Grow Your Practice with Grandparent 529 Plans
Grandparents want to leave a legacy for their grandchildren. 529 plans are an effective tool for clients who want to help pay for a grandchild’s college education. 529 plans offer preferential income tax and estate tax treatment and allow grandparents to contribute substantial amounts of money without being subject to gift taxes.
But, a grandparent’s financial gift may hurt their grandchild’s eligibility for need-based financial aid. Here are some important points to cover when discussing 529 plans and college funding with your clients.
Should a parent or a grandparent own the 529 plan?
Grandparents may open a 529 plan in their own name or contribute to a 529 plan owned by the child’s parent or a custodial 529 plan owned by the grandchild. There are advantages and disadvantages to each option, and recommendations should be made on a case-by-case basis.
Advantages of grandparent-owned 529 plans
- The 529 plan account owner retains control of the 529 plan funds throughout the life of the account. A grandparent may change the 529 plan beneficiary or withdraw the funds at any time. However, non-qualified distributions are subject to income tax and a 10% penalty on the earnings portion of the withdrawal.
- Grandparents who own their own 529 plan may be eligible for a state income tax deduction or state income tax credit. Over 30 states offer a state income tax benefit for 529 plan contributions, but in 10 states only the 529 plan account owner is eligible to claim the benefit.
- Assets held in a grandparent-owned 529 plan are not reported as an asset on the Free Application for Federal Student Aid (FAFSA). They do not affect a student’s eligibility for need-based financial aid, so long as the funds remain in the 529 plan account. (However, grandparent-owned 529 plans are included on the CSS Profile.)
Disadvantages of grandparent-owned 529 plans
- Distributions from a grandparent-owned 529 plan will reduce the student’s need-based financial aid eligibility by as much as 50% of the amount of the distribution.
- The grandparent will need to coordinate with the child’s parent regarding the 529 plan account balance and withdrawals.
- Distributions from a custodial or parent-owned 529 plan are not reported as income on the FAFSA.
- The grandparent can allow the parent to manage the 529 plan account, making it easier to track progress.
- The grandparent will lose control of the 529 plan account and the ability to withdraw the funds or change the beneficiary.
- The grandparent may not be eligible for state income tax benefits for contributions made to a custodial or parent-owned account.
While a custodial 529 plan or parent-owned 529 plan yields more favorable financial aid treatment, the grandparent loses control over the money and may lose certain state tax breaks. However, if the child is a minor, a custodial 529 plan allows the grandparent to retain control as the custodian of the account until the child reaches the age of majority.
How much can grandparents contribute to a 529 plan?
There are no annual contribution limits for 529 plans. However, 529 plan contributions are treated as a gift for gift tax and generation-skipping tax purposes. Gifts up to $15,000 will qualify for the annual gift tax exclusion and will not be counted against the grandparent’s lifetime gift and estate tax exemption.
If a grandparent is looking to reduce their gross estate, they may consider superfunding a grandchild’s 529 plan. With 529 plan superfunding, grandparents may be eligible to contribute up to $75,000 per donor, per beneficiary if they elect to treat the gift as if it were made over a five-year period.
Your clients may prefer 529 plan superfunding to other estate planning methods because they retain control of the 529 plan account even though the assets are removed from their estate.
However, there are drawbacks of 529 plan superfunding.
- If a client uses the entire gift tax exclusion amount with 529 plan contributions, no other tax-free gifts can be made during the 5-year period.
- If the client dies within the 5-year period, part of the gift may be added back to the client’s estate pro-rata and subject to estate taxes.
- Superfunding limits a grandparent’s gift to $75,000 ($150,000 for grandparent couples), which may not be enough to fully fund a grandchild’s education.
Grandparents who are willing to use up some of their lifetime gift and estate tax exemption can fully fund a grandchild’s college education upfront. Individuals are not subject to gift tax or generation-skipping transfer tax unless the total amount of gifts they give over the course of their lifetime exceeds the $11.4 million lifetime gift and estate tax exemption.
Should grandparents pay the college directly?
Instead of contributing to a 529 plan, grandparents may pay the grandchild’s college directly. Tuition payments made directly to a grandchild’s college are also considered tax-free gifts and will not count against the grandparent’s lifetime gift exemption.
But, direct tuition payments on behalf of a student may reduce a student’s need-based financial aid eligibility on a dollar-for-dollar basis.
Recommendations for grandparent-owned 529 plans
To reduce the negative impact on financial aid from a grandparent-owned 529 plan, clients may use one of the following strategies:
- Rollover a year’s worth of 529 plan funds from a grandparent-owned 529 plan to a parent-owned 529 plan in the same state after the FAFSA is filed and spend the funds on qualified expenses before the next FAFSA is filed.
- Wait to take a 529 plan distribution until January 1 of the grandchild’s sophomore year in college (junior year if the student will take 5 years to complete college). The distribution will not affect financial aid at this point in time, since the FAFSA uses the prior-prior year for income and tax information.
- Take a non-qualified distribution after the grandchild graduates to pay down student loans. The earnings portion of the withdrawal will be subject to income tax at the beneficiary’s rate and a 10% penalty tax.
A good place to start