As grandparents, the desire to provide a strong foundation for your grandchildren's future is an aspiration that is both noble and cherished. With the rising costs of education, planning for this crucial aspect of their lives has become increasingly important. Selecting the best strategy to contribute to your grandchildren's education-related expenses involves weighing the efficiency, advantages, disadvantages, and the overall impact on your family's financial planning.
Among the plethora of options available, 529 plans have emerged as one of the most effective and flexible ways to support your loved ones' academic pursuits. Furthermore, the recent FAFSA Simplification Act has brought about significant changes to the financial aid landscape, making it even more critical to understand the implications of your savings strategy.
In this article, we will delve deep into the world of 529 plans and the FAFSA Simplification Act, equipping you with the knowledge to make well-informed decisions and create a lasting legacy for your grandchildren's education.
Read on to learn:
- What is a 529 plan
- Types of 529 plans
- Implications of 529 plans on the grandparent and their grandchildren
- Advantages and disadvantages of 529 plans
WHAT IS A 529 PLAN?
A 529 plan is a tax-advantaged account to save money for a beneficiary's education-related expenses. Grandparents and parents typically establish them on their grandchild's or child's behalf to cover education expenses from Pre-K to higher education.
There are two types of 529 plans: education savings and prepaid tuition.
EDUCATION SAVINGS PLAN
The education savings plan is the most popular option between the two programs. The program works as an investment account using money market and mutual funds to amass earnings on parental contributions.
The money contributed to the education savings plan is invested in investments the account holder prefers, and it grows tax-free. The withdrawals are tax-free if used for tuition, room and board, fees, and other related costs. They can also be used to pay student loans.
PREPAID TUITION PLANS
Prepaid tuition plans are less popular overall, but they are an excellent option for those who are sure that the beneficiary will enroll in a participating school. Prepaid tuition plans are offered in select states by a few institutions. Withdrawals are not taxable and don't cover room and board.
One of the advantages of this option is that it allows investors to lock in current tuition rates and pay tuition now for the school their child will attend in future. This helps investors save money since the invested money doesn't lose value in due course with inflation. As an investor, you can opt to make a one-time payment or purchase prepaid tuition plans through installments.
WHAT ARE THE IMPLICATIONS OF 529 PLANS?
One of the most significant caveats of saving for your grandchildren's college costs using 529 plans used to be their impact on qualifying for need-based federal financial aid. Students were required to report all the additional support they received when applying for financial aid.
So, if the funds in the 529 plan were withdrawn to pay for their college expenses before the final two years of attendance, they were considered a source of income to pay for their schooling. It would hurt their qualification for federal financial aid because FAFSA determines financial need by considering the student's income and assets. Up to 50% of students' income and 20% of assets held in their name can count towards their expected contribution towards college costs.
The only way to avoid hurting the beneficiaries' financial aid qualification was to wait until they were in their junior or senior year of college to provide them with the 529 funds. Fortunately for grandparents, that is not the case anymore.
Thanks to the FAFSA Simplification Act, grandparents can contribute to their grandchildren's college education without hurting their ability to qualify for or access federal financial aid.
WHAT IS THE FAFSA SIMPLIFICATION ACT?
The FAFSA Simplification Act, enacted by Congress in December 2020, eliminates the requirement to report funds from gifts and grandparent-owned 529s in the application for financial aid. All the student income information will be taken from tax return data.
This means grandparents and any other parties can help cover a student's education-related expenses without worrying that their assistance will cost them the financial aid they would otherwise be eligible for. They won't have to wait until junior year or give up ownership to avoid the implications.
The Act was supposed to launch in the 2023-2024 award year, but it has been postponed to 2024-2025. When it launches, gifts made from 2022 won't be considered in a free application for financial aid.
ADVANTAGES OF 529 PLANS
529 plans have been attractive options for grandparents to help fund their grandchildren's education expenses even before the FAFSA Simplification Act was announced. They offer several advantages for people who have already retired or are in their peak earning years.
Below are the top benefits of investing in 529 plans:
THEY ARE FLEXIBLE
529 plans are flexible in the sense that investors can transfer ownership easily. If your circumstances make it best for you to own the account, you can list yourself as the owner. When the need arises, you can easily transfer ownership to the parent or beneficiary.
Besides being able to change the beneficiary of a 529 plan, you also have the freedom to decide when and how to spend the money if your grandchild does not get into college. You can decide to invest it elsewhere or use it yourself.
Investors of 529 plans get to enjoy a range of tax benefits. For instance, the funds in the 529 plan grow tax-deferred and are exempt from federal taxes when withdrawn and used for qualified education-related expenses.
Although there are no federal tax deductions, Ohio and 34 other states offer deductions on in-state 529 plans. The deductions could be in the form of a tax break or a tax credit. In Ohio, the tax deduction is $4,000 per beneficiary/per year.
GIFT TAX EXEMPTIONS
Money that you contribute to the 529 plan is considered a gift. That means gift taxes can apply. There are two ways to avoid paying gift taxes.
- Contribute up to $17,000 annually for single filers and $34,000 for joint filers in 2023 per beneficiary/grandchild.
- Use the frontloading or superfunding process, where you can contribute up to $85,000 for single filers and $170,000 per beneficiary/grandchild without being subject to the gift tax. However, you can only do this once every five years.
THEY CAN BE USED TO PAY STUDENT LOANS
The SECURE Act of 2019 allows people to repay up to $10,000 in student loans for the beneficiary and another $10,000 for any of their siblings with 529 plans.
Other advantages of investing in 529 plans include the following:
- They are easy to open. You can open one online or through a financial advisor.
- They help with estate planning legacy, allowing you to provide something for your grandchild while you can.
- Unlike other savings plans, 529 plans have no limit to how much you can contribute per year.
- 529 plans are considered a parental asset and have a relatively minimal effect on the beneficiaries' eligibility for financial aid.
THEY CAN BE USED TO FUND ROTH IRAS
SECURE Act 2.0 was passed in December of 2022 and has provided a new benefit for 529 savings plans. Starting in 2024, a plan beneficiary can transfer funds from their 529 account into their own Roth IRA without taxes or penalties. There are several rules and stipulations that must be followed, such as how long the 529 has been open, titling of the accounts, when the money was contributed to the 529, eligible compensation, and lifetime limits.
DISADVANTAGES OF 529 PLANS
Along with the advantages of 529 plans, there are several disadvantages to consider. They include:
- If the funds are used for non-education-related expenses, the earnings are taxed at your ordinary income plus a 10% penalty. The contributions are not taxed. You can overcome this drawback by changing the beneficiary or paying for your own education.
- If you aren't well off, you may lose Medicaid assistance. Assets in a 529 account owned by the grandparent are considered theirs, so the balance in the 529 plan would have to be used up before the Medicaid assistance begins.
After considering both the advantages and disadvantages of 529 plans, you'll determine whether investing in one is the right thing for you and your grandchild. Other important factors to consider include the state you live in, how much you intend to save for K-12, grad school, college, or apprenticeships, and whether you're planning to utilize the funds exclusively for educations savings.
OTHER WAYS TO SAVE FOR YOUR GRANDCHILD'S EDUCATION
Apart from 529 plans, grandparents can use UTMA or UGMA accounts. They don't limit contributions and have a wider range of investment options. The gift tax implication still applies, and the accounts are considered student assets. With these accounts, your grandchild will gain control over the account once they reach a specified age.
You can also use Coverdell Education Savings Accounts, but the eligibility and contributions are limited. For example, you can only open an account for a grandchild below 18. Contributions made after 18 years are subject to a penalty tax.
529 plans are an attractive option for grandparents looking to save for their grandchildren's education. They have the best combination of control, tax advantages, flexibility, advantages, and disadvantages. And with the FAFSA Simplification Act's changes, they have no effect on the student's eligibility for financial aid. Investors should carefully consider investment objectives, risks, charges and expenses. This and other important information is contained in the fund prospectuses, summary prospectuses and 529 Product Program Description, which can be obtained from a financial professional and should be read carefully before investing. Depending on your state of residence, there may be an in-state plan that offers tax and other benefits which may include financial aid, scholarship funds, and protection from creditors.. Before investing in any state's 529 plan, investors should consult a tax advisor. If withdrawals from 529 plans are used for purposes other than qualified education, the earnings will be subject to a 10% federal tax penalty in addition to federal and, if applicable, state income tax.
A FINANCIAL ADVISOR CAN HELP YOU PLAN
Like any other financial decision, you need some financial planning before opening a 529 account. If you use the education savings plan, you must make good investment options to ensure the funds grow. If you choose to use the prepaid tuition plan, you must be certain the rate you are locking the tuition cost in will lead to savings. That is why you need the services of a financial advisor.
If you haven't hired a financial advisor yet, consider working with Gudorf Financial Group, LLC. We are an independent, fee-only financial services firm providing tax planning, investment management, retirement income, and estate planning advice to individuals over 50 in the greater Dayton, Ohio area and beyond. We can help you make the right decisions to support your grandchild's education and meet your other financial goals.
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