What to Know About the 529 Grandparent Loophole




SmartAsset: How the 529 Grandparent Loophole Works
SmartAsset: How the 529 Grandparent Loophole Works  

A 529 plan can be a powerful way to save for college, offering tax-free growth and other tax benefits. These accounts are so powerful, in fact, that many grandparents choose to open them for their grandchildren. In the past, there was a downside to a grandparent 529, though. Distributions from these accounts were included on the Free Application for Federal Student Aid (FAFSA), which had a negative impact on a student's federal financial aid eligibility. However, new changes to the FAFSA form mean that grandparents can now contribute to a 529 for their grandkids without hurting the student's ability to get federal financial aid. Here's how the grandparent 529 loophole works.

A financial advisor could help you put a financial plan together for your family's education needs and goals.

How Grandparent 529 Distributions Were Treated on FAFSA

While distributions from grandparent 529s weren't directly reported on the FAFSA in the past, they were counted as untaxed student income. Students were required to manually report their income on the FAFSA, and past rules dictated that 50% of a student's gross income over a certain amount ($7,040 for 2022-2023) could be used to pay for college. So a large distribution from a grandparent 529 could detrimentally impact their grandchild's need-based eligibility because of its treatment as student income.

So let's say a grandparent saved $35,000 in a 529 plan to cover one year of college for their grandchild. That $35,000 distribution would be counted as student income, which would then be reported on the FAFSA, effectively reducing the student's financial aid package by $17,500. By contrast, assets in a parent 529 can only reduce financial aid eligibility by 5.64%.

What's Changed With FAFSA and Grandparent 529 Plans

However, changes to the FAFSA were announced in 2021 and go into effect for the 2024-2025 school year. These changes will positively affect how grandparent 529 distributions are treated. Now, instead of students being required to self-report their income on the FAFSA, the numbers will be taken directly from their tax returns through the IRS Data Retrieval Tool (DRT).

Since they won't be considered as income on a student's tax return, distributions from grandparent 529s will no longer be included as untaxed student income on the FAFSA, eliminating the concern about negatively affecting need-based eligibility. This creates a grandparent 529 loophole, which allows you to contribute to your grandkids' college education without worrying about detrimental financial aid implications. These changes are good news for families saving for college.

Other Benefits of a Grandparent 529 Plan

SmartAsset: How the 529 Grandparent Loophole Works
SmartAsset: How the 529 Grandparent Loophole Works  

In addition to being a smart way for grandparents to help their grandkids save for college, grandparent 529 plans also have valuable tax and estate planning benefits. Investments in a 529 account are tax-deferred and contributions can grow tax-free. And in certain states, account holders can benefit from a state tax deduction for 529 contributions. Depending on where you live, up to $20,000 in contributions may be deductible from your state taxes. Rules about deductions and amounts vary by state, though, so be sure to do your research.

Beyond the tax benefits, grandparent 529 plans have estate planning benefits too. Contributions are considered gifts to the beneficiary, even though you retain control over the assets in the account. In 2022, you can contribute up to $16,000 (or $32,000 if you're married) to a 529 each year without incurring a gift tax. But because of the way 529s are structured, you can also opt to front load your contributions when you open an account, adding up to $80,000 (or $160,000 if you're married) at once without triggering a gift tax. Those contributions are then excluded from your total taxable estate, reducing your estate tax liability.

You're allowed to change the beneficiary of a grandparent 529 plan as well, and this flexibility can be useful. For instance, if the original beneficiary decides not to go to college, you could designate a qualified family member as a new beneficiary. Per the IRS, qualified family members can include the original beneficiary's mother or father, brother or sister, niece or nephew, daughter or son, and others.

Bottom Line

SmartAsset: How the 529 Grandparent Loophole Works
SmartAsset: How the 529 Grandparent Loophole Works  

If you're a grandparent who's thinking about opening a 529 account for your grandchild, doing so can come with several benefits. Not only will you be helping them with the cost of college, but you'll also get some valuable tax and estate planning benefits as well. These accounts also offer some flexibility in terms of beneficiaries.

Recent changes to the FAFSA make opening a 529 even more attractive, as you won't need to worry about harming your grandchild's financial aid eligibility with distributions they receive from you. While grandparent 529 plans have many benefits, those considering opening an account should speak with a financial professional before doing so. An expert will be able to advise you on whether this option makes sense for your situation.

Tips for Managing a 529 plan

  • A financial advisor could help you create a financial plan for your family's education. SmartAsset's free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.

  • You're not limited to investing in one type of plan or the one sponsored by your state, so shop around to find the 529 plan that meets your needs. We've reviewed 529 plans across the country to rate their features and benefits.

Photo credit: ©iStock.com/Halfpoint, ©iStock.com/SDI Productions, ©iStock.com/JodiJacobson

The post How the 529 Grandparent Loophole Works appeared first on SmartAsset Blog.

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