When they figure out your financial aid eligibility for college they consider your income and assets. 529 plans held by the parents or students are counted as assets of the parents and they assume you can spend 2.6-5.6% of the parents assets. 529 plans owned by grandparents are not counted in financial aid. That sounds great. However money spent out of 529 plans are then counted as student income in the next year. So the following year that student income goes up and that does impact financial aid. They assume that you can use 50% of student income towards college.
This means that money distributed from a grandparents 529 will cut financial aid in following years by 50% of the amount used.
The Smith family has two children and the older child is 18 and about to head off to college. They make $60,000 a year total. Their FAFSA says that the parents expected financial contribution is $10,000 and the childs contribution is $1000. For their local state college costing $20,000 that means they have need of $9000. Lets just say that the school's aid award includes $5,000 in loans and $3,500 in state grants.
Ok, now lets say that the Smith Grandparents saved a bunch of money and put it into a 529 for their grandkids. They have $20,000 total for each child. When Smith Jr goes off to college the 529 is not counted in their aid. But the grand parents pull $5,500 out of the 529 and pay $5500 worth of the students expenses thus keeping them from having to take out the student loans.
However in the sophomore year Smith Jr again fills out the FAFSA but this time that $5500 from the grandparents 529 counts as income for the student. The financial aid calculations assume that 50% of a students income is available for college. That $5500 from the grandparents will increase the students expected financial contribution by 50% or $2750. In the sophomore year then the students EFC will go up to $3750 and their need will go down by $2750 to $6250. In the sophomore year as a result they will qualify for $5500 in loans and only $750 in grants. The same thing would happen in the Junior and Senior years. In the end the student would not have to take out student loans but their grants would only add up to $5750.
Its better if the grand parents use their 529 funds in the later years. In fact its best to delay it all to the senior year if possible. This way the money will not be counted in following year financial aid calculations and won't undercut financial aid eligibility.
Lets instead look at the above scenario and have the grand parents distribute $10,000 a year in the junior and senior years only. This would not reduce grant funds for the sophomore and junior years since it would not increase the student expected financial contribution.
Here's how it might look if the grand parents dole out money every year :
Now if instead the grand parents hold the money till the last two years it could look like this :
The student has to take a little more in loans up front but they also save $2000 out of pocket and the parents save $3500 out of pocket. If the student and parents took that money to pay off loans right after graduation then the net loan balance would be $5,500.
Now of course this all hinges on the assumption that the student and their family's financial situation and the school aid program is such that the student could get grant aid. Thats not a given. If the family has a higher income or the college isn't very well endowed then grants may not be available at all. However even if the student can't get grant aid then it may matter to help them retain eligibility for loan aid. Subsidized loans are a form of financial aid. If you can qualify for subsidized loans versus private loans then the subsidized loans are definitely better.