529 plans offer unique benefits for grandparents, including reducing estate tax exposure, being able to retain control of the assets throughout the life of the account, ease of management and flexibility. 529 plans are one of the best ways for grandparents to save for college because while contributions to a 529 plan are not deductible at the federal level, over 30 states offer a tax deduction or credit for contributions.
Historically, one of the major concerns about grandparent-owned 529 plans was their impact on federal financial aid when withdrawn to pay for a grandchild’s education. Fortunately for grandparents, the FAFSA simplification scheduled to be implemented for the 2024-2025 award year will no longer require their financial support to be reported.
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Opening a 529 Plan for your Grandchildren
- Pros and Cons of Separate 529 Plans for Multiple Children
- How to Open a 529 Plan
- Research and Compare 529 Plans
Contributing to your Grandchildren’s College Fund
- Can a Grandparent Contribute to a Parent-owned 529 Plan?
- 10 Ways Grandparents can help pay for college
- The Generation Tax and 529 Plan Contributions
Tax and Financial Aid Considerations
- New FAFSA Removes Roadblocks for Grandparent 529 Plans
- State Gift and Estate Tax Treatment of 529 Plans
- Tuition Gift Tax Exclusion
FAQs about grandparents and 529 plans
What happens to 529 plan money if child does not go to college?
One option you would have is to change the beneficiary to another member of the family. That could be the current beneficiary's brother or sister. It could also be the beneficiary's cousin. You could even move the beneficiary up or down the family tree, naming the beneficiary's child, parent, or even yourself as replacement beneficiary.
Another option you have is to take the money back out of the 529 plan for yourself. However, you probably won't want to do this unless you have a real need for the funds. Any earnings growth in the account will be taxable to you at your ordinary income rate plus a 10-percent penalty rate. The fact that the account beneficiary can be changed as many times as you want means that any excess funds in your 529 plan can remain there to be passed down from generation to generation (check to see if your 529 plan has a restriction on how long the account can stay open—many do not).
What happens to my 529 plan if I die or become incapacitated?
Your 529 account will not terminate; it will simply continue under a new account owner. When you establish a 529 account, the application will invite you to name a successor owner. We recommend that you make this designation, as it will allow ownership of the account to be transferred easily and automatically to your named successor. If you do not designate a successor, the new account owner may have to be decided through probate. Some 529 plans have rules of succession to determine the successor owner in the event you have not named someone.
You should realize that a successor owner assumes all the rights of the original owner, including the right to request a refund. You must have confidence that the person you name as successor will fulfill your desires for the use of the 529 account. If you have any concerns about this, speak with your attorney about the possibility of naming a trust as successor.
Should I set up a separate 529 plan for each child?
We generally recommend you establish a separate 529 account for each grandchild you wish to help. The reasons most people give for thinking about placing all the 529 savings into one account are to reduce effort and paperwork and to minimize annual account maintenance fees.
But setting up just one account to benefit multiple grandchildren only delays the effort and paperwork. A single 529 account can have only one individual named as beneficiary. To use the account later on for a grandchild who is not the current beneficiary, you would first have to establish a new account for that grandchild and transfer funds (tax-free) from the “master” 529 account to the new account.
And while it makes sense to minimize account maintenance fees, there may be ways to accomplish that objective other than consolidating the 529 funds into one account. Some 529 plans will waive their annual account maintenance fees (which can range anywhere from $5 to $30 per year) if you maintain a certain balance in your 529 accounts or if you sign up for the automatic contribution plan. Also note that most 529 plans impose no account maintenance fees at all.
Opening separate accounts for your grandchildren is a good idea for several reasons. One is that you can tailor the selection of 529 plan and investment option within that plan for each grandchild. For example, let's assume your grandchildren are located in different states. It could make sense to use the 529 plan in the state where the grandchild lives if there are special state tax breaks for withdrawals from the in-state 529 plan, or if the state provides preferable treatment to residents in its own 529 plan when awarding state grants.
Another reason to maintain separate accounts is to keep your intentions clear. If something were to happen to you, and all the funds you set aside to help all your grandchildren are in the name of just one grandchild, your children could face a difficult time attempting to resolve the ultimate disposition of the 529 funds. With separate accounts, you can easily name the appropriate successor on each account and eliminate any confusion or discord in the event you die or become disabled.
How to pick 529 plan if future college is unknown
In the vast majority of 529 “savings” programs, that won't matter. Withdrawals from the account can be used at any educational institution where federal student aid is available, whether or not the school is located in the state sponsoring the 529 plan. Eligible institutions include private colleges, public universities, community colleges, graduate schools, and trade schools around the country. Foreign schools may also be eligible. To check the eligibility of any particular institution, use our school code search tool.
The situation is different with many of the 529 “prepaid” programs. These 529 plans often reserve their best benefits for students attending particular institutions. For example, the College Illinois! prepaid tuition program is targeted to Illinois families who plan on sending their children to Illinois public institutions. Another example is Independent 529 Plan, a program that permits you to lock in tuition at participating private colleges around the country. In any 529 prepaid program, the benefits can be converted for use at non-targeted institutions, but you'll want to understand the conversion formula before making the decision to join the plan.
Paying tuition directly avoids gift tax, so why use a 529 plan?
Your planner is correct in saying that the payment of tuition by you directly to a school is not considered a gift. (The school can be any educational institution, not just college.) If you have ways to utilize your $17,000 annual gift exclusion other than through contributions to a 529 plan or Coverdell ESA, the direct payment of tuition can be an effective tool for further reducing your taxable estate.
If you are not currently utilizing your $17,000 annual exclusion, you should understand the advantages of funding a 529 plan now and not waiting until your grandchild has tuition bills to pay. For one thing, you remove any risk that you will die before the money can be removed from your estate through direct payments of tuition. For another, the gift tax exclusion for direct payments applies to tuition but not to other costs that can be covered by 529 plans such as room and board, books, supplies, and equipment. Finally, be aware that the school is likely to treat your direct payment of tuition as a “resource” that reduces financial aid awards on a dollar-for-dollar basis. With a 529 plan, you can request that the withdrawal be made payable to the student, not to the institution, and this may (depending on the policies of the institution) lead to a better financial aid result.
What are the estate-planning benefits of 529 plans?
The unique advantage with 529 plans is that the value of the 529 account is removed from your taxable estate, yet you retain full control over the account including the right to ask for the money back at any time. No other vehicle affords this combination of control and estate reduction.
Some grandparents are being advised by their attorneys, accountants, and financial planners to gift away assets to younger family members as a way to reduce exposure to the estate tax. You can make up to $17,000 in gifts in 2022 to any other person and not be subject to the gift tax. If you do not use this year's $17,000 annual exclusion opportunity, you lose it. However, like many people who have worked hard to build up their net worth and who are uncertain about what the future may hold, you may be reluctant to follow through with annual gifting because you do not wish to irrevocably part with your assets.
The “excuse” not to utilize your $17,000 annual gift exclusion disappears with a 529 plan. You do not have to give up control. You can ask for the money back whether you really need it or if you just change your mind later on. (Of course, if you take the money back it comes back into your taxable estate. In addition, any withdrawal not used for the beneficiary's qualifying higher education expenses subjects the earnings to tax and 10% penalty.)
If your contributions to a 529 plan for a grandchild, when combined with all other gifts to that child during the year, exceed the $17,000 annual exclusion, you must file a gift tax return (Form 709) and compute any gift tax and generation-skipping transfer tax. Everyone has a lifetime exemption of $12.92 million ($25.84 million per married couple) for gifts, estates, and generation-skipping transfers before taxes are owed.
In any year during which your 529 contributions for a particular beneficiary exceed $17,000, you may make an election on Form 709 to spread the contributions ratably over five years (20% per year) for gift-tax purposes. This permits frontloading of up to $85,000 per beneficiary (or $170,000 for a married couple) into a 529 plan without generating a taxable gift, assuming no other gifts to that beneficiary are made during the five calendar-year period. If you make the five-year election and die before the fifth calendar year, the contributions allocated to the years after your death are included in your taxable estate.
Can I withdraw money from a 529 plan for unplanned emergencies?
Yes. Just about every 529 plan permits you to take the funds back for yourself at any time and for any reason. Subject, of course, to tax and 10% penalty on the earnings portion. This flexibility should relieve any concerns you might otherwise have about “giving” your money away now. Other types of gifts (trusts, family partnerships, UGMA/UTMA accounts, etc.) are not revocable, making the 529 plan unique in this respect.
Even though your contributions to a 529 plan are revocable, those contributions are treated as completed gifts from you to the 529 account beneficiary, and the 529 account value is removed from your taxable estate.
Do 529 plans count against Medicaid benefits?
Check to see if your state still applies an assets test for Medicaid eligibility purposes, and whether the test will be eliminated or modified in 2014 as required by the Affordable Care Act. The states that currently still consider assets when testing for Medicaid eligibility will generally treat your 529 accounts as “countable” assets. Because 529 plans permit you to take the money back, those funds will be considered available to pay for your nursing home expenses and other medical expenses. If you are concerned about maximizing Medicaid eligibility you should discuss with your attorney your desire to use 529 plans. You may wish to make someone else the owner of your 529 accounts. If you establish the 529 accounts under your own name, and later transfer ownership of the account to someone else (or even use the account to pay for college expenses), your Medicaid eligibility may be restricted by the “look-back” rules which cover transfers up to 36 months or 60 months prior to application for Medicaid.
How do Coverdell education savings accounts compare to 529 plans?
Coverdell ESAs are another option you have to help fund your grandchildren's college expenses. Like 529 plans, ESAs represent a tax-deferred and potentially tax-free way to save for college expenses. And unlike 529 plans, ESA withdrawals are tax-free when used for qualifying K-12 expenses in addition to college. However, for grandparents in particular, ESAs pose some issues not faced with 529 plans.
One concern is that only $2,000 per year can be contributed to ESAs for any child and that contributions from all sources are combined for purposes of this limit. If you were to put $2,000 into your grandchild's ESA in the same year that her parents, other grandparents, or anyone else makes contributions to her ESA, the annual limit is exceeded and your grandchild must pay a penalty. It may be difficult or impossible for you to know whether other family members are contributing to ESAs. You probably do not want to take on this risk.
Another concern with ESAs is that grandparents do not retain the same degree of control over contributed funds as 529 plans allow. Most ESA agreements require that the child's parent or guardian be the “responsible individual” on the account, leaving the grandparent out. Even if you were to find an ESA provider (bank, mutual fund, brokerage, etc.) that permits you as grandparent to be the responsible individual, you may not request a refund like you can with a 529 plan. ESA are held as trust or custodial funds for the beneficiary and distributions are reported under the beneficiary's social security number.
Does a 529 plan count against eligibility for financial aid?
Simply owning a 529 account for your grandchild will not affect your grandchild's eligibility for need-based financial aid, but actually using the account could have a negative impact in the subsequent year.
The value of assets owned by a grandparent (or other non-parent) is not reportable on the FAFSA financial aid application. This rule extends to 529 plans owned by grandparents.
However, if a grandparent provides any type of financial support to the student, that support is reportable on the following year's FAFSA as student income. The financial aid formula counts student income just as it counts student assets (although the assessment percentages and allowances are different). Most financial aid offices interpret the rules as requiring distributions from grandparent-owned 529s to be included as student income, even when the distributions are not reportable for federal income taxes (i.e. they are tax-free).
If a grandparent were to use the 529 account only to pay for the final year in college, then the income rule would not make any difference, since the student will not be applying for financial aid for the following year.
Which 529 plan investment options should I choose?
That's up to you to decide. Most 529 savings programs offer a menu of options from which to select, ranging from conservative fixed-income options to more aggressive equity options. Although every investor is different, we find that many grandparents tend towards the more conservative options, because their primary objective is to keep the principal safe, not to maximize investment returns. (Many parents seem compelled to select more aggressive options thinking that they must reach a certain target level of savings.)
The most popular option in many 529 plans continues to be the “age-based” option that automatically adjusts to a more conservative asset allocation as the beneficiary gets closer to college age. This may be an appropriate choice for many grandparents.
Prepaid tuition plans are also a popular choice for grandparents. State-sponsored prepaid tuition plans are available in a limited number of states and most of them have residency requirements. Independent 529 Plan is the prepaid tuition plan established by a consortium of over 270 private colleges (perhaps your alma mater is among them).
Is giving money to a custodial (UTMA) account a good idea?
We're certain the parents appreciate your generosity in making gifts into the UTMA for future your grandchild's college expenses. The interest, dividends, and capital gains each year from the UTMA are reported under the child's social security number. A dependent child can earn up to $1000 (in 2013) in investment income without having to file a tax return, and the next $1,000 is taxed at the lowest income tax bracket. Investment income above $2,000 is taxed at the parent's bracket under the Kiddie Tax.
Most problems with UTMA and UGMA accounts occur when they grow too large. They are treated as student assets and therefore count heavily against eligibility for financial aid. They also become the direct property of the child at a certain age established under state law, and at that time can be spent for any purpose deemed desirable by your grandchild even if not considered desirable by you or the parents. Another consideration is the burden your gifts may place on the parents if the investments trigger a need to file income tax returns. The income tax savings of putting the money into the custodial account can easily be offset or exceeded by the cost of professional help in preparing a child's tax returns.
Kiddie taxpayers include children under the age of 18 (as of December 31), 18-years-olds who are not self-supporting*, and full-time college students ages 19 through 23 who are not self-supporting.
*To be self-supporting, taxpayers must have earned income (i.e. wages) exceeding one-half their total support.