College · February 25, 2021

What to Know About the 529 Plan Rules for Grandparents

Grandparents often want to help secure their grandkids' futures, and setting up a 529 plan can be a great way to do just that.

A 529 is an education-specific, tax-advantaged savings account that allows you to set aside money for their tuition, room and board, books and other school-related expenses. When correctly executed, it can make paying for college easier and more affordable. However, it's important to understand the 529 plan rules for grandparents so you can maximize the benefit to your family.

Benefits of a 529 plan

With a 529 plan, you make contributions on an after-tax basis. As long as the child doesn't use the funds until they enroll in college, the withdrawals won't incur federal income taxes. Depending on your state, the withdrawals may not be subject to state income taxes either.

Another benefit of making a gift to a 529 college savings plan is the high annual contribution limit. You can contribute $15,000 a year, or you can do a 5-year contribution at one time to maximize the account's earnings. But you'll want to discuss the 5-year lump-sum option with an accountant or tax attorney to make sure you qualify and that you're meeting all legal requirements for the gift.

Although parents can also open these accounts for their children, the 529 plan rules for grandparents can make it more advantageous for the older generation to establish the plan, depending on your family's circumstances. When students fill out the Free Application for Federal Student Aid, or FAFSA, their parents' income factors into aid decisions, and a parent-held 529 account could reduce the level of assistance the child receives. However, if the grandparent is the account holder, the 529 won't appear on the FAFSA, which could result in a higher aid award.

Important considerations

While a grandparent's 529 account doesn't show up on the FAFSA, it can affect the student's financial aid in other ways. If the student begins making withdrawals from the 529 during their freshman year, that money will count as income and will likely decrease the amount of aid they receive the following year.

There's a way around this, however. The FAFSA is calculated based on income from 2 years past, so the longer the student can delay 529 withdrawals, the better their chances of qualifying for financial aid.

If the student will need access to the money right away, it may be better for grandparents to contribute the money to a parent-held 529. The reduction in aid caused by the parents' 529 account may be significantly smaller than the withdrawals that show up on the student's income.

Parents and grandparents will also need to decide which type of 529 is best for the child: a savings account or a prepaid tuition option. With the savings plan, the child can use the funds at whichever school they choose to attend. The prepaid tuition plan allows you to lock in current tuition rates at particular schools, providing a buffer against future cost hikes.

If your grandchild is a high school freshman and has their heart set on attending a particular state university, a prepaid plan may help you save money if tuition increases during the next 4 years.

A prepaid tuition plan only applies to tuition expenses, so you'll still need to cover room and board, books, supplies and other expenses using different funds. Not all schools support the prepaid option, but it may be worth exploring if your grandchild plans to stay close to home. If they decide to attend a different school, you'll lose access to the locked-in rate, but you can apply the money toward their costs at another college or university.

A 529 savings account may be used to cover K-12 expenses as well, although only up to $10,000 can be withdrawn penalty-free. Prepaid tuition 529 plans may not be used for K-12 costs.

Start planning early

To make the most of a 529 plan, you'll want to establish it early and figure out the best strategy for your family. It's a good idea for parents and grandparents to sit down and discuss who should set up the account, who will contribute and how much they'll contribute.

Ideally, you'll set up the account with plenty of time to save before the kids are ready for college. But if they're already in high school, you may want to include them in the conversation to determine which type of plan makes the most sense. You'll likely want to contact a financial advisor or accountant to help you finalize your decision and structure your gifts to make the biggest impact on the children's educations.


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