Regarding grandparents, the fact that they are grandparents, does not, in and of itself result in any tax benefits. However, there are certain tax provisions that may apply. First, any amounts given by a grandparent is usually considered a gift. Beginning in 2022, the annual exclusion increased from $15,000 to $16,000. Gifts to one person in excess of the annual exclusion require the filing of a gift tax return, although no gift tax is incurred because the gift tax credit is so large. Married grandparents can join together to give one grandchild $32,000 each year.
Grandparents can establish a Section 529 plan for a grandchild and possibly save state income tax in the state where the grandparent resides, depending on state law. Maryland and DC, for example, give the donor a deduction for money contributed to their state’s Sec 529 plan. A grandparent who is married can deposit $160,000 into their grandchild’s 529 plan to cover K-12 expenses—an amount equivalent to a $32,000 contribution each year over five years. When filling out their federal tax forms, they can elect to include this gift over a five-year period (i.e., $32,000 x 5 = $160,000), thereby excluding the $160,000 from any gift taxes.
Assuming the grandparents live five more years, the entire $160,000, plus the money earned from this investment, will not be taxed as part of their estate. And after this five-year period elapses, they can deposit an additional $160,000. Grandparents should be sure to consult their tax advisor before making large deposits into a 529 plan.
Here’s another opportunity. At age 72, IRA owners must start taking money – known as Required Minimum Distributions (RMD) – from their retirement accounts. Even if the person doesn’t need the RMD money, IRS still requires the distribution which is taxable.
If the grandparent contributes their RMD to a grandchild’s 529 account, the grandparent will still pay income tax on the RMD, but the money they invest in the 529 account will grow tax-deferred. And if the money is later used for qualified education expenses, the entire amount is available to the student tax-free. Additionally, the amount contributed by the grandparent to a 529 account is not included in their estate for estate tax purposes — even though they retain control over the funds. When applying for financial aid for college, by setting up a 529 account in the name of the grandparent with a grandchild as a beneficiary, these assets are not included as either the child or parent’s assets.
Finally, a grandparent can pay for college tuition. A special tax-code exemption allows a grandparent to pay college tuition and not have that money subjected to gift tax. The IRS makes an exclusion in the case of financial gifts used for tuition payments.
The exclusion, called the Gift Tax Education Exclusion for Tuition, means that money gifted to a friend or family member to pay for college tuition is not subject to the federal gift tax. Under the Internal Revenue Code, you can pay unlimited amounts for someone’s tuition and not be taxed.
To make a tuition gift that qualifies for the federal gift tax educational exclusion, the gift-giver should make the tuition payment directly to the student’s school—they should not give the money to the student.
Paying the school directly, instead of donating to a student’s 529 plan helps grandparents avoid potential gift taxes if they plan to make significant contributions. Of course, it’s not just the grandparent’s finances that must be considered, but also the student’s. Luckily, that is about to get easier.
In the past, grandparents faced issues when trying to pay for their grandchildren’s college tuition. However, with the arrival of the new Free Application for Federal Student Aid (FAFSA), a major change is coming that will be very beneficial.
Those who file the FAFSA will no longer be asked if their grandparents will be providing any assistance. This means that students whose grandparents pay part of their college expenses will no longer see their financial aid decrease, as long as the grandparents know how to properly give the money.