A 529 plan is a savings account that can help cover eligible college expenses. These plans have many advantages, such as portability and favorable tax treatment. A 529 plan allows family members such as parents and grandparents to help contribute to a child’s education. With high and rising tuition fees, a 529 plan is more essential than ever.
Here’s how grandparents can use a 529 plan to help their grandchildren pay for college.
What is a 529 plan and how does it work?
A 529 plan is a tax-advantaged account that helps cover the cost of college and other education. The account allows contributors to deposit after-tax money, place it in potentially high-yielding investments, and withdraw it tax-free if used for eligible educational expenses. Additionally, some states offer tax deductions for those who contribute to the plans.
These qualifying education expenses can include tuition, room and board, and even student loan balances, as a result of changes to the plan, as well as K-12 tuition in private schools.
Parents with young children are usually the ones who open a 529 plan. But grandparents, other relatives or even friends can also open one. The student who will ultimately use the savings plan can also open one for their own account. A 529 plan has no annual contribution limit.
1. Determine Account Ownership
If you’re a grandparent who wants to open a 529 plan to contribute to your grandchild’s college fund, you’ll run into the issue of ownership. For example, should you be the owner or the student? Or maybe one or both of the student’s parents should take ownership?
If the student is a minor when the account is opened, you or the parent(s) of the child will likely be the account holder, at least until the child reaches the age of the majority. Whether it makes more sense for you or the student’s parents to own the account will vary on a case-by-case basis. For example, you can give ownership to parents if you don’t feel comfortable managing money and investments. On the other hand, you can choose to own the account if you don’t trust the child’s parents to manage the account responsibly. It may be more convenient for the student’s parents to own the account, but you may want to be the owner to retain ultimate control.
2. Be aware of financial aid implications
One of the biggest caveats to 529 plans has been their impact on a student qualifying for financial aid. If the student received money to pay for college before the last two years of attendance, that money was considered income for the student. This could make it harder for them to qualify for financial aid.
These concerns should be allayed by the passage of the FAFSA Simplification Act, which is expected to come into effect for the 2024-2025 academic year. When the new rule takes effect, grandparents who contribute to 529 plans will no longer affect their grandchildren’s ability to qualify for financial assistance. Indeed, the new FAFSA will no longer ask questions about outside contributions to 529 plans.
And because of the delay in reporting FAFSA forms, grandparents can now start taking advantage of a 529 plan without worrying that it will hurt their parent’s other chances for help.
3. Take advantage of the tax exemption for donations
A 529 plan does not set a limit on the amount a person can contribute to the plan in any given year. However, the money a grandparent contributes is considered a gift, which means gift tax may apply. Fortunately, you can contribute up to $16,000 per year per donee in 2022 as an individual without being subject to gift tax, or $32,000 per couple.
It is also possible, in some cases, to contribute up to five years of contributions at a time without incurring gift tax, in a process called frontloading or superfunding. This means a wealthy couple can potentially contribute up to $160,000 in 2022 per donee free of gift tax, but could not contribute again for five years without incurring gift tax.
4. Use a 529 to pay off student loans
The SECURE (Setting Every Community Up for Retirement Enhancement) Act of 2019 added a provision that allows people to use 529 plans to repay up to $10,000 in student loans for the direct beneficiary of the plan. Plus, an additional $10,000 can be used for one of the beneficiary’s siblings. Payments may include both principal and interest on any qualifying student loan.
The law also allows 529 plans to cover certain apprenticeship program expenses.
5. Consider alternatives
A 529 plan offers tax benefits, portability, and control. However, it may have limited investment options and its potential impact on financial aid might make alternatives worthy of your consideration.
For example, depository accounts such as UGMA/UTMA accounts have more flexibility in their investment choices while still not having a cap on contributions. However, custodial accounts have their own drawbacks, such as less favorable tax treatment compared to 529 plans. They also give beneficiaries control once they reach the age of majority (usually 18 or 21), which can be a problem if they are not particularly interested in higher education.
Another option is the Coverdell Education Savings Account (ESA). One of the benefits of Coverdell ESAs is that they can cover not only college expenses, but also primary and secondary education expenses. Plus, earnings and withdrawals can be tax-free if they cover eligible educational expenses, and investment options are broader than for 529s. But contributions are limited to $2,000 per year. and the beneficiary must be under the age of 18 when the account is opened.
At the end of the line
A 529 plan gives parents and grandparents the ability to contribute to a child’s education fund. They have no annual contribution limit and an individual can contribute up to $16,000 per year while avoiding gift tax rules, or $32,000 per couple. A 529 withdrawal is generally free of federal taxes if used to cover eligible education expenses – and is often also free of state taxes.
However, 529 plans have their drawbacks, such as limited investment options, but if you are looking for the best 529 plans, you can find some good options. Other account types, such as UTMA/UGMA and Coverdell ESA can help with these drawbacks, although they have their own downsides. Be sure to weigh all the options before deciding what type of account to open.