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Time bomb: Grandparents' 529 college contributions

(MoneyWatch) Can grandparents save through 529 college savings plans without jeopardizing their grandchildren's chances for financial aid?

I received that question recently from the CPA of a wealthy grandmother who has been investing in 529 accounts for her seven grandchildren. This grandparent is not alone in worrying that her diligence in saving will blow up in her face.

Grandparents' 529 accounts do not have to reduce financial aid chances if they are handled properly. Here is what families need to know about this tricky issue:

As long as the money in a grandparent's 529 stays in the account, there is no chance of the money hurting financial aid chances. The Free Application for Federal Student Aid, for instance, doesn't even inquire about third parties saving for a child's college education.

529 account penalty and financial aid
Families, however, can encounter problems when grandparents withdraw the money to pay for college expenses. The 529 withdrawals must be reported on financial aid applications as the student's income. The financial aidformula assesses student income at a stiff 50 percent.

Here's an example: If the grandmother withdrew $20,000 from a 529, that money would be assessed at 50 percent. ($20,000 X 50 percent = $10,000.) The grandmother's withdrawal would reduce the grandchild's chances for need-based financial aid by up to $10,000.

Disabling a 529 financial aid time bomb
One way to disable this financial aid time bomb is for the grandparent to transfer the ownership of a 529 to a parent. Assets in a 529 account owned by the parent are only assessed at 5.64 percent for financial aid purposes. In the case of a $20,000 withdrawal, a potential financial aid award would only shrink by a maximum of $1,128.

Grandparents can avoid any hit to financial aid awards by timing their 529 withdrawals. Ideally a grandparent will wait until after the parents have filed for financial aid for the last time -- in the winter or early spring of the college student's junior year. This would be the last financial aid form the parents file (covering the child's senior year), so the parents and child's finances after that filing would be irrelevant.