Did you know May 29 (5/29) is recognized as National 529 College Savings Plan Day? This month we'll be looking at how 529 Plans may help you save for college.
For many families, a college education is a significant financial burden that is increasingly hard to meet with savings, current income, and a manageable amount of loans. For some, the ace in the hole might be grandparents, whose added funds can help bridge the gap. Big changes to the FAFSA process mean grandparents can help pay for college without worrying about the “financial-aid trap.”
Because of pending changes to the Free Application for Federal Student Aid (FAFSA), students will no longer have to disclose cash support. That means effective for the 2023-2024 school year, grandparent-owned 529 accounts will no longer impact a student’s eligibility to receive needs-based financial aid.
529 college savings plan
A 529 college savings plan is one of the best vehicles for multigenerational college funding. 529 plans are offered by states and managed by financial institutions. Grandparents can open a 529 account on their own — either with their own state's plan or another state's plan — and name their grandchild as beneficiary (one grandchild per account), or they can contribute to an existing 529 account that has already been established for that grandchild (for example, by a parent).
Once a 529 account is open, grandparents can contribute as much or as little as they want, subject to the individual plan's lifetime limits, which are typically $300,000 and up. Grandparents can set up automatic monthly contributions or they can gift a larger lump sum — a scenario where 529 plans really shine.
Contributions to a 529 plan accumulate tax deferred (which means no taxes are due on any earnings made along the way), and earnings are completely tax-free at the federal level (and typically at the state level) if account funds are used to pay the beneficiary's qualified education expenses. (However, the earnings portion of any withdrawal used for a non-education purpose is subject to income tax and a 10% penalty.)
Under rules unique to 529 plans, individuals can make a lump-sum gift of up to $75,000 ($150,000 for joint gifts by a married couple) and avoid federal gift tax by making a special election on their tax return to treat the gift as if it were made in equal installments over a five-year period. After five years, another lump-sum gift can be made using the same technique. This strategy offers two advantages: The money is considered removed from the grandparents' estate (unless a grandparent were to die during the five-year period, in which case a portion of the gift would be recaptured), but grandparents still retain control over their contribution and can withdraw part or all of it for an unexpected financial need (the earnings portion of such a withdrawal would be subject to income tax and a 10% penalty, though).
What happens at college time if a grandchild gets a scholarship? Grandparents can seamlessly change the beneficiary of the 529 account to another grandchild, or they can make a penalty-free withdrawal from the account up to the amount of the scholarship (though they would still owe income tax on the earnings portion of this withdrawal).
Bottom line
529 plans have always been a powerful college savings tool and a smart vehicle for grandparents looking to take advantage of gift and estate tax benefits. But until now, even these highly regarded features, combined with tax-free qualified distributions, haven’t always been powerful enough to overcome worries about potential impacts to financial aid. Thankfully, this is no longer a concern, and grandparents considering investing in a 529 plan to help send their grandchildren to college can now do so without fearing the financial-aid trap.