Grandparents, 529 plans are great match

Question

Dear Joe, Can a grandparent sponsor a 529 savings account? -- Robert

Answer

Dear Robert,

Grandparents and 529s were made for each other.

Establishing a 529 account is easy. Simply fill out the plan enrollment form designating your grandchild as beneficiary, select an investment from the plan's menu of options, and make your contribution either by check or by enrolling in the automatic contribution plan.

Of course, first you must select a 529 plan. If you live where there's a state income tax, consider the plan offered by your own state. That way, you may be allowed to claim a state income-tax deduction or credit for your contributions.

However, don't rule out plans offered by other states. You may find an out-of-state 529 plan with lower costs, or with investment options better suited to your tastes. It's important to read the plan's official program disclosures before investing, but all 529 plans allow your grandchildren to attend the colleges of their choice.

Your 529 plan will remain free from federal taxes, provided your future withdrawals are made in a year during which your designated beneficiary incurs qualified higher education costs. Such expenses include tuition, mandatory fees, books, supplies, equipment and a limited amount of room and board.

You can change the beneficiary to another family member as defined by the IRS (including the current beneficiary's first cousin) at any time. You can even take the money back for yourself, although the earnings then become subject to regular taxes plus a 10-percent penalty tax. Although you are not required to inform the grandchild or her parents about your 529 plan, in most cases it is better to do so. That way, they can plan accordingly.

A 529 plan is a great way to reduce your exposure to estate taxes. Your contributions are treated as complete gifts, and you can apply your $13,000 per year gift tax annual exclusion so that you don't have to report those gifts on a tax return. You may also make an accelerated contribution of up to $65,000, with a special five-year, gift-spreading election. Ask your tax adviser for the particulars.

Some grandparents prefer to make their contributions directly to a 529 account already owned by the grandchild's parents. Still others may decide to open the account themselves, but later transfer account ownership to the parents. Most (but not all) 529 plans accommodate these desires. If you decide to keep the plan in your own name, designate a successor owner on the application. If you were to die, the successor would then simply step into your shoes as owner.

A 529 plan owned by grandparents can affect the grandchild's eligibility to receive federal financial aid. A grandparent's assets are not reportable on the free application for federal student aid, or FAFSA, but the withdrawals from a grandparent-owned 529 plan are counted in the student's base-year income. Be sure to plan for that consequence, and consider either delaying withdrawals until the grandchild's final year of college, or transferring ownership of the account to the parent or to the student.

Also, before requesting a payment from the 529 plan directly to the school, check to see if the school will consider that payment to be a "resource" which reduces financial need on a dollar for dollar basis. If there is any confusion, you may be better off having the distribution made payable to your grandchild, who will then pay the college costs directly.

[Updated September 2012]