Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / Using a 529 Plan for Your Grandchild Without Losing Control
Transcript
- Lucas: If you're a grandparent and you want to help pay for a grandchild's college, the first instinct is often to just write a check or open a 529 account in your own name. But that instinct can actually trigger some ugly financial aid consequences. Luna: Yeah, the grandparent-owned 529 has a weird spot in the financial aid formula. It's treated differently than a parent-owned account. Lucas: Exactly. Let's start with the basics. Under the current FAFSA rules, a grandparent-owned 529 plan is not reported as an asset of the student or the parent. That sounds good — it doesn't count against you on the asset side. But when money is actually distributed from that grandparent-owned 529 to pay for college expenses, that distribution is counted as untaxed income to the student. And student income is assessed at a much higher rate than parent income on the FAFSA. Luna: Right — student income is assessed at fifty percent, whereas parent income is assessed at somewhere between twenty-two and forty-seven percent on a progressive scale. So that distribution can really hurt. Lucas: Yeah. So a well-meaning grandparent who thinks they're being generous by paying the tuition directly from their own 529 could actually reduce the grandchild's eligibility for need-based aid by thousands of dollars. The good news is there's a workaround, and it became much more powerful with the Secure Act 2.0 changes. Luna: What's the workaround? Let me guess — it involves the beneficiary change rules? Lucas: It does. The simplest strategy is for the grandparent to open the 529 and name the grandchild as beneficiary — that part is fine. But instead of distributing the money directly to the school or the student, the grandparent should wait until the student's final two years of college. Starting in 2024, under Secure Act 2.0, you can also roll over up to thirty-five thousand dollars from a 529 into a Roth IRA for the beneficiary, as long as the account has been open for at least fifteen years. That changes the calculus a lot. Luna: So the grandparent-owned 529 can double as a retirement savings vehicle for the grandchild? That's a huge value prop. Lucas: It is, but you have to be careful. Let me walk through a concrete example. Say Grandma opens a 529 for her grandson, contributes fifty thousand dollars over five years, using the five-year gift tax election. Under IRS rules, you can front-load five years of annual gift tax exclusion into one year, so a single contribution of up to ninety thousand dollars for a married couple or forty-five thousand for an individual won't trigger gift taxes. Grandma does that, the account grows. The grandson gets a scholarship, so there's leftover money. Grandma can roll over up to thirty-five thousand of that into a Roth IRA for the grandson, as long as the 529 has been open fifteen years and the rollover is within the annual IRA contribution limits. Luna: That's a massive planning tool. But what about the financial aid hit? You mentioned the distribution being counted as student income. Lucas: Right. So here's the tactical play. If the grandparent can time distributions for the student's junior or senior year, or better yet, use the 529 to pay for graduate school, the income impact on FAFSA is minimized. The formula uses prior-prior year income. So a distribution taken in the student's sophomore year would affect aid for the junior year — but by then, the student is closer to graduation, and the hit might be manageable. Alternatively, if the grandparent transfers ownership of the 529 to the parent, the account then counts as a parent asset on FAFSA, which is assessed at a maximum of 5.64 percent, versus the 50 percent income hit. That's often a better outcome. Luna: So ownership matters a lot. It's not just about who puts the money in. Lucas: Exactly. And grandparents who want to maintain control — maybe they're worried about a divorce or the parent mismanaging the money — they can keep ownership themselves but just be strategic about when and how they distribute. The key is to avoid distributions during the base years used for financial aid. For most students, that's the four years of college, but the FAFSA looks at tax returns from two years prior. So distributions in freshman year affect aid for sophomore year, etc. If the grandparent can hold off until the last two years, the income impact is smaller because the student has fewer aid-eligible years left. Luna: And of course, if the family doesn't qualify for need-based aid at all, then none of this matters. The grandparent-owned 529 is purely a tax-advantaged savings vehicle. Lucas: Right. For high-income families, the financial aid consideration is irrelevant, so the grandparent can just open the account, let it grow tax-free, and pay for college without any penalty. There's no income limit on contributions, no deduction for federal taxes — though some states offer a deduction for state income tax. For example, in New York, a grandparent can deduct up to five thousand dollars per beneficiary per year. In Pennsylvania, there's no limit. So it's worth checking your state's rules. Luna: One thing I want to clarify: can the grandparent change the beneficiary if the first grandchild doesn't go to college? Because that flexibility is one of the big selling points of 529s. Lucas: Absolutely. The grandparent can change the beneficiary to any other qualifying family member — a sibling, a cousin, even themselves. That's one of the most powerful features. So if the first grandchild gets a full scholarship, the grandparent can shift the account to another grandchild. Or if they want to go back to school themselves, they can become the beneficiary. There's no penalty for that change. The only thing to be aware of is the gift tax implications if you change the beneficiary to someone in a different generation — but that's a conversation for another episode. Luna: So let's talk about the new Roth rollover option again. That only works if the 529 has been open for at least fifteen years. So a grandparent opening an account for a newborn grandchild — that's perfect. By the time the grandchild is eighteen, the account is old enough to roll over into a Roth. Lucas: Yeah, and that's a game-changer for grandparents who worry about over-saving. You can put in fifty thousand dollars, let it grow, and if the grandchild doesn't need all of it for education, up to thirty-five thousand can move into a Roth IRA in the grandchild's name. That's a huge head start on retirement savings. The grandchild would have to have earned income equal to the rollover amount, but the rollover itself counts as a contribution — it doesn't require earned income from the beneficiary. So it's a way to seed a Roth IRA even for a teenager with a part-time job. Luna: That is really attractive. But there's a trap: the fifteen-year clock starts from when the account was first opened, not from when the contribution was made. So if the grandparent opens a 529 for themselves years ago and then changes the beneficiary to a grandchild, that older account qualifies for the Roth rollover sooner. Lucas: Great point. So if you're a grandparent and you already have a 529 for yourself or for your child, you can switch the beneficiary to a grandchild and the fifteen-year clock is already ticking. That's a legacy planning tool that a lot of people don't realize they have. Luna: Alright, so to summarize: grandparent-owned 529s are great for control and tax-free growth, but you need to be careful about financial aid timing. If you want to avoid the income hit, consider transferring ownership to the parent, or waiting until the student's later years to take distributions. Lucas: And don't forget the state tax deduction. If your state offers one, the grandparent might be able to deduct contributions on their state return. That's a direct savings. But if the grandparent lives in a state with no income tax, like Florida or Texas, that benefit doesn't apply. Luna: Right. So the bottom line: a grandparent-owned 529 is a powerful tool, but it requires some planning. It's not a set-it-and-forget-it strategy. Lucas: Yeah. And you know, we talk about these strategies a lot on the show, and we deliberately don't run ads on these episodes. That's a choice we've made because we want the information to be clear and uncluttered. If you find value in that and want to support the show, you can do so at buy me a coffee dot com slash fexingo. Luna: Yeah, it's a small gesture that makes a big difference in keeping this independent. So if you're able, that link is buy me a coffee dot com slash fexingo. Lucas: Now, back to the grandparent strategy. One more nuance: if the grandparent contributes to a parent-owned 529 instead, the grandparent loses control, but the money is treated as a parent asset on the FAFSA, which is assessed at a lower rate. So the trade-off is control versus aid eligibility. Luna: And if the grandparent wants to keep control but also minimize aid impact, they could just pay the school directly for tuition. Tuition paid directly to the institution is not counted as income on the FAFSA. That's different from a 529 distribution. Lucas: That's right. Direct tuition payments from a grandparent are considered a gift, not income. So if the grandparent writes a check to the university for twenty thousand dollars, it doesn't affect the student's financial aid at all. But then you lose the tax-free growth of a 529. So it's a trade-off between current cash flow and long-term tax advantage. Luna: So the ideal scenario might be: if the grandparent is wealthy and wants to maximize tax-free growth, use a 529 but plan the distributions carefully. If they just want to help without any complexity, pay the tuition directly. Lucas: Exactly. And if the grandparent wants to split the difference, they can open a 529, contribute, and then change ownership to the parent later — after the bulk of the growth has occurred. The parent then takes over and the account is treated as a parent asset. That gives the grandparent the initial control and the tax-free growth, then shifts the aid burden later. Luna: That's a clever sequencing strategy. I think a lot of grandparents don't realize they can change ownership without triggering a taxable event. The transfer of ownership is not a distribution. Lucas: Correct. As long as the beneficiary remains the same, changing the owner doesn't trigger taxes. So you can move from grandma to mom without any penalty. The only thing to watch for is the gift tax if the value transferred exceeds the annual exclusion, but that's rare for a 529. Luna: So for our listeners who are grandparents or are advising grandparents, what's the one action step you'd recommend today? Lucas: First, check if your state offers a tax deduction for 529 contributions. If it does, open the account in your name with the grandchild as beneficiary. Contribute the maximum deductible amount each year. Then, keep the account until the grandchild is in high school. At that point, evaluate the financial aid picture. If the grandchild is likely to qualify for need-based aid, consider transferring ownership to the parent. If not, keep it and time distributions for later years. Luna: And if the grandchild is still a baby, you have a long runway. You can take advantage of the Roth rollover option down the line. So there's really no downside to starting early. Lucas: None at all. The biggest risk is not starting. The market returns over eighteen years can turn a modest contribution into a significant education fund. So whether you're a grandparent or a parent, the key is just to begin.