Helping Your Grandchildren Pay for College With a 529 Plan

Rande Spiegelman
CPA, CFP®, Vice President of Financial Planning, Schwab Center for Financial Research

If you plan on helping your grandkids pay for college, you might as well do it in the most tax-efficient way possible. For many tax-savvy grandparents, that means opening a 529 plan on behalf of their grandchildren.

Earnings in a 529 plan grow federally tax-deferred, which means your money has a chance to compound faster because you don't have to pay taxes on current investment income or capital gains. Even better, withdrawals are income tax-free as long as you use the money to pay for qualified education expenses, which typically include tuition, books, school supplies, and room and board (hang on to those receipts for at least six years in case you're audited).

Also, if you invest in your own state's 529 plan, you may benefit from state income tax deductions on contributions and state tax exemptions on withdrawals.

Nothing in life comes without a catch, and 529 plans are no exception. First of all, there's no guarantee that investing in a 529 will produce the desired results. Of course, there's also no guarantee associated with saving and investing in a less tax-efficient way either. Beyond that, there are some IRS rules you need to follow. The following are some frequently asked questions grandparents have when it comes to 529 plans for the grandkids.

How much can I give?

There's no annual limit to how much you can contribute (though, there are some gift tax considerations). Instead, there's a lifetime maximum, which varies by state and generally ranges upward of $200,000 per beneficiary. If you make a special election, you can contribute a lump sum of up to $65,000 to one or more 529 plans in a single year (a married couple can contribute $130,000) without incurring the gift tax—the IRS views the money as an annual $13,000 (or $26,000 for spouses) gift over five years. However, if you contribute more money on behalf of the same child during those five years, you trigger the gift tax.

Who owns the account?

If you establish a 529 plan in your name with your grandchild as the beneficiary, you own and control the account. If your grandchild is the beneficiary of more than one 529 plan (for example, if the parents have also established an account), be sure to coordinate with the other account owner(s) so that the total contributions don't exceed the lifetime state maximum.

If my first grandchild doesn't go to college, can I change the beneficiary to another grandchild?

Yes. You can switch the beneficiary on your 529 plan to any of your other grandchildren without penalty.

What if I change my mind and need the money for myself?

If you decide at some point that you'd like to take a few college courses yourself, you can name yourself as beneficiary and make tax-free withdrawals to pay for your own qualified education expenses. If you simply decide you want to take the money out and spend it on something else, you can do so, but you will have to pay ordinary income tax plus a 10% federal penalty on the earnings (state taxes may also apply, including taxes associated with previously deductible contributions at the state level, if any).

Since the account is in my name, will it impact my Social Security and Medicare benefits?

No. While the balance of a 529 plan owned by you would be included as an asset for purposes of determining Medicaid eligibility, it would not impact your Social Security or Medicare benefits. Qualified non-taxable withdrawals will not impact your benefits either. However, depending on your overall income level, non-qualified withdrawals you take for yourself could impact the taxability of Social Security benefits or the amount of Medicare premium you are required to pay, because they would be included in your overall income.

What impact will the account have on financial aid for my grandchild?

Currently, none. Financial aid formulas consider 20% of the assets held in a child's name and 5.64% of the parents' assets to be available for college expenses. When grandparents own the 529 plan account, under current rules it would not factor into initial financial aid eligibility at all.