It is no secret that parents are taking advantage of the tax favored 529 plans to save for their children’s qualified education expenses, but many grandparents are unaware of how beneficial it can be for them and their grandchildren as well. As a grandparent, there are a number of ways that you can contribute to the post-secondary education of your grandchild(ren), but a 529 plan could be the best option available to you.
As of the end of 2016, 34 states offer a state tax deduction for contributions to a 529 savings plan. Most require that you be a resident of that state where the 529 plan is owned in order to be eligible for the state tax deduction. (For example, if you live Virginia you must contribute to a VA 529 plan to take the deduction.) Only 8 states (California, Delaware, Hawaii, Kentucky, Massachusetts, Minnesota, New Jersey, and North Carolina) that currently have state income taxes do not offer a state income tax deduction or tax credit for contributions to the state's 529 college savings plan. States have different rules about who can qualify for the deduction. Most of the states that offer a tax deduction allow the state resident who made the contribution to claim the deduction, regardless of whether you are a parent, relative or friend. However, some states will only allow the deduction for contributions from the owner of the account. Here in Virginia, the account owner can claim a deduction for contributions made by others. The rules vary between states so it is important to do a little homework before making any “third-party” contribution. Just because you cannot claim the deduction does not mean that the owner of the account will be able to claim it.
The best way to ensure that you can claim the deduction is to open the 529 account yourself. (Assuming of course that you are not a resident of one of the 9 abovementioned states that do not offer the tax incentive.) There is no limit to the number of 529 plans that one can own, or be the beneficiary of, and many states allow excess contributions to be carried forward for future filings. Also, there is no requirement that the beneficiary be your child or relative.
Aside from the tax incentives, there are a number of other reasons that a grandparent may want to consider a 529 plan for their grandchildren.
As the owner of the account, you will retain control over it (and the assets in it) until you transfer the ownership. You could choose to transfer the ownership during your living years, or name a successor owner who will receive it in the event of your passing. Retaining ownership of the account can ensure that the funds will be used for their intended purpose. For many, this is a significant advantage over an UTMA/UGMA account, where once the minor reaches the age 18 or 21, depending on the state, the control of the account is transferred to him/her permanently. They can use the funds however they decide.
The 529 plan can be an estate planning tool as well. A 529 plan allows the owner to make a large gift (up to $14,000 per year) to the beneficiary, thereby removing the assets from their taxable estate, but still maintaining full control over the account. For those who would like to make a large up-front contribution to a 529 plan of up to $70,000 per beneficiary, ($140,000 for a married couple) they can file a Form 709 to spread the contribution out evenly at 20% over five years. Permanently parting with some of the money that you have worked so hard to save may not sound very good to you. This allows the owner to remove the assets from the estate, maintain control, and if you change your mind later and need the funds, you can revoke the account.
529 plans are very flexible. In most cases, invested dollars will be eligible for a state tax deduction, grow tax-deferred, and can be withdrawn tax-free when they are used for eligible post-secondary education. This is not limited to public or private four-year institutions only. Vocational programs, foreign schools, online classes, etc., can qualify. Further, college savings plans typically cover all "qualified education expenses" at eligible colleges, universities and other post-secondary institutions, including tuition, fees, books and supplies, room and board, as well as computers and peripherals. If the beneficiary (your grandchild) doesn’t use all or any of the funds in the account, you can easily change the beneficiary to another grandchild, or someone else, without a taxable event. If the beneficiary is awarded a scholarship or decides to attend a U.S. Military Academy, they will get an exception to the 10% penalty rule if they make a non-qualified withdraw. (However, withdraws will still be subject to applicable income taxes.)
Before contributing to someone else’s 529 plan, or opening your own account for the benefit of a grandchild, or other, it would be wise to consult with a knowledgeable financial or legal professional, depending on your primary goal for creating the account. 529 plans are not ideal for everyone, as the investment options will be limited compared to an UTMA/UGMA and non-qualified withdrawals can incur a 10% penalty.
Kevin Warman, CIMA®, RMA®
(Last Updated 1/12/2017)