Grandparent 529 plans are becoming a popular way to save for college and for good reason. With a 529 plan, you can build an educational legacy for your grandchild while taking advantage of tax and estate planning benefits. The new FAFSA is being released over the next two years which provides a 529 grandparent loophole where the contributions won’t count against a grandchild’s ability to get financial aid.
With the pending FAFSA changes set to take place by 2024, now is the time to set up a 529 plan for a grandchild who isn’t currently in school. You can start accumulating assets for them that won’t hurt their financial aid ability when they do enroll. See our best 529 plans available in your state.
529 Plans for Grandparents
One potential drawback of grandparent 529 plans traditionally has been that they can affect financial aid eligibility for the beneficiary. However, thanks to upcoming changes to the Free Application for Federal Student Aid (FAFSA), grandparents no longer have to worry about the “financial aid trap”.
Two-thirds of existing questions are scheduled to be removed from the new FAFSA, including one that asks about cash gifts from grandparents, said Shannon Vasconcelos, director of college finance at Bright Horizons College Coach.
“The Department of Education has not issued any guidance on the FAFSA Simplification provisions of the Consolidated Appropriations Act of 2021 yet, but it does appear that grandparents (along with non-custodial parents and anyone else outside of the custodial household) will be able to assist with college payments without negative federal financial aid implications,” she said.
The new, simplified FAFSA goes live on October 1, 2023 for the 2024-25 academic year. This is subject to change, however, so it’s important to keep an eye on this page for any updates.
How Grandparent 529 Plans Affect Financial Aid
Overall, 529 plans have a minimal effect on financial aid. But, the FAFSA treats parent-owned accounts more favorably. For example, you report 529 plan assets as parent assets, which can only reduce aid eligibility by a maximum of 5.64% of the account value. The FAFSA ignores distributions from a parent-owned 529 plan.
When it comes to a grandparent 529 plan, you do not report the assets on the FAFSA. However, under current rules, you must report distributions as untaxed student income. Untaxed income to a student can reduce aid eligibility by as much as 50% of the amount of cash support. For example, taking a $10,000 529 plan distribution to help pay for college can reduce your grandchild’s aid eligibility by $5,000, under current rules (that are changing).
There are some workarounds to help reduce the impact of grandparent support on the FAFSA, but they can be somewhat complicated. For example, you could change the 529 plan account owner to a parent or time your 529 plan distribution carefully to avoid having to report it. The new, simplified FAFSA eliminates the need for workarounds.
This is why it’s such a big deal that the rules are changing. Now, a grandparent will be able to open a 529 plan for their grandchildren and all of the same benefits that parents currently enjoy will be passed on to these accounts.
Changes to Grandparent 529 Plan Rules
The updated FAFSA does not require students to manually report cash support. That means a grandparent-owned 529 plan will not have any impact on need-based financial aid eligibility. With the new form, the amount of a student’s “total income”, which includes untaxed income, will come directly from federal income tax returns via the IRS Data Retrieval Tool (DRT). So, a student’s total income amount will only consist of data that comes from the federal income tax return.
A student’s FAFSA includes income and tax information from the prior-prior year, so the 2023-24 FAFSA will include information from 2021 tax returns. Because of this “prior-prior” rule for income reporting, grandparents can start taking advantage of the new rules this year.
In other words, a grandchild does not have to report a distribution that was taken from a grandparent’s 529 plan in 2021. (Prior to the new rules, the student would report the 2021 distribution as untaxed income on the 2023-24 FAFSA).
How FAFSA Changes Affect Grandparent 529 Plans
Grandparent 529 Plan Assets
Grandparent 529 Plan Distributions
Current FAFSA Rules
Reported as untaxed student income, 50% of the gift is counted as available funds for college
New FAFSA Rules
Keep in mind, however, that grandparent 529 plans will still be considered on the CSS Profile. The CSS Profile is an additional financial aid form used by about 200 private colleges to award their institutional aid.
It’s still unclear how the upcoming FAFSA changes will affect the CSS Profile and institutional aid eligibility at other schools. Vasconcelos says cash support from grandparents will likely still have an impact.
“It is also possible that with the reduction of questions on the FAFSA, more colleges that are interested in collecting information that is no longer available on the FAFSA will begin to require the Profile or their own institutional application,” she said.
Example of the 529 Grandparent Loophole
Let’s say a grandparent wants to contribute $20,000 to a 529 plan for their grandchild. Under the old rules, that $20,000 would be reported as income on the grandchild’s FAFSA application, reducing the total aid package by 50% or $10,000. Under the new rules, it wouldn’t be reported and there would be no reduction.
529 Plan Tax Benefits for Grandparents
529 plans offer tax-deferred investment growth and distributions are tax-free when used to pay for qualified education expenses. With these tax savings, you can build a substantial college fund for a grandchild without having to worry about the money hurting any of their financial plans.
You may also be eligible for additional state tax benefits, depending on where you live, and which plan you use. Over 30 states allow residents to claim a state income tax deduction or credit for contributions to a 529 plan. Most of these states only offer tax benefits when you use your home state’s plan. Check your state’s rules to see if you qualify.
529 Plan Estate Planning Benefits
Some financial professionals advise grandparents to contribute to a 529 plan as part of an estate planning strategy. In most cases, you have to consider the Generation Skipping Transfer Tax (GST) when leaving an inheritance to a grandchild. But, 529 plan contributions up $16,000 per beneficiary (in 2022) qualify for the annual gift tax exclusion. For example, married grandparents who contribute $32,000 to a grandchild would not include the amount in their taxable estate.
529 plan contributions above the $16,000 annual limit will count against your GST lifetime exemption. In 2022, the GST tax exemption is the same as the lifetime gift tax exemption ($12.06 million).
You can shelter an even larger gift if you elect to spread a lump-sum contribution between $16,000 and $80,000 over a five-year period. This strategy is called superfunding a 529 plan.
When you save for a grandchild in a 529 plan, you retain control of the assets over the life of the account, even though you removed the value from your estate. However, you will have to add the value back to your taxable estate if you revoke the gift from the beneficiary.
The Bottom Line
A 529 plan is a smart investment that can set your grandchild up for future success. 529 plans already offer numerous benefits for grandparents, and the new financial aid treatment makes them even more attractive. But, the financial aid process can change dramatically at any time, Vasconcelos warns.
“When it comes to preparing over 18 years for college payments, the best you can do is to plan based upon the information available to you at the time, but know that there is no guarantee that the rules in effect when you start saving for college will remain in effect when the time comes to pay for college,” she says. “The more you save, however, the better prepared you will be for whatever shifts in policy and priorities occur.”
529 plans are still relatively new from a legislation standpoint so you’re still seeing changes being made from time to time. All of the recent changes have been to benefit 529 plans and to help people be more active in using a 529 plan to help pay for a college education.
Frequently Asked Questions (FAQs)
Is it better for a grandparent or parent to own a 529 plan?
Many advisors will push people to have the parent own the 529 plan because current rules have grandparent contributions hurting total financial aid eligibility. While this will change with the new FAFSA, many private colleges still will use the CSS system so it could still hurt the student if the grandparent owns the account.
Can grandparents write off 529 plan contributions?
More than 30 states offer a state income tax deduction to grandparents who contribute to a 529 account. They can still qualify for this deduction if someone else owns that 529 account. The amount and eligibility will depend on the state where the grandparent resides.
How much can a grandparent contribute to a 529 plan?
There is no individual limit to how much you can contribute to a 529 plan in a year. Every account has a lifetime limit of primary contributions that it can receive, and it varies based on who administers the account. It typically varies between $350,000 to $550,000 and doesn’t include any growth accumulation.
The grandparent might trigger certain gift tax rules though if they give too much to a single account, or beneficiary, during the course of a single year.