The ‘grandparent loophole’ is putting much-needed money back in the pockets of college students — here's how it's helping younger Americans

How the 529 savings account can help

A 529 savings account is designed to help families save for a child’s education. It’s a tax-advantaged account that’s typically opened by a parent (or grandparent), with the child designated as the beneficiary.

Contributions are considered gifts — the amount that’s exempt from the IRS gift tax is $18,000 per year for individuals and $36,000 for married couples.

Money grows tax-deferred in the account, with some states also offering tax deductions on contributions. If withdrawals are made for qualified education expenses (as defined by the IRS), they won’t be subject to state or federal taxes.

Qualified education expenses include tuition, mandatory fees, room and board, books and other school-related expenses. Withdrawals can be used for tuition at any U.S. college or university, as well as some international institutions.

But for many students, their savings aren’t enough to fund an education, so they still require some form of financial aid. In 2022-23, for example, the average aid per full-time equivalent undergraduate student was $15,480, according to the College Board.

In addition, the Education Data Initiative reported that the average federal student loan borrower has $37,088 outstanding.

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The ‘grandparent loophole’

To apply for student aid — including grants, scholarships and loans — from more than 6,400 colleges and universities in the U.S., you’ll need to fill out a Free Application for Federal Student Aid (FAFSA).

The form, which collects demographic and income information, allows you to list up to 10 schools that you’d like to attend. If you’re successful in getting aid, you’ll hear back directly from these schools.

It’s here that the “grandparent loophole” now exists. Starting with the 2024-25 FAFSA, an applicant's total income will be calculated directly from the IRS Data Retrieval Tool (DRT), so it will only be based on their federal income tax return. This means that cash support, such as disbursements from a grandparent’s 529, won’t affect financial aid eligibility.

Previously, distributions from a grandparent-owned 529 plan had to be reported as untaxed student income, which could reduce financial aid eligibility by as much as 50% of the withdrawal amount.

Now, grandparents, or other family members and friends, can gift money to a student without hurting the student’s eligibility for financial aid.

Maximizing the benefits of the 529

To maximize the benefits of a 529, open it as early as possible so your investments have more time to grow. You also have the option to gift five years’ worth ($90,000 for an individual and $180,000 for a couple) in one lump sum and still avoid the gift tax.

It can pay to consult a financial advisor to help optimize the portfolio you build from your contributions. It may also be a good idea to move to a more conservative portfolio before you need to start taking withdrawals, which can help preserve the gains you’ve made and ensure the money will last.

However, make sure withdrawals from the plan are used only for qualified expenses — you’ll face heavy tax penalties if they’re spent on non-qualified expenses.