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Section 529 College Savings Plan Loophole

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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. However, the College Cost Reduction and Access Act of 2007 changed the treatment of such plans effective with the 2009-10 award year. The change eliminates the benefit of the loophole.

Assets of Third Party Account Owner

If the student is a dependent student, only qualified education benefits that are owned by the student or the parent are reported as assets on the Free Application for Federal Student Aid (FAFSA). Qualified education benefits that are owned by a grandparent (or any third party other than the student or parents) are not reported as an asset on the FAFSA. (Qualified education benefits that are owned by the student, such as a custodial 529 plan account, are reported as parent assets on the FAFSA. This provides them with a more favorable treatment than the treatment normally given to student assets.)

If the student is an independent student, all qualified education benefits that are owned by the student are reported as student assets on the FAFSA, regardless of who owns the qualified education benefit. (If the independent student does not own the qualified education benefit, but is named as a beneficiary, the qualified education benefit is not reported as an asset on the FAFSA. The reporting of a qualified education benefit as an asset is based on account ownership, not the beneficiary, as the account owner can change the beneficiary at any time.)

The term "qualified education benefit" includes section 529 college savings plans, prepaid tuition plans and Coverdell education savings accounts.

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This loophole applies only to the FAFSA. The CSS/Financial Aid PROFILE form asks the family to list all 529 college savings plans that name the student as a beneficiary, regardless of whether the student is dependent or independent, so plans owned by a grandparent but with the student named as a beneficiary would have to be reported. (College savings plans that name a sibling as a beneficiary or which are owned by the student or the student's parents are also reported on the PROFILE form.)

Are Distributions from a College Savings Plan Income?

If a qualified education benefit is reported as an asset on the FAFSA, distributions from the college savings plan are not included in income, in assets or as estimated financial assistance.

If a qualified education benefit is not reported as an asset on the FAFSA, then distributions from the college savings plan are reported as untaxed income to the beneficiary on the subsequent year's FAFSA.

This treatment stems from amendments made to sections 480(a)(2), (f)(3) and (j)(2) of the Higher Education Act of 1965 by the College Cost Reduction and Access Act of 2007, effective July 1, 2009. Section 480(a)(2) was amended to exclude distributions from qualified education benefits from income or assets. However, the exclusion was limited to just those qualified education benefits described in section 480(f)(3). Section 480(f)(3) identifies the qualified education benefits that are reported as an asset on the FAFSA. Thus distributions from a qualified education benefit that is reported as an asset on the FAFSA are not included in income or assets. But if the qualified education benefit is not reported as an asset on the FAFSA, the distributions from this college savings plan are reported as untaxed income to the beneficiary on the next year's FAFSA. (The distributions are reported as untaxed income to the beneficiary because section 26 USC 529(c)(3)(B)(iv) of the Internal Revenue Code of 1986 treats distributions from a 529 college savings plan or other qualified tuition plan as distributions to the beneficiary, meaning that such distributions are (currently untaxed) income to the student.) Section 480(j)(2) specifies that untaxed distributions from qualified education plans are not treated as estimated financial assistance or resources that reduce aid eligibility dollar for dollar. Taxable distributions are not treated as resources because they are included in adjusted gross income.

Note that section 480(f)(3) specifies that qualified education benefits that are owned by a dependent student or the dependent student's parent are reported as a parent asset on the FAFSA regardless of whether the account owner is the student or the parent if the student is a dependent student. If the student is an independent student, all qualified education benefits that are owned by the student are reported as student assets on the FAFSA.

The inclusion of distributions as untaxed income to the beneficiary overwhelms any benefit from having a qualified education benefit not reported as an asset on the FAFSA.

Guidance from the US Department of Education

The US Department of Education has given clear guidance concerning the treatment of qualified education benefits. Page AVG-18 of the 2009-10 Application and Verification Guide states:

Qualified tuition programs (QTPs, also known as section 529 plans because they are covered in section 529 of the IRS tax code) and Coverdell education savings accounts are grouped together in the law as qualified education benefits and have the same treatment: they are an asset of the owner (not the beneficiary because the owner can change the beneficiary at any time), except when the owner is a dependent student, in which case they are an asset of the parent. When the owner is some other person (including a non-custodial parent), distributions from these plans to the student count as untaxed income, as "money received."
The last sentence did not appear on page AVG-20 of the 2008-09 Application and Verification Guide, which states:
The HERA grouped qualified tuition programs (QTPs, also known as section 529 plans because they are covered in section 529 of the IRS tax code) and Coverdell education savings accounts in the new category of qualified education benefits, which all have the same treatment: these savings vehicles are an asset of the owner (not the beneficiary because the owner can change the beneficiary at any time), but they are excluded as an asset when the owner is a dependent student.
This, in turn, was a change from the guidance on page AVG-20 of the 2006-07 Application and Verification Guide, which 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.
That letter, however, does not appear to have contemplated the possibility that a section 529 college savings plan naming the student as a beneficiary would not be owned by either student or parent.

Fixing a College Savings Plan Owned by a Third Party

There are two main approaches to fixing the financial aid treatment of a qualified education benefit owned by a grandparent or other third party. One is to change the account owner to the student or to the student's parents. The other is to delay taking a distribution until the student's senior year in college, when affecting next year's financial aid eligibility is no longer a concern. (Technically one can take the distribution any time after January 1 of the junior year in college.)

Statutory Language

The following is the statutory language from sections 480(a)(2), (f)(3) and (j)(2) of the Higher Education Act of 1965:

   (a)(2) No portion of any student financial assistance received from
          any program by an individual, no portion of a national
          service educational award or post-service benefit received
          by an individual under title I of the National and Community
          Service Act of 1990 (42 U.S.C. 12511 et seq.), no portion of
          any tax credit taken under section 25A of title 26, and no
          distribution from any qualified education benefit described
          in subsection (f)(3) that is not subject to Federal income
          tax, shall be included as income or assets in the
          computation of expected family contribution for any program
          funded in whole or in part under this chapter.

   (f)(3) A qualified education benefit shall be considered an asset of --
       (A) the student if the student is an independent student; or
       (B) the parent if the student is a dependent student, regardless 
           of whether the owner of the account is the student or the parent.

   (j)(2) Notwithstanding paragraph (1), a tax credit taken under
          section 25A of title 26, or a distribution that is not
          includable in gross income under section 529 of such title,
          under another prepaid tuition plan offered by a State, or
          under a Coverdell education savings account under section
          530 of such title, shall not be treated as estimated
          financial assistance for purposes of section 471(3) of this
          title.

Caveat

The statutory language in sections 480(a)(2) and (f)(3) of the Higher Education Act of 1965 represent an affirmative statement that distributions from certain qualified education benefits are not included in income or assets. The absence of this exclusion for distributions from other types of qualified education benefits does not represent an affirmative requirement that such distributions be included in income. Such distributions are reported as untaxed income to the beneficiary in the subsequent year's FAFSA because of guidance from the US Department of Education. This guidance is subject to change, but is unlikely to change.

 

 
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