Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / 529 Plan Gift Tax Rules and Grandparent Contributions
Transcript
- Lucas: If our money conversations have helped you think about a decision differently, let me say this: today is actually a perfect example of why listener support matters — we get to dig into a real tax rule that most families don't even know exists, no ads, no sponsors, just the details you can actually use. Luna: And honestly, the gift tax stuff around 529 plans is one of those topics where a single clarification can save you thousands. So if today is useful, the way this stays free is buy me a coffee dot com slash fexingo. Lucas: Yeah, exactly. It's a small gesture that keeps the show going. Alright — let's get into it. Lucas: Today we're tackling a question that I guarantee comes up in most financial advisor meetings around this time of year: how do 529 plan contributions interact with the federal gift tax? Luna: And specifically, grandparents who want to help without accidentally triggering a tax form. Lucas: Right. The annual gift tax exclusion for 2026 is eighteen thousand dollars per person per beneficiary. So if you're a grandparent and you want to contribute that amount to a grandchild's 529, you're fine — no filing requirement. Luna: But what if they want to give more? Like, say, thirty thousand in one year? Lucas: That's where the special rule comes in. The IRS allows what's called a five-year election for 529 plans. You can treat a lump-sum contribution as if it were spread evenly over five years. So a single gift of up to ninety thousand dollars — eighteen thousand times five — can be made without eating into your lifetime estate tax exemption, as long as you file IRS Form 709. Luna: Right, and that form is really just informational — it's not a tax bill. You're just telling the IRS, 'Hey, I'm electing to spread this over five years.' Lucas: Exactly. No tax due unless you exceed the lifetime exemption, which for 2026 is about thirteen point six one million dollars per person. So for most families, the five-year election is a straightforward planning tool. Luna: But what about a couple — say both grandparents want to contribute for the same grandchild? Can each do the five-year election? Lucas: Yes. Grandparent A can contribute ninety thousand, and Grandparent B can contribute another ninety thousand, each filing their own Form 709. That's one hundred eighty thousand dollars in a single year for one child, all gift-tax-free. Luna: And the catch — there's always a catch — is that during those five years, you can't make additional gifts to that same beneficiary without potentially triggering a taxable gift, because you've already used up your annual exclusion for those years. Lucas: Right. So if Grandma front-loads ninety thousand in 2026, she's treated as having given eighteen thousand each year from 2026 through 2030. If she then wants to give a birthday gift of two thousand in 2027, that would be a taxable gift — though again, it would just reduce her lifetime exemption. Luna: So it's more about tracking than actual tax. But there's another angle I want to explore: the Kiddie Tax. That's the rule that unearned income above a certain threshold for a child is taxed at the parents' marginal rate — or the estate and trust rates if the parents are in a lower bracket. Lucas: And that's relevant because if you put money in a custodial account under the Uniform Transfers to Minors Act — a UTMA account — the investment earnings are subject to the Kiddie Tax. But 529 plans are different. The earnings grow tax-deferred and can come out tax-free for qualified education expenses. So the Kiddie Tax doesn't apply. Luna: That's a huge advantage. A grandparent could give ninety thousand to a UTMA, and the child might pay taxes on the earnings at the parents' rate — which could be thirty-two percent or higher. With a 529, no tax at all if used for school. Lucas: And there's one more nuance: state tax deductions. About thirty states offer a state income tax deduction for 529 contributions. But many of those deductions have a cap, and some are per beneficiary, some per account, some per tax return. Luna: So a grandparent living in New York — which deducts up to five thousand dollars per year for single filers, ten thousand for married couples — could still benefit from the state deduction even if they use the five-year election for federal purposes? Lucas: That depends on the state. Some states conform to the federal five-year rule; others don't. In New York, the five-year election applies for state purposes too, so you'd deduct one-fifth of the contribution each year. But in a state like Pennsylvania, which doesn't offer a deduction at all, it's irrelevant. Luna: So the key takeaway: check your state's rules before front-loading. Lucas: Absolutely. Now, let's talk about the impact on financial aid. Grandparent-owned 529 plans used to be treated differently for the FAFSA — they weren't reported as assets, but distributions were counted as student income. That changed with the FAFSA Simplification Act. Luna: Right, starting with the 2024-2025 FAFSA, grandparent-owned 529 plans are now reported as assets of the student if the grandparent is the account owner and the student is the beneficiary. But distributions from a grandparent-owned 529 are no longer counted as student income. Lucas: So it's actually more favorable now. The asset itself may reduce aid slightly, but the distributions won't hit the income calculation. Compare that to a UTMA account, where both the assets and the realized gains can reduce aid. Luna: Let's also mention the estate planning angle. A 529 contribution is considered a completed gift for estate tax purposes, meaning it's removed from your estate. So if a grandparent has a large estate and wants to reduce its size, front-loading a 529 for each grandchild can be an effective strategy. Lucas: And because the five-year election allows ninety thousand per grandparent per grandchild, a couple with three grandchildren could move five hundred forty thousand dollars out of their estate in a single year — all without using any of their lifetime gift tax exemption. Luna: That's a powerful wealth transfer tool, especially for families who are charitably inclined or have already maxed out other strategies. Lucas: One more thing: what happens if the grandchild doesn't go to college? You can change the beneficiary to another family member — a sibling, a cousin, even the grandparent themselves if they want to take a course. Or you can withdraw the money, but the earnings would be subject to income tax and a ten percent penalty. Luna: Unless the beneficiary receives a scholarship — then you can withdraw up to the scholarship amount penalty-free, though you still pay tax on the earnings. Lucas: Right. So it's not a perfect instrument for every family, but for those who are relatively confident the money will be used for education, the gift tax benefits are substantial. Luna: Let's wrap up with a concrete example. Suppose a grandparent wants to contribute to a newborn grandchild's 529 in 2026. They can put in ninety thousand, file Form 709 with their tax return, and then not have to worry about annual gifts until 2031. Lucas: And if they want to continue contributing after that, they can start fresh with another eighteen thousand per year. Meanwhile, the account grows tax-free for eighteen years, and when the grandchild goes to college, withdrawals for tuition, room, board, books, and even some technology are completely tax-free. Luna: That's the kind of planning that makes a real difference. Okay, so to sum up: the annual exclusion is eighteen thousand per person per beneficiary for 2026. You can front-load up to ninety thousand using the five-year election. File Form 709. State rules vary. And it's generally better than a UTMA for both tax and aid purposes. Lucas: One last thing: if you're a grandparent who already has a 529 account, you can also use the five-year election for new contributions going forward. It's not a one-time option. Luna: Good point. Alright, that's episode one hundred — a nice round number. Thanks for sticking with us.