Should Parents or Grandparents Open a 529 Plan?

A 529 plan is a tax-advantaged savings vehicle designed for educational expenses, including tuition, fees, room, board, and books. Deciding who should own a 529 plan, whether a parent or a grandparent, involves considering account mechanics, financial aid implications, tax considerations, and flexibility in managing the funds.

Understanding 529 Account Ownership

A 529 plan involves two primary roles: the account owner and the beneficiary. The account owner establishes and controls the account, making investment decisions, controlling distributions, and having the authority to change the beneficiary. This can be a parent, grandparent, other family member, or the student.

The beneficiary is the student for whom the funds are saved and who will use the money for qualified education expenses. The account owner maintains control, with funds designated for the beneficiary’s educational future.

Financial Aid Considerations

The ownership of a 529 plan can significantly impact a student’s eligibility for need-based financial aid, particularly when completing the Free Application for Federal Student Aid (FAFSA). Parent-owned 529 plans are considered parental assets, assessed at a maximum rate of 5.64% of their value when calculating the Student Aid Index (SAI), which determines financial aid eligibility. Distributions from parent-owned 529 plans used for qualified educational expenses are not counted as income on the FAFSA.

Historically, distributions from grandparent-owned 529 plans were considered untaxed student income on the FAFSA in the subsequent aid year. This could significantly reduce financial aid eligibility. However, starting with the 2024-2025 academic year, the FAFSA no longer requires students to report distributions from grandparent-owned 529 plans. This change, part of the FAFSA Simplification Act, means that distributions from grandparent-owned accounts no longer negatively impact a student’s federal financial aid eligibility. This update removes a previous disincentive for grandparents to contribute to these plans.

Tax Implications and Benefits

529 plans offer various tax benefits, which are a primary reason for their popularity as education savings tools. Contributions to a 529 plan are not deductible for federal income tax purposes. However, many states offer income tax deductions or credits for contributions to their state’s 529 plan. These state-level benefits typically accrue to the contributor, who is often the account owner, potentially favoring parent ownership if they reside in a state offering such incentives.

Contributions to a 529 plan are considered gifts to the beneficiary for federal gift tax purposes. The annual gift tax exclusion allows an individual to contribute without incurring gift tax or using their lifetime gift tax exemption. An accelerated gifting option allows a donor to contribute up to five times the annual exclusion amount in a single year, treating the contribution as if it were made over a five-year period. This can be a valuable estate planning tool, particularly for grandparents, as the funds are generally removed from the donor’s taxable estate even though the account owner retains control.

The most significant tax benefit of a 529 plan is the tax-free growth of earnings and tax-free qualified distributions. When funds are withdrawn and used for qualified higher education expenses, such as tuition, fees, books, and room and board, the earnings are exempt from federal income tax and typically from state income tax as well. This tax-free growth and distribution apply regardless of whether a parent or grandparent owns the account, making it an efficient way to save for education.

Control and Flexibility

The account owner of a 529 plan maintains significant control over the funds, including making investment decisions, changing the designated beneficiary, and initiating withdrawals. The funds within the 529 plan are not legally considered the property of the beneficiary until they are distributed.

Designating a successor owner is an important consideration, especially for grandparent-owned accounts. A successor owner assumes all rights and responsibilities for the account if the original owner passes away or becomes incapacitated. This ensures the continuity of the education savings plan and helps avoid potential probate issues. The flexibility to change the beneficiary to another qualified family member, such as a sibling or cousin, without tax penalties is another valuable feature, providing an option if the original beneficiary does not pursue higher education or has leftover funds. If funds are withdrawn for non-qualified expenses, the earnings portion of the withdrawal is subject to federal income tax and generally a 10% federal penalty.