Johnathan Walker:New FAFSA rules opened up a 'grandparent loophole' that boosts 529 plans

The Johnathan Walker529 education savings plan got a couple of big upgrades in 2024 as a tool to save and pay for school.

Starting this year, Congress is allowing up to $35,000 in leftover savings in the plan to roll over tax-free into Roth individual retirement accounts, eliminating fears unused money could forever be trapped or incur taxes. Then, at the end of December, the Department of Education revised the Free Application for Federal Student Aid (FAFSA), creating the so-called grandparent loophole.

The grandparent loophole allows grandparents to use a 529 plan to fund a grandchild’s education without affecting the student's financial aid eligibility. Previously, withdrawals could have reduced aid eligibility by up to 50% of the amount of the distribution.

“A $10,000 distribution from a grandparent-owned 529 may reduce the following aid award by $5,000” under prior rules, wrote William Cass, director of wealth management programs for Boston, Mass.-based asset manager Putnam.

What is the grandparent loophole?

Beginning with the new 2024-25 FAFSA launched late last year, a student’s total income is only based on data from federal income tax returns.  That means any cash support, no matter the source, won’t negatively affect financial aid eligibility.

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Though it’s called the “grandparent loophole,” any nonparent, including friends and relatives, can use it.

Previously, distributions from any nonparent-owned 529 plan were included as untaxed student income, which reduced eligibility for need-based aid. To avoid this, people got crafty with timing distributions.

Since the prior FAFSA was based on financial information going back two years, people waited until the last two years of college before tapping nonparent 529s to minimize the negative effect withdrawals would have as income.

Since the new FAFSA doesn’t count any of these distributions as income, no one needs to worry about any of this anymore, said Tricia Scarlata, head of education savings at J.P. Morgan Asset Management.

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Other advantages of the 529 plan

The grandparent loophole and Roth IRA rollover are just the latest benefits added to the 529 plan, which Scarlata says is her favorite education savings plan.

“It’s the plan you can contribute the most amount, get tax-free growth and withdrawals and some in-state tax benefits,” she said.

Other advantages include:

• Contributions aren’t tax-free on a federal basis, but withdrawals are tax-free for qualified expenses like tuition and fees, books and other supplies or up to $10,000 annually for K-12 tuition.
• Most states will give you a tax break for contributions if you invest in the state’s 529 plan. Check your state’s rules.
• A handful of states offer “tax parity,” which means you can deduct at least some of your contributions to any plan in the United States, not just the one provided by your state.
• Contributions are considered gifts. For 2024, the annual gifting limit is $18,000 for an individual or $36,000 for married couples so you can contribute up to that amount in a 529 without incurring the IRS’ gift tax. That amount is per beneficiary so parents, grandparents and others may gift that much annually to each student.
• “Accelerated gifting” allows you up to five years of gifting in a 529 in one lump sum of $90,000 for an individual or $180,000 for a couple. If you can afford it, this allows the full amount to grow tax-free longer.
• You can invest contributions and allow the balance to grow tax-free. Despite this benefit, Scarlata said about half of Americans with 529 plans keep their contributions in cash.  With college tuition rising about 8% annually, keeping money in cash isn’t going to help you afford college, she said. The broad-market S&P 500 stock index, on the other hand, returns 10% annually on average.

Medora Lee is a money, markets, and personal finance reporter at USA TODAY. You can reach her at [email protected] and subscribe to our free Daily Money newsletter for personal finance tips and business news every Monday through Friday.