How Grandparents Can Save for College in Massachusetts

November 20, 2019

Grandparents who help save for college can help reduce a grandchild’s future student loan debt burden while leaving an educational legacy. In Massachusetts, grandparents who contribute to a 529 plan that they own are eligible for a state income tax deduction. There are also financial aid and tax considerations that grandparents should be aware of when saving for college.

Using a 529 plan to save for a grandchild’s college education

For most grandparents, a 529 plan is the best way to save for a grandchild’s college education. The investment grows on a tax-deferred basis, and distributions are tax-free when the money is used to pay for qualified education expenses.

The federal tax benefits are the same whether the grandparent owns the 529 plan account, the child’s parent owns the account, or the account is a custodial 529 plan account. Grandparents who want to open a 529 plan account may consider MEFA’s U. Fund, a 529 plan that offers low-cost investment options, an initial $50 seed contribution for newborn and adopted children and a state tax incentive for residents.

Massachusetts state tax benefits

Massachusetts offers an annual state income tax deduction for contributions to a Massachusetts 529 plan of up to $1,000 ($2,000 if married filing jointly). However, the state income tax deduction is only available to the 529 plan account owner. A Massachusetts grandparent who contributes to a parent-owned 529 plan account would not be eligible for a state income tax deduction.

Financial aid considerations

A grandparent-owned 529 plan can have a negative impact on a student’s financial aid eligibility. A grandparent-owned 529 plan is not reported as an asset on the Free Application for Federal Student Aid (FAFSA), but distributions count as untaxed income and will reduce the grandchild’s financial aid eligibility by as much as 50% of the distribution.

However, Massachusetts grandparents may want to open their own 529 plan so that they are eligible for a state income tax deduction, or because they want to retain control of the funds over the life of the 529 plan account.

One way to reduce the negative impact on financial aid eligibility is to wait until January 1 of the grandchild’s sophomore year of college to take a 529 plan distribution (or junior year if the student is graduating in five years). The FAFSA uses income from two years prior for income and tax information, so by that time, there will be no subsequent year’s FAFSA to be affected by the distribution.

Grandparents may also consider other workarounds, such as changing ownership to a parent or rolling the 529 plan funds into a parent-owned account. However, if there is a change in ownership, the grandparent is subject to state tax recapture for any income tax deductions previously taken. Another option is to help the grandchild pay down their student loans after they graduate. But, student loan payments are considered a non-qualified expense, so the distributions is subject to ordinary income tax and a 10% penalty on the earnings portion.

A grandparent may serve as the custodian of a grandchild’s custodial 529 plan account. By doing this, the grandparent will have control of the account until the grandchild reaches age of majority, and distributions used to pay for college will not affect financial aid eligibility.

Generation-Skipping Transfer Tax

A grandparent’s contribution to a grandchild’s 529 plan is subject to the Generation-Skipping Transfer Tax (GST). But, contributions up to $15,000 per donor per beneficiary qualify for the annual gift-tax exclusion and are not subject to GST or gift taxes and will not count against the grandparent’s lifetime exemption of $11.58 million.

Some grandparents make larger contributions to a 529 plan as part of an estate planning strategy. Grandparents may use 5-year gift tax averaging to contribute up to $75,000 per beneficiary ($150,000 for couples), if the contribution is treated as if it were spread evenly over the next five years. For example, grandparents with three grandchildren can shelter up to $450,000 from their taxable estate in one year by contributing to their 529 plan accounts. As long as the grandparent is the account owner, they will retain control of the assets throughout the life of the account.

Grandparents also have the option to fully fund a grandchild’s college education in one year if they choose to use up part of their lifetime gift and estate tax exemption of $11.58 million. The aggregate contribution limit for 529 plans in Massachusetts is $400,000. If married grandparents were to contribute the entire $400,000 at once: