Navigating 529 Plan Rules for Grandparents

They say it takes a village to raise a child. With the rising cost of college, students can use all the help they can get. And grandparents are stepping up.

More than half of grandparents are contributing or planning to help their grandchildren pay for college, according to a study by Fidelity.

A popular way for parents to fund a child’s education is by saving in a 529 account, where money can grow and can be used for qualified higher education expenses tax free. Grandparents also have the ability to participate in a 529 plan.

However, 529 plan rules for grandparents are slightly different from parents, including how it impacts federal financial aid. Here’s what you need to know to help make the most of your 529 benefits and avoid any costly mistakes.

You can open a 529 account in any state

Each state sponsors its own 529 plan, and you can invest in any one of them. That’s right, you don’t have to only use the plan offered by your state. The tax benefits can differ from state to state, so shop around with the help of a financial adviser to find the 529 plan that is best for your situation.

Further, students may use the funds to attend a qualified school in any state. Therefore, you could live in Michigan, participate in Ohio’s 529 plan and use those funds to pay a grandchild’s tuition at a school in Illinois.

That flexibility doesn’t apply to prepaid 529 plans, which are available only in some states. With these plans, you can prepay a future student’s tuition at an in-state, public college at today’s dollar and current tuition rates. Of course, you want to be sure your grandchild will likely attend an in-state, public school first.

529 contribution limits and options

There are no federal contribution limits when it comes to 529 plans. Instead, limits vary by state, reaching up to $300,000 or more.

More than 30 states also offer tax deductions or credits on 529 contributions.

You can contribute to a 529 account over time, much like a 401(k), or you can front-load one. However, contributions may be subject to the gift taxes (see more below). As an alternative, grandparents can contribute to a 529 account owned by a parent.

Gift-tax exclusions

Regardless of whose account you contribute to, one set up by you or a parent, contributions are considered gifts. That means taxes may apply if you contribute more than the annual gift-tax exclusion ($15,000 in 2019 per donor per beneficiary).

However, the IRS gives you some wiggle room. It will treat larger contributions, up to $75,000 ($150,000 for couples), as if they were being made over a five-year period. Therefore, you can front-load a 529 account without incurring any gift taxes, as long as no other annual exclusion gifts are made to that individual during the five-year period. For example, you could contribute $50,000, which would be reported as five $10,000 annual gifts. This is a potential way for grandparents to reduce their taxable estate. But should a grandparent pass away during those five years, a portion of the contribution will be included in the donor’s taxable estate.

The various tax implications are another reason why it is beneficial to work a financial adviser when opening a 529 account to help you avoid any pitfalls.

Your 529 plan can affect financial aid

One important thing to be aware of as a grandparent is the impact a 529 account can have on your grandchild’s financial aid eligibility.

The U.S. Department of Education factors in a student’s income and family contributions when determining his or her financial aid eligibility. When a parent owns a 529 account, up to 5.64% of its value counts toward the student’s Expected Family Contribution when filling out the Free Application for Federal Student Aid (FAFSA).

A 529 account owned by a grandparent isn’t reported on the FAFSA form. However, when money is provided from a 529 account by a grandparent, even for qualified expenses, it is reportable as the grandchild’s own income, which will reduce the following year’s financial aid award.

Since a grandparent-owned account doesn’t count toward financial aid until funds are distributed, it may be best to wait to use it until your grandchild’s final year or so of school. If he or she has very little other income, then the funds will only minimally affect financial aid.

Withdrawals are only for qualified higher education expenses

What counts as qualified higher education expenses goes beyond tuition. It includes any mandatory fees, room and board (on and off campus), textbooks, computers and more. You can check with your grandchild’s financial aid office to find out what specifically qualifies.

Although the funds in a 529 account are meant for your grandchild, you retain control over them. You can withdraw money from the account at any time. But doing so could hurt. Any withdrawn earnings on your investments used for nonqualified expenses are subject to a 10% tax penalty on top of ordinary income taxes. You won’t owe income taxes on withdrawals of your contributions, but the IRS may require you to pay back any previously claimed tax deductions.

A common exception is if your grandchild receives a scholarship. You can withdraw funds equal to the scholarship amount awarded for a nonqualified expense and avoid the 10% penalty. The earnings portion of the withdrawal, however, are still also subject to ordinary income taxes.

If your grandchild receives a full-ride scholarship or decides to take a different path, you can still preserve your savings. They can be used for graduate school, or you may change the beneficiary to anyone in your grandchild’s immediate family.

If you find yourself thinking about taking money from your grandchild’s 529 plan, then it’s probably a good time to sit down with a financial adviser who can work with you to come up an alternative financial solution for your needs. Should your financial goals change, he or she can help you appropriately allocate your money to sidestep any unnecessary taxes.

The bottom line

Even with all the 529 plan rules for grandparents, it remains a primary savings vehicle for a grandchild’s education. But families should work together with the guidance of a financial professional. This will help ensure the right plan is in place and the student gets the most out of it.