Significantly, this money is considered removed from the grandparents' estate, even though in the case of a grandparent-owned 529 account the grandparent would still retain control over the funds. There is a caveat, however. If a grandparent were to die during the five-year period, then a prorated portion of the contribution would be "recaptured" into the estate for estate tax purposes.
Example: In the previous example, if Mr. Brady were to die in Year 2, his total Year 1 and 2 contributions ($32,000 would be excluded from his estate. But the remaining portion attributed to him in Years 3, 4, and 5 ($48,000) would be included in his estate. The contributions attributed to Mrs. Brady ($16,000 per year) would not be recaptured into the estate.
Grandparents who are considering opening a 529 account for their grandchild should keep a few things in mind. Withdrawals from a 529 account used for a purpose other than college expenses — for example, medical expenses or emergency purposes — face a double consequence: the earnings portion of the withdrawal is subject to a 10% penalty and will be taxed at the grandparents' ordinary income tax rate. Also, funds in a grandparent-owned 529 account may still be factored in when determining Medicaid eligibility, unless these funds are specifically exempted by state law.
Regarding financial aid, grandparent-owned 529 accounts do not need to be listed as an asset on the FAFSA. However, distributions (withdrawals) from a grandparent-owned 529 plan are reported as untaxed income to the beneficiary (grandchild), and this income is assessed at 50% by the FAFSA. Note: Starting with the 2024-2025 FAFSA, students will not need to report distributions from a grandparent-owned 529 plan. To avoid having a distribution from a grandparent-owned 529 account count as student income, a grandparent can delay taking a distribution from the 529 plan until any time after January 1 of the grandchild's sophomore year of college. Another option is to wait and take a 529 distribution after the grandchild graduates and use the funds for student loan repayment (there is a $10,000 lifetime limit per 529 plan beneficiary on repaying student loans).
By contrast, parent-owned 529 accounts are reported as a parent asset on the FAFSA (and assessed at 5.6%), and distributions from parent-owned plans aren't counted as student income.
Colleges treat 529 plans differently for purposes of distributing their own financial aid. Generally, parent-owned and grandparent owned 529 accounts are treated equally because colleges simply require a student to list all 529 plans for which he or she is the named beneficiary.
Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing; specific plan information is available in each issuer's official statement. There is the risk that investments may not perform well enough to cover college costs as anticipated. Also, before investing, consider whether your state offers any favorable state tax benefits for 529 plan participation, and whether these benefits are contingent on joining the in-state 529 plan. Other state benefits may include financial aid, scholarship funds, and protection from creditors.