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With the price of higher education increasing nearly eight-times faster than wages, saving and paying for college is a common concern for many families. While there are multiple ways to begin saving for educational expenses, 529 plans are the most common. These plans are tax-advantaged investment accounts specifically designed to encourage saving for future education costs.
But when it comes to ownership of 529 plans, questions from clients are extremely common. Whose name should the 529 plan be in? Does it matter if the owner is a parent versus a grandparent? The answer is “yes” – but the impact differs for account ownership versus distributions made from these plans.
Parent versus grandparent-owned 529 plans
Parent-owned 529 plans are treated differently than grandparent-owned 529 plans when applying for financial aid and completing the free application for student aid (FAFSA). A 529 plan owned by a dependent student or custodial parent is considered a parental asset set aside for education that must be reported. In contrast, grandparent- (or other relative-) owned 529 plans do not have to be reported on the FAFSA. Therefore, money sitting in these accounts will not affect a student’s financial aid eligibility.
But before recommending a change in ownership to maximize aid, plans for distributions to pay for college expenses need to be discussed. When a 529 plan is owned by a parent or student, distributions are ignored. But when distributions from a 529 plan occur from an account owned by a grandparent or other relative, it is considered untaxed student income, which is important because income carries a much more significant impact on aid eligibility than assets. This income can reduce eligibility for need-based aid by as much as half of the withdrawal.
The timing of distributions can also affect this impact. When completing the FAFSA, there is a two-year “look-back” period. For families filing the FAFSA in fall 2020, they will be completing this form using 2018 tax data. For a student attending a four-year university, grandparent-owned 529 plan distributions used to pay for expenses in their first few years of college will impact FAFSA filings for their later years. To avoid reporting income for grandparent-owned 529 plans, consider waiting until after January of the student’s sophomore year to make distributions.
Be creative with funding strategies! If distributions from 529 plans will be needed to fund the first two years of college, consider shifting part of the plan balance to a plan owned by parents or the student and take these distributions from there. While the account will be considered a reportable asset, only up to 5.64% of a parent’s assets are considered available funds to pay for college – so the impact is minimal. If other funding strategies can pay for the first few years, grandparent-owned 529 plans can be reserved to fund the later years. In addition, thanks to the SECURE Act signed into law last year, up to $10,000 of unused 529 plan balances can be now be used to pay off student loans. This means grandparents will have the option to make distribution after a grandchild graduates to help pay down student loan debt.
Tax considerations
Understand the tax impact of 529 plan ownership when considering contributions or change of ownership. Contributions to 529 plans are tax deductible in 34 states. In order to claim the state tax deduction for a contribution, the taxpayer usually needs to be the owner of the 529 plan. Since different states have different requirements, review the guidelines within your home state.
If changing the ownership of 529 plans from grandparents to parents is recommended, there should not be any adverse tax consequences. The IRS allows one tax-free rollover per 12-month period for 529 plans with the same beneficiary. While no income taxes would be due, you may need to file a gift tax return depending on your situation. Consult a tax professional to determine if this is necessary.
Naming contingent owners
Succession planning is also an important aspect of managing 529 plans. When opening a 529 plan, most states require plan custodians to designate a contingent owner. If something were to happen to the owner, this person would step in to own and manage the 529 plan with no tax impact to them as the new custodian. If something happens to both the owner and contingent owner simultaneously, the estate plan would dictate next steps. Most advisors recommend a spouse, the parental custodian, or the student as the successor owner and in many circumstances this makes the most sense. Knowing distribution plans as the student beneficiary gets closer to college age makes determining a successor owner a bit easier.
Sarah Mouser, CFP®, CTS™, CES™ is director of financial planning for Cassaday & Company, Inc., an award-winning independent wealth management firm in the Washington, D.C. metropolitan area. While Sarah and Cassaday & Co. focus on holistic planning, Sarah has a special passion and expertise surrounding education-planning topics.
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