- The 529 education savings plan offers an appealing combination of tax advantages, control, flexibility, and minimal impact on student aid.
- Determine how much control you want to retain over the money you gift to grandchildren.
- Consider the importance of potential tax advantages in your gifting decision.
Many grandparents naturally want to help prepare their grandchildren for their futures, and helping to fund their education is a great way to get them started.
Step 1 is to start a family conversation.
“There are a number of strategies for grandparents to help, but you have to consider how these strategies might impact the whole family: the grandparents, their adult children, and the grandchildren,” says Mike Rusinak, vice president of Fidelity's Financial Solutions group.
Once everyone is on the same page about strategy, grandparents can consider the most tax-efficient options for their investment.
One flexible way for grandparents to help their grandchildren save for college is with 529 college savings plans, which offer an appealing combination of tax advantages, control, flexibility, and minimal impact on student aid.
Some of the pros
- Tax advantages. The contributions you make to 529 plans are after-tax, but earnings and withdrawals are federal income tax-free when used for qualified education expenses. This includes up to $10,000 in tuition expenses for elementary, middle, or high school education.1 Also, up to $10,000 can be spent from a 529 account to repay qualified student loans and expenses for certain apprenticeship programs.2
Although there are no federal deductions for 529s, since earnings grow on a tax-deferred basis, some states offer deductions on in-state plans. Others may offer tax breaks on 529 plan contributions in any state, or may use a tax credit. Depending on where you live or where you started your 529 plan, you could be eligible for one of these benefits.3 Our 529 college savings plan comparison tool allows you to view plans by state and compare up to 4 plans at a time.
- Flexibility. At the college and graduate level, 529 plan funds can be used at accredited institutions for tuition, books, fees, supplies, and other qualified expenses. In addition, once the annual gift has been made to the 529 plan, the money is no longer considered part of the parents’ or grandparents’ estate, for estate tax purposes.
- Control. When you open a 529 account with a child or grandchild as a beneficiary, you maintain control of the account, which lets you decide when to take a distribution; you can even decide to change the beneficiary if you wish.4 A grandparent can open a 529 and maintain total control. Or they may choose to gift to a 529 account owned by the parent, so that the parent maintains control.
- Front-loading of college savings. You can front-load a 529 plan (giving 5 years' worth of annual gifts of up to $16,000 at once, for a total of up to $80,000 per person, per beneficiary) without having to pay a gift tax or chip away at the lifetime gift tax exclusion.5 Of course, that means the grandparent can’t make any more excluded gifts to the grandchild during those 5 years. Also, if the grandparent dies during that 5-year period, the contributions for any remaining years would be brought back into their estate.
- One financial aid catch. A 529 account held by a grandparent isn’t included as a parental asset in the federal Expected Family Contribution (EFC) calculation—which can be a good thing. But, under current rules, once the money is distributed, it is considered student income, which can have a significant negative impact on financial aid if it is used before the final 2 years of attendance. Due to the recent passage of the FAFSA Simplification Act, the federal aid form will be changed over the next few years, and once phased in, will no longer ask about these assets. However, some colleges ask for supplemental information, so be sure to check with each institution. If grandparents contribute to the parent’s 529 college savings plan, the money is considered a parental asset when calculating the current EFC for federal financial aid. So, they count for up to 5.6% of assets versus 20% for a student asset, which is how they would be counted for a custodial account. (See section on Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts.)
- Limited investment options. 529 plans typically offer a selection of investment options, often including age-based funds that automatically become more conservative as the beneficiary approaches college age. However, the range of options is not as broad as those available in Coverdell Education Savings Accounts or UGMA/UTMA brokerage accounts. This can be a pro or a con—depending on your skill, will, and time to choose and manage investments.
- Penalties on certain withdrawals. If you've set up a 529 account yourself and are the owner, you can withdraw the money yourself at any point. However, be prepared to pay income taxes on any earnings, plus a 10% penalty on those earnings if the money is not used for qualified education expenses.
- Medicaid implications. A major drawback to ownership of a 529 plan account for grandparents who aren’t that well off is the possible loss of Medicaid assistance. When Medicaid evaluates a grandparent's means, assets in a 529 set up by that grandparent are considered that grandparent's assets. The 529 plan account balance would have to be spent on your care before Medicaid payments could begin.
"The 529 plan is a particularly attractive savings option for younger children because of the front-loading option and the long-term market growth potential," says Ajay Sarkaria, a senior wealth planning specialist at Fidelity Investments. "They also provide a vehicle for tax-free gifting."
Other ways to save
A parent or grandparent can use an UGMA or UTMA account (i.e., "custodial" account) to save for a child, and they would have broad investment options and no limit on contributions. But the child named on the account would gain control once they reach a specified age governed by state rules, which in many places is 18. Grandparents would also still have gift tax limitations of up to $16,000 per beneficiary. So, you would need to be ready to give up control of the money and consider the tax implications.
There is also the potential for less student aid because the accounts would be counted as a student asset and are generally factored into the EFC at 20%, which is much higher than the 2.6%–5.6% factored in for parental assets.
- Broad investment options. While the loss of control might be a disadvantage to many parents or grandparents, the greater range of investment options in a custodial account versus a 529 plan could be attractive to a knowledgeable, self-directed investor.
- No limit on contributions. You can contribute virtually any type of asset, for any amount, on both UGMAs and UTMAs. Note, though, that taxes may apply, so you should consult with a tax attorney or accountant before making a contribution as the gift tax may be a consideration.
- Loss of control. The custodian controls the account until the child reaches a specified age, typically 18 or 21 (rules vary by state). Once the account beneficiary reaches that age, they can use the money for anything. This might be a concern for people who fear that the beneficiary might spend the money unwisely or on noneducational expenses.
- Potential for less student aid. Because custodial accounts—such as UGMAs and UTMAs—are counted as a student's asset, they are generally factored into the EFC at 20%, which is much higher than the 2.6%–5.6% factored in for parental assets.
- Potential for modest tax liability. The interest, dividends, and capital gains each year from the UGMA/UTMA are reported under the child's Social Security number. For tax year 2022 and after, unearned income between $1,150 and $2,300 is taxed at the child's tax rate. Unearned income above that level would be taxed at the parents' marginal tax rate. The standard deduction for minors in 2022 is either $1,150 or earned income plus $400, not exceeding $12,950—whichever is greater. To learn more about how investments owned by children are taxed, visit Viewpoints: What to know about the kiddie tax.
Also, unlike 529 plans, UGMA/UTMA accounts are included in the estate of the account’s custodian (parent or grandparent) for estate tax purposes until the minor takes possession.
More ways to save
Coverdell Education Savings Accounts (ESAs) offer a tax-deferred and potentially tax-free savings option if used for college expenses or other education expenses, from kindergarten through college. But eligibility and contributions are limited.
- Broader uses. Coverdell ESAs can be used to save for education expenses, from kindergarten through college.
- Tax benefits. Earnings and withdrawals are tax-free if used for qualified expenses. For taxpayers who claim an American Opportunity credit or Lifetime Learning credit, the credit must be used for different qualified expenses than withdrawals from the Coverdell ESA, if taken in the same year. In addition, once the annual gift has been made to the Coverdell ESA, the money is no longer considered part of the parents' or grandparents' estate for estate tax purposes.
- More investment options. Coverdell ESAs also have a wider range of investment types that are eligible to be contributed to, or purchased by, these accounts, which could be attractive to a knowledgeable, self-directed investor.
- Lower contribution limit and possible confusion. Coverdell ESAs have a low annual contribution limit of $2,000. This is the total amount that all individuals can contribute to one account—or to multiple Coverdell accounts for the same beneficiary—in any year. Unless all family members know what others are contributing and how many accounts have been opened, it could be easy to make an excess contribution. In that case, the holder of the account would owe a penalty.
- Age limits may apply. A Coverdell ESA can only be opened for beneficiaries under age 18. Contributions made to the account after age 18 may be subject to a penalty tax of 6%. Generally, the funds in the account must be used by the time the beneficiary turns 30 years old or withdrawn within 30 days of the 30th birthday.
- Limited eligibility. Coverdells have income limits for contributions. For the 2022 tax year, the ability to contribute to a Coverdell ESA begins to be phased out for single tax filers with modified adjusted gross income (MAGI) of $95,000, and the ability to contribute ends at MAGI of $110,000; joint filers are phased out with MAGI of $190,000 to $220,000.
- Loss of control. Most ESAs require the child's parent or guardian to be responsible for the account. In losing control of the account, a grandparent would no longer have the option of transferring the money to a different beneficiary, or of withdrawing the money if needed for other purposes. That said, there is no law that prevents a grandparent from opening a Coverdell account.
What is the right solution for you?
Another approach for parents and grandparents may be to combine the features of custodial accounts and 529 college savings plans with a custodial 529 plan account. A custodial 529 account is not the same as custodial account (UGMA/UTMA), and also not the same as the traditional 529 account. When the student takes ownership of the account, they must use the money for college expenses or pay a penalty. A custodial 529 account still counts as a parental asset even when the student takes ownership—in contrast to the UGMA/UTMA account which is always considered an asset owned by the child.
The contribution limits for a custodial 529 account align with the limits for a UGMA/UTMA account. For federal tax purposes, the annual contribution limit is the federal annual gifting limit currently in effect for the year in which a contribution is made to an account—$16,000 in 2022.
Also, you cannot make an accelerated gift to a custodial 529 account.
Alternatively, grandparents can pay for college directly. For estate planning purposes, the advantage of paying directly is that the payment is not considered a gift. So, a grandparent could still use their annual gift exclusion to give up to $16,000 to the same grandchild. The downside is that a direct tuition payment could potentially reduce subsequent financial aid. Another potential downside is losing years of tax-advantaged savings offered with a 529 plan or a Coverdell ESA—but every situation is different.
For many grandparents looking for a tax-smart way to contribute to their grandchildren's education, 529 accounts may prove to be an attractive education funding vehicle. But it's not right for everyone. So think through your personal situation with your loved ones. If you need help, work with a financial consultant.