529 Plans Hidden Pitfalls for Grandparents Trying to Help College-Bound Grandchildren

For families saving for college529 Plans are extremely popular. These allow families to invest savings without taxation, as long as the proceeds are used for their children’s education.

Though 529 plan contributions are not federally deductible, Maryland allows state tax deductions of up to $2500 per beneficiary. A contribution to a 529 plan may also be treated as a gift for federal estate tax purposes, reducing the size of one’s taxable estate. For contributions up to $14,000 per year, there may be no gift tax either.

A recent nationwide survey of 529 Plans rated the Maryland College Investment Plan as offering the best portfolio of mutual funds.

There is, however a problem that families should consider before allowing well-meaning grandparents to set up a 529 for a grandchild. A grandparent’s 529 plan could interfere with a student’s eligibility for financial aid and other benefits.

Generally, contributions from parents do not count as student income for purposes of federal student aid. 529 plans created by parents are therefore no hindrance to eligibility. But contributions from other sources, such as grandparents, do count, and might disqualify a student. The result could be ineligibility for Federal grants, subsidized loans, and work-study programs.

There may be some alternatives for grandparents who would like to be generous.

Grandparents can give the money directly to parents to use for a grandchild’s education. Those funds would not be counted in determining a student’s eligibility for financial aid, but they would also not earn money tax-free.

Grandparents can sometimes transfer ownership of a 529 account to the parents before making withdrawals. Some plans prohibit this, however, or treat transfers as a distribution subject to taxes and a 10% penalty.

Grandparents can give the grandchildren the money in their senior year. If it is the final year of education, the student might not have to file additional financial aid requests, so the assistance would not be reported. This stratagem might not work, as some institutions require students to disclose whether they are named as beneficiaries of any 529 plans even if they have not yet received funds from them.

For parents and grandparents exploring ways to enable children to go to college, the first step should be to consult an attorney with expertise in the tax law and the practical impact of 529 plans and other approaches. The tax planning attorneys at Longman & Van Grack in our Rockville and Bethesda Offices have extensive expertise and can advise you on the approach best suited to your family’s needs. For a free consultation, call (301) 291-5027.