If a grandparent owns a 529 college savings plan for a grandchild, an old federal financial aid penalty that used to punish those withdrawals is gone. The FAFSA Simplification Act removed the “cash support” question from the federal FAFSA, so distributions from a grandparent-owned 529 are no longer reported as untaxed student income. The change took effect with the 2024-25 FAFSA, yet many families still plan around a rule that no longer exists.
Old Penalty That Scared Grandparents Away
Before the FAFSA simplification, a 529 plan owned by a grandparent or other non-parent relative did not show up as an asset on the financial aid application. That was the upside. The problem surfaced later when distributions were taken to cover tuition. Those withdrawals were treated as untaxed income to the student on the next year’s FAFSA, and that could slash aid eligibility by as much as 50% of the amount distributed.
Consider a $20,000 tuition withdrawal from Grandma’s 529. That could quietly reduce the following year’s financial aid package by up to $10,000. The workaround advisors suggested was to delay using those funds until the student’s junior or senior year, when no future FAFSA would be filed. So that money, intended to help, sat on the sidelines for years just to avoid the penalty. The same warning applied to aunts, uncles, and other non-parent relatives. Clark Howard confirmed this when asked directly, giving a straightforward “Yes.”
What the Federal Form Actually Asks Now
The new FAFSA uses a Student Aid Index, or SAI, which replaces the old Expected Family Contribution. It no longer asks students to report cash support or money paid on their behalf by others. A 529 plan owned by a grandparent is still not counted as a parent or student asset, and distributions from it are no longer treated as student income. That means the old penalty, where a grandparent’s withdrawal could slash aid eligibility by as much as half the distributed amount, is now gone on the federal FAFSA.
Strategies This Change Unlocks
Several planning moves become simpler once the reporting penalty is gone:
- Own the 529 directly instead of gifting into the parents’ account. Money contributed to a parent-owned 529 gets added to the parent’s reported asset base on the FAFSA. A grandparent-owned account stays off that list entirely.
- Spend it whenever needed. Freshman-year tuition, senior-year tuition, or graduate school. Timing withdrawals around FAFSA cycles is no longer a federal aid concern.
- Front-load contributions with the five-year gift-tax election. The 2026 annual gift-tax exclusion is $19,000 per donor, per recipient. A special 529 rule lets a contributor treat a lump-sum contribution as if it were spread across five years for gift-tax purposes, so a grandparent can seed an account with a large one-time deposit without dipping into the lifetime gift-tax exemption.
- Redirect a beneficiary. A 529 owner can change the beneficiary to another grandchild or qualifying family member if the original student wins a scholarship, skips college, or does not need the full balance, as Clark Howard has noted in describing how flexible these accounts are: “You can take the money tax-free and move it to another niece or nephew or grandchild and no tax problem at all.”
Where the Old Rules Can Still Bite
The federal FAFSA is not the only application in play. A few hundred private colleges also use the CSS Profile, which can still ask about grandparent-owned 529 accounts and grandparent support, so families applying to those schools should not assume the money is invisible. State aid formulas and individual institutional aid policies can differ as well, and some schools apply their own methodology on top of federal data.
Other caveats worth knowing: the 529 owner controls the account, not the beneficiary, so a grandparent’s estate plan should address what happens to a funded account if the owner dies before the balance is spent. Withdrawals used for non-qualified expenses trigger income tax on the earnings and, in most cases, a 10% penalty. And gifts above the annual exclusion, or above the five-year election amount, must be reported on a federal gift-tax return even when no tax is owed.
The federal penalty that kept grandparent 529 money on the sidelines has been off the books since the 2024-25 aid year. For families that never got the memo, the account they already own works differently than the advice they were given.
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