If you’re anything like me, you had a bumpy road toward paying for your college education. Indeed, the average college graduate these days has about $35,000 in student loan debt, and my wife and I each had about that amount in student loans (along with a few other bank-financed bad decisions). It took us the better part of five years to finally pay them off. One reason I decided to go to law school was to put myself in a position such that my kids might not have to deal with student loans at all. With my first child well on the way, I’ve been exploring the options. One option is the 529 Education Savings Plan, and in particular, an account that is owned by the child’s grandparent. Let’s dig in.
What is a 529 college savings plan?
In short, 529 plans are state-administered, tax-advantaged education savings accounts to help finance education costs for a named beneficiary. Plans can be owned by the beneficiary herself (e.g. the child), her parents, or even her grandparents or some other generous relative or family friend. Because 529 plans are investment vehicles, returns are subject to the volatility of the underlying assets, and a plan could lose money in a downturn.
Contributions to 529 plans aren’t tax deductible, but as long as future withdrawals are used for qualifying education expenses, any earnings will grow completely tax free. Some states will allow an account owner to deduct 529 contributions from taxable income for state income tax purposes.
When it comes to paying for your child’s college expenses, the best type of plan for your situation depends on a number of factors, but in general, a 529 education savings plan provides the greatest flexibility and return on investment. Most of the information in the remainder of this article will focus on the education savings plan option for 529 plans.
What tax advantages do 529 plans provide?
A 529 plan is somewhat similar to a 401(k) retirement account. The account grows tax-free as long as withdrawals meet certain requirements. But unlike a 401(k), you can’t deduct 529 plan contributions from your federal taxable income. That said, many states allow account owners to deduct 529 plan contributions from taxable income for state income tax purposes. For example, my home state of Virginia allows a deduction of up to $4,000 per year per beneficiary for 529 contributions.
How do 529 plans affect financial aid?
Federal student aid is doled out after the Free Application for Federal Student Aid (FAFSA) calculates the student’s Expected Family Contribution (EFC). In determining the amount of federal financial aid a student can receive, FAFSA looks at the overall financial situation of the student and their family. In general, a 529 plan that is owned by either the student or their parents is considered a parental asset and is therefore included in calculating the EFC. In effect, a large 529 savings balance owned by the student or her parents could reduce the amount of federal aid that the student is eligible for. Plans owned by others, including grandparents, are treated a bit differently, as discussed in depth below.
NOTE: Beginning in the 2023 Aid Year (July), the EFC will be replaced by the Student Aid Index (SAI). Really this is just a change in nomenclature to more accurately reflect what the FAFSA is really telling you.
What are the investment options available for 529 plan owners?
Each state administers its own 529 plan (or plans), generally by selecting a plan manager. This is in some ways similar to the 401(k) administrator selected by your employer. Where 529s diverge from 401(k) plans is that the investment options are generally much more limited for a 529 plan. Many states have 529 plans where the owner has a limited set of investment options, such as target enrollment date portfolios.
The limited options seem to be intended to make college savings through a 529 plan simple and automatic, geared toward the novice investor. If you’re a bit more hands-on with your investments, this can be frustrating, as even your financial advisor can’t exercise any greater control over your 529 plan investments than selecting one of the portfolio options. Still, saving for college with a set-it-and-forget-it 529 portfolio might be a low-hassle, pain free solution, even for the experienced investor.
What can 529 distributions be used to pay for?
Distributions from 529 can be used, tax and penalty free, for qualified education expenses. This includes college expenses like tuition and mandatory fees, textbooks, and even computer equipment. Distributions can also be used to pay for up to $10,000 per year in private K-12 education costs or to pay off up to $10,000 of the beneficiary’s student loans. Only the account owner may determine when, if, and in what amount distributions can be made.
If distributions are used for non-qualified expenses, such distributions are subject to income taxes and a 10% penalty. It’s best to stick to qualified expenses.
Who can contribute to your child’s 529 plan?
Regardless of who owns the 529 account (e.g. parent, child, grandparent, etc.), anyone can contribute. This can be a very convenient way to save for your child’s future education costs. Instead of your relatives buying a bunch of toys your child doesn’t need or clothes that she’ll outgrow in two weeks, they can make contributions to a 529 plan set up for your child’s benefit. Grandma and Grandpa can simply write a check and invest in their grandchild’s college education.
Grandparents and 529 plans
If your child’s grandparents, or any other relative or family friend, wants to make regular investments toward your child’s future education expenses, they can reap significant benefits by opening their own 529 account for your child’s benefit.
Do grandparents get any tax benefits from owning a 529 plan?
Like any other 529 savings plan, one owned by the student-beneficiary’s grandparents has significant tax benefits. IRS rules don’t allow grandparents to take a federal tax deduction for 529 plan contributions, but many states allow account owners to take a state income tax deduction for 529 plan contributions.
How can 529 plans be used for estate planning?
Another way 529 savings plans can provide a benefit to grandparents is by removing assets from their taxable estate without relinquishing control. When grandparents open a 529 savings account for a grandchild, they retain complete control over the investments and distributions from the account. Contributions are treated as gifts, subject to the annual gift tax exclusion of $15,000 per beneficiary per year.
So, a married couple could contribute up to $30,000 per year to each of their grandchildren’s 529 accounts. Keeping within the annual gift exclusion limit completely avoids the problems associated with directly leaving an inheritance to a grandchild (known as the Generation Skipping Transfer Tax). With a 529, grandparents can contribute to their grandchild’s education while reducing their own taxable estate and retaining control over investments and distributions.
Account owners can also elect to make one large lump sum contribution of up to $75,000 to a grandchild’s 529 and have it treated as if it had been made in installments over five years. A grandparent could choose to contribute $50,000 this year to her oldest grandchild’s 529, and for gift tax purposes, it would be treated as though the grandparent had made $10,000 per year contributions over a five year period. The grandparent would have $5,000 of the annual exclusion remaining during each of those five years for her oldest grandchild. Interested grandparents would be well advised to consult with their estate planner or financial advisor to maximize this 529 benefit.
How do grandparent-owned 529 plans affect aid eligibility?
In general, a 529 plan owned by a grandparent has minimal effect on the student-beneficiary’s eligibility for federal student aid. Forthcoming changes, discussed below, reduce the impact even further. Assets in a grandparent-owned 529 plan are not reported on the student-beneficiary’s FAFSA; there is no effect on the student’s financial aid eligibility.
This will remain true after the new FAFSA is rolled out for the 2023 aid year.
For aid years before 2023, students must report distributions from any 529 plan as untaxed income. So, if Grandma distributes funds to her grandson from a 529 plan she owns for his benefit, he must report that distribution on the FAFSA as income. Up to 50% of student income can be considered available for educational expenses.
Beginning in aid year 2023, the only income a student must report on her FAFSA is imported directly from their federal income tax return, so distributions from a grandparent-owned 529 will no longer have any impact on the student’s federal aid eligibility.
What if the student’s parents already have a 529?
If you’ve already set up a 529 educational savings account, you might wonder how your parents can contribute to your child’s educational expense planning. It is perfectly allowable for one child to be the beneficiary of multiple 529 accounts. So both sets of grandparents, aunts and uncles, or anyone else with the means and desire can open a separate 529 plan for the child’s benefit.
Saving for college made easy
A 529 plan is a great way to save for college. It comes with great tax advantages and benefits that extend beyond just the student or their parents. Plus, if your child doesn’t use all of the funds in a 529 account you own, you can easily switch the beneficiary to another child, relative, or even your own grandchild.
Joshua Carrigan is a 3L at George Washington University Law School. Joshua spent eight years as a Nuclear Submarine Officer for the US Navy and is also a licensed skydiver. Four years ago Joshua and his wife embarked on a journey to become debt free, paying off $170,000 in student and car loans along the way.