While it should come as no surprise that obtaining a college degree these days carries a hefty price tag, what may surprise some is just how much college has ballooned over the past twenty years. According to U.S. News & World Report, in-state tuition and fees at public national universities increased 175% from 2002 to 2022. In comparison, the consumer price index (the most widely used measure of inflation) only increased by 65% during the same period. Comparing figures such as these make it easy to see how significantly the cost of college has exceeded the inflation rate.
What is not so easy for many families, however, is being able to fund the ever-rising cost of college for their children. Many students graduate with tremendous amounts of debt. According to Forbes, U.S. graduates carry some $1.75 trillion in total student loan debt, with the average borrower owing close to $30,000. Obviously, this has negative implications for home ownership, building retirement savings, and other financial goals that are important to people starting their careers.
On the other hand, with proper planning and some help from older family members who have funds available for gifting, the financial outlook becomes less bleak for those wishing to pursue higher education. One of the most popular and effective strategies you can implement to fund education is the 529 plan, also known as a qualified tuition plan. These funding vehicles boast a variety of tax advantages and, perhaps more importantly, can have minimal impact on students’ eligibility for other forms of financial aid if used correctly. While it is true that anyone can contribute to a 529 on behalf of a beneficiary, contributions are typically made by family members such as parents and grandparents. The account owner contributes after-tax dollars to the account, with many states offering a state income tax deduction on the contribution. The assets grow tax-deferred inside the account and can be withdrawn tax-free if used for qualified educational expenses. One of the many advantages of 529 plans is that qualified educational expenses can include up to $10,000 in tuition expenses for elementary, middle, or high school education. Also, up to $10,000 can be withdrawn from a 529 account to repay qualified student loans and expenses for certain apprenticeship programs. In addition to their ability to cover a variety of education-related expenses, 529 plans allow the account owner to maintain control of the account. This includes the ability to decide when distributions are to be made, as well as being able to change the beneficiary if so desired.
The ability to front-load the account can also serve as a valuable estate-planning or wealth transfer tool for affluent grandparents. For example, grandparents might wish to gift an amount equal to five years’ worth of the annual gift exclusion ($16,000 in 2022) in a single year. In 2022, a single grandparent can gift $80,000 ($16,000 X 5) to a grandchild’s 529, and married grandparents can gift up to $160,000, with no federal transfer tax being incurred and no federal transfer exemption being used. Front-loading a 529 can thus be an effective way for grandparents to transfer assets from their estate if they are close to the federal exemption limit.
There are some cautions to observe, however. Regarding front-loading, no additional exclusion gifts can be made to the same grandchild within the next five years. Also, if the grandparent does not outlive the five-year term following the gift, the portion of the gift that represents the period of the five years after their death will be placed back into their estate.
It’s also important to note that investment selection is rather limited for 529 plan owners, compared to other funding vehicles like Coverdell Education Savings Accounts or UGMA/UTMA accounts. Because each state sets the rules for its 529 Plans, owners in a given state may not be able to invest in individual stocks, mutual funds, or ETFs. Some states restrict their 529 plans to target-date funds that are designed to reduce risk (and, sometimes potential for higher returns) as the beneficiary approaches college age.
Grandparents who may be trying to qualify for Medicaid should know that assets in a 529 plan set up by that grandparent are considered the grandparent’s assets. The 529 plan account balance would have to be spent on medical care before Medicaid payments could begin.
One key differentiator between parent-owned and grandparent-owned 529 plans is the potential impact on student aid eligibility. While a 529 plan owned by a grandparent isn’t included as a parental asset in the expected family contribution calculation drawn from information on the Free Application for Federal Student Aid (FAFSA), the money is considered student income once distributed. This can have a profoundly negative impact on student aid, and workarounds must be implemented to reduce the impact. For example, you could change the 529 plan account owner to a parent or time your 529 plan distribution carefully to avoid having to report it. The good news is that changes to the FAFSA that take effect in the 2024–25 school year will reduce the impact of grandparent-owned 529 plans on student aid.
Ultimately, 529 plans remain a highly effective way to contribute to the cost of a child’s education. As education costs continue to skyrocket, the use of these tax-advantaged plans by grandparents, parents, and others can be a valuable way to fund the education of the next generation and save money on taxes at the same time.
