For grandparents who want to leave a legacy to their grandchildren, the gift of a 529 college savings plan is an option. Not only can opening a 529 plan account help a grandchild with educational expenses, it can also help grandparents with their estate planning goals.
In the past, grandparent 529 plans had the potential to reduce student aid eligibility. However, changes to student aid application rules mean that soon, 529 distributions from grandparents will not count toward a student’s income on the most-used financial aid form. This is welcome news for grandparents who want to help cover the ever-increasing costs of higher education without impacting a student’s need-based financial aid eligibility.
About 529 Plans
College tuition costs and student loan debt keep going up, so much so that student debt has reached a crisis point. Student loan debt in the United States is approaching $2 trillion and grows six times faster than the national economy.[1] The average annual cost of a private four-year college is more than $32,000—not including expenses such as housing, food, books, and supplies.[2] Between 2005 and 2020, the average per-student debt level nearly doubled, from $17,000 to $30,000.[3]
Student loan debt is an economic drag that can limit opportunities long after graduation. One of the most popular ways to save for an education is a 529 plan, also known as a qualified tuition program. These plans take their name from Section 529 of the Internal Revenue Code, but they are established and maintained at the state level. Every state except Wyoming has a version of the 529 plan.[4]
Grandparent-Owned 529 Plans
A 529 plan is the most popular way for Americans to save for a child’s education.[5] Grandparents may contribute to a 529 plan that has already been established by the parents, or they can open a separate plan.
Until recently, there was a major disincentive for grandparents to open a 529 plan because, when a student received funds from it, they had to report the funds as untaxed income on their Free Application for Federal Student Aid (FAFSA) form. As a result, the income from a grandparent-owned 529 plan could reduce the amount of financial aid the student qualified for. The same was true of parent-owned 529 plans, but the maximum reduction amount was significantly lower than the one from grandparent-owned plans.
FAFSA Changes and Grandparents
The FAFSA Simplification Act, signed into law in late 2020, made several changes to the Higher Education Act of 1965, including changes to the FAFSA form. One of the changes is that students will no longer have to disclose cash support on their FAFSA form.
The upshot for grandparents is that they no longer have to worry about the financial aid trap previously associated with grandparent-owned 529 accounts.[6] They can use a 529 account to help pay for their grandchild’s education without concerns that it will harm financial aid eligibility.
Importantly, income reporting changes are not yet in effect. Until they are, money from grandparent 529 plans may count as untaxed income on a student’s FAFSA form. The Department of Education announced in the summer of 2021 that full implementation of FAFSA changes, originally scheduled for the 2023–24 school year, will be delayed until the 2024–25 school year.
This delay should not affect plans to fund a grandchild’s education, because the funds in a grandparent-owned 529 plan come into play only when they are released. Therefore, grandparents can continue to put money into a 529 plan without affecting student aid eligibility.
In the meantime, grandparents will want to pay attention to when the new FAFSA rules take effect. They should also keep in mind that a grandparent 529 plan will still be considered on the College Scholarship Service Profile—an additional financial aid form used by a small number of private colleges.
Other Benefits of 529 Plans
A 529 plan can fund more than just tuition. Qualified expenses include fees, books, supplies, equipment such as computers and printers, software, and internet access. In addition, students living off campus may use the funds to pay for rent, utilities, and food. And, a 529 plan does not even have to be for higher education: tuition for primary or secondary school qualifies as well.
Leaving a legacy in the form of education funding is its own reward, but 529 plans provide financial benefits to both grandkids and grandparents, including the following:
● Investment earnings and withdrawals from a 529 plan are tax-free if they go towards qualified educational expenses.
● The money from a 529 plan can be used for non–education-related expenses. The money withdrawn is subject to a 10 percent penalty and taxes on the investment gain but the money can be tapped in an emergency.
● If the beneficiary (i.e., the grandchild) decides not to attend college, the grandparent owner can change the beneficiary. In fact, the beneficiary and the ownership can be changed at any time.
● Contributions to a 529 plan are removed from the owner’s taxable estate, lowering estate tax liability.
● While 529 contributions are considered gifts to the beneficiary and could be subject to the federal gift (and generation-skipping transfer) tax, this tax can be avoided by spreading a lump-sum contribution over a five-year period, a strategy known as “superfunding” a 529 plan.[7] Superfunding can be done for an unlimited number of beneficiaries.
● Some states offer a tax break for contributing to a 529 plan.[8]
● State rules vary for 529 plans, including contribution limits, but you can pick a plan from any state. You are not limited to plans in the state where you live, and students can use the money to attend a qualified school in any state.
It is important to remember that anytime you are dealing with the Internal Revenue Service, there are myriad rules and regulations that must be met, and 529 plans are no exception. State rules also apply to 529 plans. To get the most out of your plan, make sure you work with a knowledgeable professional. To learn more about ways you can help the next generation with their education and help yourself with a proper estate plan, call us.
[1] Melanie Hanson, Student Loan Debt Statistics, EducationData.org (Nov. 17, 2021), https://educationdata.org/student-loan-debt-statistics. [2] College Costs: FAQs, CollegeBoard, https://bigfuture.collegeboard.org/pay-for-college/college-costs/college-costs-faqs (last visited Dec. 27, 2021). [3] Scholarship America, The Far-Reaching Impact of the Student Debt Crisis, Our Blog (Jan. 2021), https://scholarshipamerica.org/blog/the-far-reaching-impact-of-the-student-debt-crisis/. [4] Though Wyoming stopped operating its own 529 plans around 2006, the state has partnered with other states to create similar plans established under the other state’s law and operated by that state's treasury department. [5] Hanson, supra note 1. [6] See Joseph Hurley, Avoiding the financial-aid trap with grandparent 529s, Saving For College (Nov. 12, 2014), https://www.savingforcollege.com/articles/avoiding-the-financial-aid-trap-with-grandparent-529s. [7] See Joseph Hurley, 10 Rules for Superfunding a 529 Plan, Saving For College (Feb. 25, 2021), https://www.savingforcollege.com/article/10-rules-for-superfunding-a-529-plan. [8] Compare 529 Plans by Features, Saving for College, https://www.savingforcollege.com/compare-529-plans/state-tax-deductions (last visited Jan. 24, 2022).
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