A 529 plan is a savings account that can help cover eligible education expenses. These plans have many benefits, 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.
According to the Education Data Initiative, the average annual tuition cost at a four-year college is $9,678, while out-of-state tuition averages $27,091. Additional costs for things like books, supplies and food average $16,000-17,000 per year. With college costs high and only rising, a 529 plan is more important than ever.
Here’s how grandparents can use a 529 plan to help grandchildren with education costs.
Key Student Debt Statistics
- According to an April 2023 Bankrate survey, 36 percent of American adults have student loan debt.
- About a quarter of people who have or have had student debt say it’s keeping them from buying a home or paying off other debt, the Bankrate survey found.
- Of those who took out student loans to pay for college, 23 percent said they would have applied for more scholarships, while 20 percent said they would have liked to work more, Bankrate’s survey found.
- 35 percent of people who took out a student loan say their education significantly increased their job prospects and earning potential, Bankrate’s research found.
- Of those who say money negatively impacts their mental health, 47 percent say having debt is a major contributor, according to a 2023 Bankrate survey.
What is a 529 plan and how does it work?
A 529 plan is a tax-advantaged account that can help you cover the cost of college and other education expenses. The account allows contributors to deposit after-tax money, put it into investments with potentially high returns, and withdraw it tax-free when used for qualified education expenses. In addition, some states offer tax deductions for those who contribute to the plans.
These qualified education expenses can include tuition, room and board, and even student loan balances due to plan changes, as well as for primary and secondary education at private schools.
Parents with young children are typically the ones who open a 529 plan. But grandparents, other family members or even friends can open one too. The student who will ultimately use the savings plan can also open one himself. A 529 plan has no annual contribution limit.
Sometimes college plans change, but fortunately you can change the plan beneficiary, use plan money to pay off student loans, or, starting in 2024, deposit unused 529 plan money into a Roth IRA for the plan beneficiary. If the money can’t be used or rolled into a Roth IRA, it can be withdrawn, but you’ll likely pay a 10 percent penalty and have to pay taxes on the earnings.
1. Determine account ownership
If you are a grandparent looking to open a 529 plan to contribute to your grandchild’s college fund, you will encounter the issue of ownership. For example, should you be the owner, or should it be the student? Or perhaps one or both of the student’s parents should take over responsibility?
If the student is a minor at the time the account is opened, you or the child’s parent(s) will likely own the account, at least until the child reaches adulthood. Whether it makes more sense for you or the student’s parents to be an account owner varies from case to case. For example, you can give ownership to the parents if you are not confident in managing money and investments. There may also be financial aid implications to consider.
You can also only transfer the account once a year, unless there is a change of beneficiary. Plans can be transferred to different family members or their spouses.
2. Consider the implications of financial aid
One of the most important caveats about 529 plans is their impact on a student’s financial aid eligibility. If the student received money to pay for college before the last two years of college, that money was considered income for the student. That could make it more difficult for them to qualify for financial aid.
These concerns should be addressed by passage of the FAFSA Simplification Act, which will go into effect for the 2024-2025 academic year. When the new rule takes effect, grandparents contributing to 529 plans will no longer harm their grandchildren’s ability to qualify for financial aid. This is because the new FAFSA will no longer ask for outside contributions to 529 plans.
And because of the delayed reporting timing for the FAFSA forms, grandparents can now start taking advantage of a 529 plan without fear of it hurting their family member’s other aid opportunities.
3. Take advantage of the donation exemption
A 529 plan does not limit how much a person can contribute to the plan in a given year. However, money contributed by a grandparent is considered a gift, meaning gift taxes may apply. Fortunately, in 2023, as an individual, you can contribute up to €17,000 per year per donee without having to pay gift taxes, or €34,000 per married couple.
In some cases, it is also possible to make up to five years’ worth of contributions at once without incurring any gift tax, in a process called frontloading or superfunding. That means a wealthy couple could potentially contribute as much as $170,000 per donee in 2023, free of gift taxes, but not be able to contribute again for five years without gift taxes.
4. Use a 529 to pay back student loans
The Setting Every Community Up for Retirement Enhancement (SECURE) Act of 2019 added a provision that allows people to use 529 plans to repay up to $10,000 in student loans to the plan’s direct beneficiary. Additionally, another $10,000 can be used for the beneficiary’s siblings. Payments may include both principal and interest on qualified education loans. If desired, the beneficiary can also be changed to pay another grandchild’s loans.
The law also allows 529 plans to cover certain expenses for apprenticeship programs.
Pros and cons of using 529 plans to pay off student loans
Positives
- No age limit on contributions
- Tax-free growth
- Can change beneficiaries
Disadvantages
- Limit of $10,000
- Not eligible for student loan tax deductions
- Only applies to student loans
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 may make alternatives worth your consideration.
For example, custodial accounts such as UGMA/UTMA accounts have more flexibility in their investment choices, while still not having a limit on contributions. However, custodial accounts have their own drawbacks, such as less favorable tax treatment compared to 529 plans. They also give control to beneficiaries once they come of age (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). An advantage of Coverdell ESAs is that they can cover not only college costs, but also primary and secondary education costs. Additionally, earnings and withdrawals can be tax-free if they cover eligible education expenses, and the investment options are broader than for 529s. But contributions are limited to $2,000 per year, and the beneficiary must be under 18 when the account is opened.
Of course, you can also simply pay for the school from general funds. This approach gives you maximum flexibility for the money, but doesn’t offer the tax benefits of 529 plans.
529 plan overview
A 529 plan gives both parents and grandparents the opportunity to contribute to a child’s education fund. They have no annual contribution limit and an individual can contribute up to $17,000 per year while avoiding the gift tax rules, or $34,000 per couple. A 529 withdrawal is generally free of federal taxes if used to cover eligible education expenses – and is often free of state taxes as well.
However, 529 plans have their drawbacks, such as limited investment options, but if you search for the best 529 plans, you can find good options. Other types of accounts, such as UTMA/UGMA and Coverdell ESAs, can overcome these disadvantages, although they have their own drawbacks. Make sure you weigh all your options before deciding which type of account to open.
