Some grandparents may hesitate to contribute to a 529 plan owned by their grandchild’s parent. A 529 plan account owner, not the beneficiary, controls the assets in the 529 plan account and may decide to use the funds for something other than their intended purpose. Nothing stops a parent from changing the beneficiary of a 529 plan they own or taking a non-qualified withdrawal.
Grandparents who are concerned about contributing to a parent-owned 529 plan may consider opening a 529 plan in their own name or opening a custodial 529 plan for their grandchild. There are advantages and disadvantages to each option.
Risks of contributing to a parent-owned 529 plan
A 529 plan beneficiary has no legal rights to a 529 plan account. Instead of using the funds to pay for the beneficiary’s college expenses, a parent may decide to spend the funds on a big screen TV, a new Porsche or a European vacation.
Non-qualified 529 plan distributions are subject to income tax and a 10% penalty, but only on the earnings portion of the withdrawal. In some cases, the financial impact of a non-qualified 529 plan distribution is no worse than taking a distribution from a taxable investment account.
Even parents with good intentions can end up dipping into a child’s college savings. Parents who unexpectedly become unemployed may take a 529 plan withdrawal to pay for rent or groceries if they don’t have an emergency fund.
Grandparent-owned 529 plans
Grandparents may open a 529 plan in their own name to retain control of the assets. The grandparent can change the 529 plan beneficiary or take a non-qualified distribution if the beneficiary decides not to go to college. As the 529 plan account owner, a grandparent also has access to the funds in the event of a medical emergency.
State income tax benefits may also be available for grandparents who contribute to a 529 plan in their own name. In 10 states, only the 529 plan account owner is eligible to claim an income tax deduction or income tax credit for 529 plan contributions. Tax savings can be reinvested into the 529 plan to give the grandchild’s college fund an extra boost.
However, grandparent-owned 529 plans can hurt a grandchild’s eligibility for need-based financial aid. A grandparent-owned 529 plan is not counted as an asset on the Free Application for Federal Student Aid (FAFSA), but they are considered by nearly 200 schools who use the CSS Profile.
A bigger concern arises when a grandparent takes a 529 plan distribution to pay for college. The amount of the distribution is considered untaxed income to the student on the FAFSA and can reduce the student’s need-based financial aid eligibility by as much as 50% of the amount of the distribution. Grandparents should pay attention to the timing of 529 plan distributions and consider workarounds to address the negative impact on financial aid.
Custodial 529 plans for grandchildren
Grandparents may prefer to open a custodial 529 plan account for a grandchild. With a custodial 529 plan account, the grandchild is both the beneficiary and the account owner. Since the child is a minor, the grandparent can be the custodian to manage the 529 plan account on behalf of the child.
Assets held in a custodial 529 plan account are considered parent assets on the FAFSA and are counted at a maximum rate of 5.64%. A child’s custodial 529 plan assets are not counted on a sibling’s FAFSA but are included on the CSS Profile. Distributions from a custodial 529 plan are not reported as income on the FAFSA.
Contributions to a custodial 529 plan are irrevocable, which means the grandparent cannot take the money back. Once the grandchild reaches age of majority they will have legal control of the custodial 529 plan funds. Grandparents may be concerned about their grandchild taking a non-qualified distribution to buy a sports car instead of paying for college.
An added benefit of a custodial 529 plan or a grandparent-owned 529 plan is the grandparent can keep the account secret from the rest of the family until the grandchild enrolls in college. There’s no annual tax reporting on 529 plans until a disbursement occurs. To open a 529 plan as the account owner or custodian, all the grandparent needs to know is the grandchild’s name, date of birth and Social Security Number.