Grandparent Owned 529 Accounts Just Got Better

A 529 account owned by a grandparent is often considered one of the most effective ways to save for college for a student. Mainly because 529 accounts owned by the grandparents are invisible to the college financial aid calculation (FAFSA) when determining the financial aid package that will be awarded to a student.  But there is a little-known pitfall about distributions from grandparent owned 529 accounts but thankfully the rules have changed.  In this article, we will review:

• Advantages of grandparent owned 529 accounts

• The FAFSA pitfall of distributions from grandparent owned 529 accounts

• The FAFSA two-year lookback period

• The change to the 529 rules

• Tax deductions for contributions to 529 accounts

• What if your grandchild does not go to college?

• Paying K – 12 expenses with a 529 account

Pitfall of Grandparent Owned 529 Accounts

Historically, there has been a major issue when grandparents begin distributing money out of these 529 accounts to pay college expenses for their grandchildren which can hurt their financial aid eligibility. While these accounts are invisible to the FAFSA calculation as an asset, in the year that the distribution takes place from a grandparent owned 529 account, those distributions did count as “income of the student” in the year that the distribution takes place. Income of the student counts heavily against the need-based financial aid award.  Currently, any income of the student above the $9,410 threshold counts 50% against the financial aid award.

For example, if a grandparent distributes $30,000 from the 529 account to pay college expenses for the grandchild, in that determination year, assuming the child has no other income, that distribution could reduce the financial aid award two years later by $11,480.  

FAFSA Two-Year Lookback

FAFSA has a two-year lookback for purposes of determining income in the EFC calculation (expected family contribution), so the family doesn’t realize the misstep until two years later.  For example, if the distribution takes place in the fall of the student’s freshman year, the financial aid package would not be reduced until the fall of their junior year. 

Since we are aware of this income two-year lookback rule, the workaround has been to advise grandparents not to distribute money from the 529 accounts until the spring of their sophomore year. If the child graduates in four years by the time they are submitting the FAFSA application for their senior year, that determination year that 529 distribution took place is no longer in play.  

Quick Note: All of this only matters if the student qualifies for need-based financial aid.  If the student, through their parent’s FAFSA application, does not qualify for any need-based financial aid, then the impact of these distributions from the grandparent owned 529 accounts is irrelevant because they were not receiving any financial aid anyways.

New Rules Starting in 2023

But the rules have changed starting in 2023 to make these grandparent owned 529 accounts even more advantageous. Under the new rules, distribution from grandparent owned 529 account will no longer count as income of the student.  These 529 accounts owned by the grandparents are now completely invisible to the FAFSA calculation for both assets and income, which makes them even more valuable.

Tax Deduction For 529 Contributions

There can also be tax benefits for grandparents contributing to 529 accounts for their grandkids. Certain states allow state income tax deductions for contributions up to a certain thresholds. In New York State, there is a $5,000 state tax deduction for single filers and a $10,000 deduction for joint filers each tax year. The amounts vary from state to state and some states have no deduction, so you have to do your homework.

What If The Grandchild Does Not Go To College?

What happens if you fund this 529 account for your grandchild but then they decide not to go to college?  There are a few options here. The grandparent can change the beneficiary of the account to another grandchild or family member. The second option, you can just take a distribution of the account balance. If the balance is distributed but it’s not used for college expenses, the contribution amounts are returned tax and penalty-free but the earnings portion of the account is subject to ordinary income taxes and a 10% penalty since it wasn’t used for qualified college expenses.

K - 12 Qualified Expenses

The federal government made changes to the tax rules in 2017 which also allow up to $10,000 per year to be distributed from 529 accounts for K - 12 expenses. If you have grandchildren that are attending a private k -12 school, this is another way for grandparents to potentially capture a tax deduction, and help pay those expenses.

However, and this is very important, while the federal government recognizes the K – 12 $10,000 per year as a qualified distribution, the states which sponsor these 529 plans may not adhere to those same rules.   In fact, in New York State, not only does New York not recognize K – 12 expenses as “qualified expenses” for purposes of distributions from a 529 account, but these nonqualified withdrawals also require a recapture of any New York State tax benefits that have accrued on the contributions. Double ouch!!   These rules vary state by state so you have to do your homework before paying K – 12 expenses out of a 529 account.

About Michael……...

Hi, I’m Michael Ruger. I’m the managing partner of Greenbush Financial Group and the creator of the nationally recognized Money Smart Board blog . I created the blog because there are a lot of events in life that require important financial decisions. The goal is to help our readers avoid big financial missteps, discover financial solutions that they were not aware of, and to optimize their financial future.

Frequently Asked Questions (FAQs):

Why are grandparent-owned 529 accounts beneficial for college savings?
Grandparent-owned 529 accounts are not counted as assets in the FAFSA financial aid calculation, which can help maximize a student’s eligibility for need-based aid. Starting in 2023, distributions from these accounts are also excluded from the student’s income calculation, making them completely invisible to FAFSA.

What was the previous FAFSA pitfall with grandparent 529 distributions?
Before 2023, when grandparents made distributions from a 529 account to pay for college expenses, those withdrawals were considered “income of the student.” Since student income counts heavily against financial aid, these distributions could significantly reduce need-based aid two years later.

What changed with the FAFSA rules in 2023?
Under the new FAFSA rules, distributions from grandparent-owned 529 accounts are no longer treated as income to the student. This change eliminates the previous penalty and makes these accounts one of the most favorable tools for college funding.

Can grandparents receive tax benefits for 529 contributions?
Yes. Many states, including New York, offer state income tax deductions for contributions. In New York, the deduction is up to $5,000 for single filers or $10,000 for joint filers. Rules and deduction limits vary by state, so it’s important to review your state’s specific guidelines.

What happens if the grandchild doesn’t attend college?
If the grandchild doesn’t use the 529 funds for education, the account owner can change the beneficiary to another family member or withdraw the funds. Contributions can be withdrawn tax- and penalty-free, but earnings are subject to income tax and a 10% penalty if not used for qualified education expenses.

Can 529 funds be used for K–12 tuition?
Federally, up to $10,000 per year can be used for K–12 tuition expenses. However, not all states recognize K–12 expenses as qualified distributions. For example, New York does not and requires recapture of prior state tax deductions if K–12 withdrawals are made.

Are grandparent 529 distributions still reported on the FAFSA?
No. Beginning in 2023, both the value of grandparent-owned 529 accounts and any distributions from them are excluded from FAFSA’s financial aid calculation, eliminating the previous two-year lookback issue.

Potential investors of 529 plans may get more favorable tax benefits from 529 plans sponsored by their own state. Consult your tax professional for how 529 tax treatments and account fees would apply to your particular situation. To determine which college saving option is right for you, please consult your tax and accounting advisors. Neither APFS nor its affiliates or financial professionals provide tax, legal or accounting advice. Please carefully consider investment objectives, risks, charges, and expenses before investing. For this and other information about municipal fund securities, please obtain an offering statement and read it carefully before you invest. Investments in 529 college savings plans are neither FDIC insured nor guaranteed and may lose value.