It’s common for grandparents to want to help pay for their grandchildren’s college education. But they also want to make sure they’re making wise decisions about their own finances. I often hear from grandparents asking how they can do both.
One way is through a 529 plan, a tax-advantaged savings plan designed specifically for education-related expenses. These plans offer a powerful combination of estate-planning benefits and tax-free growth, making them an attractive option for grandparents who want to invest in their grandchildren’s education.
A grandparent can put money into a 529 plan as a child is growing up, but that money remains under the grandparent’s control. If the grandchild decides not to attend college (or trade school), the grandparent can change the name of the beneficiary on the 529 account without penalty. Unlike with custodial accounts, the beneficiary does not gain control of the money in a 529 upon reaching the age of majority (typically 18) and cannot use the money on anything other than expenses associated with higher education.
Savings plans and prepayment plans
There are two types of 529 plans, savings plans and prepaid plans:
Savings plans allow families to invest money that grows tax-free, similar to the way a 401(k) works for retirement savings. Contributions are not tax-deductible, and your returns are determined by the performance of the underlying investments, which generally consist of mutual funds. Most 529 savings plans have age-based portfolios, in which investment allocations get more conservative as the beneficiary gets closer to enrolling in college.
Prepaid plans allow families to pay tuition at today’s rates for enrollment in the future. Certain states and some colleges and universities administer prepaid tuition plans. With these plans, funds are pooled and invested to keep up with (or beat) inflation. When the child is ready to attend college, the money is transferred directly to the school.
Estate planning benefits
In general, the federal tax code allows each individual to give any other person up to $14,000 a year without triggering federal gift taxes. (A married couple can therefore give someone $28,000 — $14,000 from each spouse.) This means grandparents can make substantial tax-free gifts to their grandchildren. While a gift in excess of that “annual exclusion” amount would normally be subject to the gift tax, special 529 rules allow the gift giver, or grantor, to use five years of annual exclusions at once. Grandparents can take advantage of this by giving up to $70,000 (up to $140,000 for couples) in one year.
Since contributions to 529 accounts are considered a completed gift to the beneficiary, contributions and earnings are excluded from the grantor’s taxable estate. In other words, the money is still under the grandparents’ control but is no longer part of their estate. That makes these savings plans a smart option for savvy individuals.
Grandparents can establish and contribute to 529 plans for as many beneficiaries as they see fit, subject to estate and gift tax limits. For instance, my clients Grandpa Richard and Grandma Nancy were delighted to be able to deposit a total of $56,000 in the 529 plans for their twin granddaughters Isabella and Alexandra ($14,000 from each grandparent into each granddaughter’s account). The plans also accept third-party contributions, if other family members wish to contribute.
Restrictions on use of funds
While 529 plans are a compelling, tax-advantaged way to save for college, they have restrictions. Funds from a 529 plan can be used only for tuition, room and board at postsecondary educational institutions. Although there are a host of other ways to support the collegiate ambitions of your grandchild — such as paying for standardized test tutoring, school supplies, after-school programs or college counseling — you can’t pay for such things from 529 plans.
Complications arise if the grandchild whose name is on the account ends up without any (or enough) education expenses to spend the 529 money on. As mentioned, if the beneficiary of the account doesn’t go to school, you can change beneficiaries. But what if no grandchildren end up attending school? In that case, you can withdraw the money. Your contributions — the money you put into the account — aren’t taxed at withdrawal, but any investment earnings you take out will be taxed as ordinary income and will be subject to an additional 10% tax penalty.
If a student goes to school but receives a scholarship, reducing the costs that can be paid from the 529 and resulting in money left over in the account, grandparents have some options:
- The beneficiary on the plan can be changed to another family member.
- The excess funds can be earmarked for graduate school.
- The extra funds can be withdrawn. In this situation, withdrawals of contributions are again not taxed, and withdrawn earnings are again subject to income tax — but the 10% federal tax penalty on earnings does not apply.
The power of planning
As a retiree, your first priority should be maintaining your standard of living and quality of life. The estate planning benefits and tax advantages of 529 plans resonate with grandparents who want to invest in their grandchildren’s college education. However, whether you wish to open a 529 plan or explore other ways to support your grandchildren, the advantages of planning ahead cannot be overstated. Every dollar invested today means less money that your children or grandchildren will have to borrow in the future.