529 plans for grandchildren

A client of mine recently reached out about whether or not to fund a 529 plan for his granddaughter – and she’s not due to be born for another four months. Talk about getting a head start on college planning!

He’ll have to wait a bit though. You cannot set up a 529 plan for an unborn child since a Social Security number is required for the named beneficiary of the plan. But you certainly can begin contributing once your grandchild arrives.

In many states, New York included, contributions to 529 plans are tax deductible. As the owner, you are allowed to deduct up to $5,000 per year of contributions by an individual and up to $10,000 per year by a married couple filing jointly when computing New York State taxable income. The money in a 529 plan can grow tax free and withdrawals aren’t taxable if used to cover eligible education expenses, including college books and supplies, computers and internet access, and room and board in addition to tuition. Up to $10,000 of annual K through 12 costs are also considered eligible education expenses.

Another benefit of a 529 plan is that contributions are considered gifts for tax purposes. In 2022, you can contribute up to $16,000 as an individual, or $32,000 as a married couple, without having to pay gift taxes. You also have the option of “superfunding” a 529 plan: making a contribution of up to five times the annual gift tax exclusion (up to $80,000 from an individual in 2022 or $160,00 from a married couple), without owing any gift taxes.

You are able to change beneficiaries on the 529 plan without negative tax consequences, as long as the new beneficiary is a member of the original beneficiary’s family. So if your oldest grandchild receives a full scholarship to their dream school, you are able to use the funds for her younger sibling – or perhaps for yourself, if you’re interested in reinventing!

In the past, I might have recommended that you gift the funds to your child, who would open the 529 plan as the owner with their child as beneficiary. This was because, under current FAFSA rules (the Free Application for Federal Student Aid is the form parents fill out to qualify for financial aid), any tuition payments from 529 plans held by grandparents were considered untaxed income to the student and could reduce aid eligibility by up to 50% of the distribution amount.

When new FAFSA rules go into effect in October 2022, only income reported on federal tax returns will be considered. Students will not be required to report any cash support they receive, including any contributions from 529 plans held by grandparents. In other words, it’s now much more attractive for grandparents to open and contribute to 529 plans, since they will have no impact on financial aid at schools that use the FAFSA form.

Be aware that grandparent-held 529 plans may still be considered by the CSS Profile, another financial aid application used by approximately 300 schools, including some of the most elite universities. It remains to be seen if this will be adjusted in the future to reflect the changes in the FAFSA form. Since income from two years prior is used for the application (i.e., 2019 income was used for the 2021-2022 school year), grandparents can still set up a 529 plan, being careful to pay tuition only in the last two years of school so as not to affect the CSS Profile financial aid eligibility.

Not surprisingly, many of us are interested in helping our grandchildren and, by extension, our children pay for the high cost of future college tuition. If this sounds like you, consider the benefits of opening a 529 plan sooner rather than later.

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