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Pros and cons of 529s for grandparents
Surveys show that many grandparents like the idea of using part of their wealth to help pay for their grandchildren's college expenses. Grandparents recognize not only the value of a college education but also how difficult it can be for grandchildren and their parents to pay or borrow their way through college as costs keep rising. We have an entire section of the site devoted to grandparents. Here are the essential reasons why grandparents should consider using 529 plans, along with a few cautions.
- Your money won't mess up your grandchild's income tax returns.
The money in a 529 plan grows tax-deferred, so there are no interest, dividends, or capital-gains distributions to report on the child's income tax return. Most parents will love not having to worry about even filing tax returns for their children as the account grows through the years. They won't love it so much if you instead decide to make straight gifts to your grandchild, causing income tax headaches and a high tax bill, especially now that the abominable "kiddie tax" has been expanded to include college students up through the age of 23.
- Your money won't mess up your grandchild.
Simply stated, the grandchild named as beneficiary on the 529 account has absolutely no rights to the money no matter how old he or she gets to be. The grandparent continues to have complete ownership and control for as long as he or she decides to keep the money in the 529 plan. How many times have you heard about a child making poor decisions because of the money that legally comes their way at the age of 18 or 21? In spite of the grandparents' best intentions, gifts of cash or stocks made while the child is young can become a parent's nightmare. That won't happen with a 529 plan.
- You will be reducing exposure to estate taxes.
A 529 plan offers the only way for you to remove assets from your estate while retaining all of your ownership rights. Your contributions into the 529 plan are treated as completed gifts from you to the account beneficiary. Gifts are subject to a federal gift tax, but you have an annual exclusion of $12,000 to apply towards each beneficiary before running into taxable territory. (Even if your gifts do go over the annual exclusion amount, you pay the federal gift tax only after you exhaust your $1 million lifetime exemption.) A special rule available only with 529 plans allows to you accelerate five years worth of annual exclusions into one year. This means that you can put as much as $60,000 ($120,000 for a couple) into a 529 plan for each grandchild and stay within your gift-tax annual exclusion.
- Your college savings fund will grow faster.
It grows faster because the 529 account is not subject to tax. End of story? Well, not quite. You should also know that 529 plans offer a variety of investment options. Many grandparents tend towards the more conservative options, which provide the greatest tax break when compared to their taxable counterparts. Many experts are predicting that income tax rates will be increasing regardless of who wins the upcoming presidential election, but 529 plans will assuredly retain their tax-favored status.
- You may be eligible for a state income tax break.
Take a look at the tax rules in the state you live in. Are you able to deduct on your state income tax return the contributions you make to the in-state 529 plan? Thirty states (including D.C.) offer a deduction or state tax credit for in-state contributions. Five states (AZ, KS, ME, MO, and PA) offer a break when using either the in-state or an out-of-state 529 plan. It's unlikely your state gives you dollars towards any other type of college investment.
- You can change your mind.
As the owner of the 529 account, you determine when to take a withdrawal, how much to withdraw, and what to use the money for. Of course, it's tax-free only if you withdraw for the designated beneficiary's qualified higher education expenses. Otherwise, you will owe tax on the earnings portion of the withdrawal and in most cases a federal 10% tax penalty on those earnings. The comfort of knowing the money is there for you in the event you change your mind about paying college expenses is very reassuring to many grandparents who resist making outright gifts. Of course, very few do change their minds, except perhaps to switch the beneficiary designation to a different family member if it turns out that the original beneficiary no longer needs the money for college.
- A 529 plan can be a great place for RMDs
If you are taking required minimum distributions ("RMD") from your IRA, but have no spending needs beyond what you receive from other income sources, consider using the IRA money to fund 529 accounts for your grandchildren. The IRA distributions are still subject to income tax, but once in the 529 plan that money will grow tax-free and remain outside your estate as long as it is eventually used for qualified higher education expenses.