, as well as for their tax benefits. A few of these benefits include:

1. More than half the states offer a state income tax deduction for 529 Plan contributions.
2. The option to contribute up to five years of the IRS’s annual exclusion amount all at once to a 529 Plan. This means one person can contribute $85,000 (five times the $17,000 annual exclusion in 2023), or $170,000 from a married couple to a 529 Plan this year. It can be carried out for an unlimited number of beneficiaries, too. With the recent market pullback, perhaps now is an ideal time to superfund a young grandchild’s 529 Plan and allow the power of time and compounding do the rest.
3. Tax-free growth if the assets are used towards qualifying education expenses – another compelling reason to fund the account sooner rather than later. If the funds are not ultimately used towards qualifying expenses, only the growth is penalized 10%, perhaps an acceptable trade-off if the assets have experienced years of tax-free growth. And SECURE Act 2.0 has given us a new, third option for unused 529 Plan assets: the ability to rollover up to $35,000 to a Roth IRA in the beneficiary's name, if certain conditions are met.
4. While not exactly a tax benefit, 529 Plans provide unusual flexibility for their class. They are held in the account owner’s name, not the beneficiary’s (i.e., the student’s), so if all the funds are not used up, simply change the beneficiary to another person or grandchild. This could be a powerful opportunity to fund education across many generations and transfer substantial wealth at one time. It also provides an opportunity for expectant parents or those planning to have a family to open an account now, name themselves as beneficiary, then switch the account once the new beneficiary has their own Social Security number.

A Word of Warning

As with most planning techniques, there’s no such thing as a free lunch. Therefore, it’s important to remember that these changes only apply to FAFSA and that some schools, especially highly selective private schools, may use what is called a CSS Profile. It’s another financial aid tool that may consider gifts or distributions as student income, so it’s especially important to check before making them.

We wouldn’t blame you if you have legislation-fatigue by this point but that’s why we’re here, helping you stay abreast of all the changes and understanding how it may impact your financial plan. If you have questions or want to understand how you can potentially take advantage of this recent change, you can schedule a call with us any time to learn more.

Please consult with an attorney or a tax or financial advisor regarding your specific legal, tax, estate planning, or financial situation. The information in this article is not intended as legal or tax advice.