Latest / The College Savings Podcast with Fexingo: 529 Plans, Education Funding, and Student Costs / 529 Plans as Inheritance Vehicles for Grandchildren
Transcript
- Lucas: Luna, I want to talk about something that I think most financial advisors and grandparents overlook when it comes to 529 plans. We've talked a lot about saving for your own kids, but what about using a 529 as a way to pass wealth across generations, to grandchildren, without triggering the tax headaches that come with inherited retirement accounts? Luna: You mean like, instead of leaving a grandkid an IRA or a Roth, you leave them a 529? Lucas: Exactly. And the timing is actually pretty interesting right now, because the SECURE Act — the one that passed back in 2019 and had further tweaks — basically killed the 'stretch IRA' for most non-spouse beneficiaries. If you inherit a traditional IRA today, you generally have to empty it within ten years. That can create a huge tax bill, especially if the grandchild is in their peak earning years when they inherit. Luna: Right, because that money is taxed as ordinary income. Whereas a 529 — if used for qualified education expenses — comes out tax-free. Lucas: Precisely. So you're comparing apples and oranges a bit, because the 529 is restricted to education. But if the grandparent's goal is to fund a grandchild's college, and maybe even graduate school, a 529 can actually be a more efficient vehicle than leaving them cash or an IRA. And here's a specific number that a lot of people don't know about. Luna: I'm listening. Lucas: Under the gift tax annual exclusion, you can contribute up to $18,000 per year, per recipient, in 2026, without filing a gift tax return. But 529 plans have a special rule: you can elect to treat a contribution as if it were made over five years. So a single grandparent can put up to $90,000 into a 529 for one grandchild in a single year, and as long as they don't make additional gifts to that grandchild over the next five years, it doesn't eat into their lifetime estate tax exemption. Luna: That's a huge lump sum. And it gets the money compounding early, inside the account, tax-free. Lucas: Exactly. So if a grandparent has six grandchildren, they could put $540,000 into 529s in one year, all without filing a gift tax return, as long as they do the five-year election properly. Now, that's an extreme example, but it shows the power. And here's the multi-generational twist: the account owner doesn't have to be the parent. The grandparent can open the 529, name themselves as the owner, and name the grandchild as the beneficiary. Luna: Wait, but then when the grandparent passes away, what happens to the account? Does it get inherited by the grandchild? Lucas: That's the key question. If the grandparent dies and the grandchild is already the named beneficiary, the account typically passes to the grandchild as the new owner, and the beneficiary stays the same. The account retains its tax-advantaged status. There's no required distribution like with an IRA. The grandchild can keep the money in the account, let it grow, and use it for qualified expenses down the road. Luna: So it avoids the ten-year rule entirely. That's almost like bringing back the stretch IRA, but just for education. Lucas: In a way, yes. And there's another layer: if the grandchild doesn't need the money — maybe they get a full scholarship, or decide not to go to college — you can change the beneficiary to another family member, like a sibling, a cousin, or even a future great-grandchild. The account can keep rolling generationally. Luna: But what if the grandchild uses some of the money and then has leftovers? Or what if the grandparent wants to keep control even after the grandchild is an adult? Lucas: Great point. The grandparent can remain as the owner of the account even after the grandchild turns 18 or 21. That means the grandparent controls how the money is distributed. If they're worried about the grandchild blowing the money on something non-qualified — which would trigger taxes and a penalty — they can keep the reins. They can also change the beneficiary if circumstances change. Luna: That's a lot of control compared to, say, an UTMA or UGMA custodial account, where the kid gets full control at the age of majority. Lucas: Exactly. And with UTMAs, the money counts as the child's asset for financial aid purposes, which can reduce need-based aid. A 529 owned by a grandparent is different: before 2024, distributions from a grandparent-owned 529 were counted as student income on the FAFSA, which could hurt aid. But the FAFSA simplification that went into effect last year changed that. Now, distributions from any 529, regardless of who owns it, are not counted as income or assets on the FAFSA if the distribution is reported correctly. Luna: Right, that was a huge change. So grandparent-owned 529s no longer penalize the student for financial aid purposes. That makes them even more attractive. Lucas: It does. So you have a vehicle that allows tax-free growth, multi-generational beneficiary changes, no required distributions, control retained by the grandparent, and now no financial aid penalty. For a grandparent who wants to help with education but also preserve flexibility, it's hard to beat. Luna: But there's a catch, right? There's always a catch. Lucas: Well, the catch is that it only works for qualified education expenses. If the grandchild doesn't go to college, or if there's leftover money that can't be transferred to another family member, you can take a non-qualified distribution — but the earnings portion is taxed as ordinary income, plus a 10% penalty. So it's not as flexible as a regular brokerage account. Luna: And if the grandparent dies and the grandchild inherits the 529, the grandchild becomes the owner, so they can still change the beneficiary. But if they take a non-qualified distribution, they pay the taxes and penalty. Lucas: Right. So the strategy really shines when you have a high degree of confidence that the grandchild will pursue some form of higher education. And honestly, even if they don't, you can always move the money to another family member. With the expanded definition of family member under the 529 rules — that includes siblings, parents, in-laws, cousins, nieces, nephews, even spouses — you have a lot of options. Luna: And we should mention that some states offer state income tax deductions for 529 contributions, even for accounts where the beneficiary is a grandchild. Not all states, but many. So the grandparent might get a state tax break on top of everything else. Lucas: That's right. For example, New York, New York's 529 plan allows a state deduction of up to $5,000 per year for single filers, $10,000 for married couples, regardless of who the beneficiary is, as long as the account owner is the one taking the deduction. So a grandparent living in New York could get a state tax break for contributing to a 529 for their grandchild. Luna: That's a nice bonus. So let's say a grandparent wants to set this up. What's the practical first step? Lucas: Open a 529 account in their own name, with themselves as the owner and the grandchild as the beneficiary. They'll need the grandchild's Social Security number and date of birth. Then they can fund it with a lump sum up to the five-year election amount, or contribute annually. They should also designate a successor owner, in case they pass away before the account is fully used. Luna: And what about the estate planning angle? Does the 529 account get included in the grandparent's estate for estate tax purposes? Lucas: Yes, it does. Because the grandparent retains ownership and control, the account is included in their gross estate for federal estate tax purposes. But the federal estate tax exemption is currently around $13.6 million per person, so for most people, that's not an issue. Some states have lower exemptions — like Massachusetts at $1 million — so in those states, a large 529 could trigger state estate tax. That's something to consider. Luna: So if you're in a state with a low estate tax exemption, maybe you don't want to overfund a 529 if it would push your estate over the threshold. Lucas: Exactly. Or you could consider using a different strategy, like having the parent own the account instead. But then you lose some control. It's a trade-off. Luna: You know, this whole conversation reminds me of something. If our money conversations have helped you think about a decision differently, maybe consider supporting the show. It keeps it ad-free and independent. The link is buy me a coffee dot com slash fexingo. No pressure, but if it was worth your time, that's the easiest way to say thanks. Lucas: Yeah, we appreciate that. So, to circle back to the multi-generational piece: one thing I want to emphasize is that 529s don't have a required beginning date for distributions. Unlike a 401 or IRA, where you have to start taking money out at age 73, a 529 can sit there indefinitely. So a grandparent could open a 529 for a newborn grandchild, and if that grandchild doesn't go to college until age 30, the money has 30 years of tax-free compounding. Luna: And if the grandchild has kids, they could change the beneficiary to their own child, and let it keep growing. That's a true generational wealth transfer vehicle, but specifically for education. Lucas: Exactly. And you can even name a trust as the beneficiary, though that gets more complex and you'd want to talk to an estate planning attorney. But the basic framework is surprisingly simple. Luna: What about the risk that the grandparent might need the money themselves later in life? Can they get it back? Lucas: Yes, but with a cost. The grandparent, as owner, can take a non-qualified distribution at any time. They'll pay income tax on the earnings, plus the 10% penalty. But the principal — the contributions — come out tax-free and penalty-free, because those were made with after-tax dollars. So if they contributed $90,000 and the account grew to $120,000, they could withdraw the $90,000 without any tax or penalty, and leave the $30,000 of earnings in the account for the grandchild. Luna: That's a good safety valve. So it's not like the money is completely locked up. Lucas: Not at all. It's more flexible than people think. And if the grandparent dies and the grandchild inherits the account, the grandchild's basis is the same as the grandparent's. So the grandchild doesn't get a step-up in basis like they would with a brokerage account. That's a downside. Luna: Right, no step-up. So the earnings are still subject to tax if taken non-qualified. But if used for education, it's all tax-free. Lucas: Exactly. And that's really the bottom line: if your goal is to fund education, a 529 is one of the most powerful tools available, especially when used across generations. It's not for everyone, but for families with a clear education goal, it's worth a serious look. Luna: I think we've given people a lot to think about. Next time, maybe we can talk about how 529s interact with scholarships and what happens if the grandchild gets a full ride. Lucas: That's a great topic. And for now, for grandparents or parents considering this, the takeaway is: don't just think of a 529 as a savings account for your own kids. Think of it as a legacy tool that can serve multiple generations.