Many of our retired and soon-to-be retired clients also happen to be grandparents, and as such, they frequently ask us how they can help pay for their grandchildren’s college costs. After all, according to data from the College Board, tuition costs have increased at approximately twice the general inflation rate over the past several decades, creating a significant financial burden for many families. While we always advise our clients to make sure their own retirement needs are comfortably covered first, some grandparents are in the fortunate position of having sufficient assets to help family members pay for college as well.
Several vehicles and strategies are available, but as usual, each has nuances and trade-offs. In this newsletter, we’ll review some of the more common approaches we have seen grandparents, in particular, use. In most cases, it comes down to understanding the facts and then weighing the scale in terms of what’s most important to you.
Established by Congress in 1996 and named after the relevant section of the federal tax code, 529 plans (technically known as “qualified tuition programs”) typically are sponsored by individual states and have become quite popular due to their tax advantages. There are two basic types: prepaid tuition plans and savings plans. We will focus our discussion on the latter, given that they offer more flexibility and we have more direct experience with them.
Earnings on savings plans are not subject to federal tax and are generally not subject to state tax when used for qualified college and postgraduate education expenses by the designated beneficiary, such as tuition, fees, books, and computer equipment/technology, as well as room and board.1 For nonqualified distributions, the portion that is allocable to earnings (as opposed to the portion that represents a recovery of contributions, or “basis”) may be subject to federal income tax, at ordinary income tax rates, an extra 10% penalty tax, and state and local income taxes.
Moreover, as of now, 35 states, including the District of Columbia, provide a full or partial state income tax deduction for contributions when you invest in your state’s plan (our home state of California is not among them). Notably, seven states offer a tax benefit for contributions to any state’s plan.
This is an important consideration for grandparents who live in a different state than their grandchildren. However, before grandparents fund a savings plan in their own state to receive a state tax deduction, they also should evaluate other factors, such as underlying administrative and investment costs of the savings plan.
In addition to tax-free compounding, savings plans provide the opportunity to save large sums. There are maximum aggregate limits, which vary by plan and currently range between $235,000 and $511,758.2 Technically, under federal law, 529 plan balances cannot exceed the amount necessary to provide for the qualified education expenses of the beneficiary.
And while there are no annual contribution limits (as there are for Coverdell Education Savings Accounts, discussed later), one does has to be mindful of gifting thresholds. The current annual gift tax limit is $14,000 per beneficiary, so a grandparent couple can give up to $28,000 combined to each grandchild without having to file a gift tax return and use any of their lifetime gift exclusion. An additional benefit of 529 plans is that a grandparent can front-load five years’ worth of gifts and make a total contribution of $70,000 per beneficiary, or $140,000 combined, for a grandparent couple. This can be beneficial for grandparents who desire to get assets out of their estate, while also allowing the assets to grow tax-free over a longer period of time. Front-loading contributions in this way requires the filing of a gift tax return (Form 709) for IRS tracking purposes, but the gift is not applied toward the lifetime gift exclusion. However, the grandparent(s) cannot make any additional annual gifts to the beneficiary during the entire five-year time period. Moreover, if the grandparent dies within five years of making the front-loaded gift/contribution, a prorated portion of the contribution would be included in his or her estate.
Further, 529 savings plans allow the account owner—in this case, the grandparent—to retain some control over the funds. More often, if you want to get money out of your taxable estate, you have to forgo any claim to it. Control includes overseeing how the funds are invested (each state’s plan typically has a menu of prescribed investment options), as well as the ability to change beneficiaries and transfer assets to another state’s savings plan. For grandparents, retaining control also eliminates the risk of having the account’s assets divided if the grandchild’s parents were to divorce. If, instead, a parent opens the 529 account, grandparents can still contribute to it (as can anyone), but the parent maintains control. It is also worth mentioning that there can be multiple 529 accounts for a given beneficiary, so both the grandparents and parents can open separate accounts.
An especially important consideration for grandparents who own a 529 plan is naming a successor owner to manage the investments and distributions, in case the grandparent passes away before the beneficiary goes to school. This could entail grandparent couples naming each other, and then the child’s parent, as the successor.
What are some of the drawbacks of 529 plans? First, contributions can be made only with cash. This is particularly relevant if the child beneficiary already has an invested custodial account (i.e., a UGMA or UTMA, as discussed later) with unrealized capital gains. Technically, custodial accounts can be transmuted to a 529 plan, but the assets first need to be liquidated, possibly realizing taxable gains. Furthermore, 529 savings plans funded with custodial account assets need to retain a custodial account registration, which carries more restrictions, including the inability to change beneficiaries (which could be an issue should the original beneficiary not go to college). Additionally, when the current beneficiary reaches the age of legal ownership (such as his or her 18th or 21st birthday, depending on the state), he or she will have the right to contact the savings plan administrator and take direct ownership and control of the account.
Then there is the question of need-based financial aid. Generally speaking, 529 plans have a minimal impact on financial aid if a parent or dependent student (for tax purposes) is the account owner, as the 529 account in this case is considered a parent asset and is thus assessed at a lower rate in calculating the expected family contribution (EFC) for federal financial aid (i.e., a 529 plan is assessed at 5.6% of the parent’s assets, as opposed to 20% for student-owned assets, such as custodial accounts). A 529 plan account owned by a grandparent is not included as an asset in the EFC calculation, but once money is distributed, it is considered student income and can have a significant impact on financial aid. Thus, it is generally advised for grandparents to wait until the student’s last two years in college to distribute assets from their plan, so that this income will not affect federal financial aid calculations.3 Another solution is to transfer ownership of the 529 plan account to the parent, either prior to or during college, although this comes with the trade-offs noted earlier.
Finally, one of the benefits mentioned earlier can also be a convoluted curse—namely, generous contribution limits can lead to possible overfunding of the plan. Granted, an account can be transferred at any time to a different beneficiary who is an eligible family member of the original beneficiary.4 However, transfers to the generation after the original beneficiary’s generation could possibly trigger a gift tax, as saving plans are not intended to be used for perpetual, dynastic purposes.
Other College Savings Vehicles
Although 529 plans have become quite popular, there are other college savings options available, each with trade-offs depending on individual circumstances and preferences. We briefly describe a few of these options here.
Technically known as Uniform Gifts to Minors Act/Uniform Transfers to Minors Act (UGMA/UTMA) accounts, these were the more common vehicles for college savings before the advent of 529 plans. They are investment accounts established for a minor but administered by a custodian (typically a parent or other relative), who can use the assets only for the child’s benefit.
A key benefit of custodial accounts compared to 529 plans is flexibility, in that the custodian can use the account assets for any purpose that benefits the child, not just education. Furthermore, there is no cap on the total amount you can contribute, nor is there an income restriction in terms of one’s eligibility to contribute. With that said, contributors still have to be mindful of the annual gift tax exclusion, and unlike 529 plans, custodial accounts do not allow for front-loading up to five years’ worth of gifts.
UGMA/UTMA accounts also allow you to invest in an almost unlimited selection of options, including our preferred vehicles, cost- and tax-efficient diversified index funds.
A drawback of custodial accounts is that they do not allow tax-free compounding, as 529 plans do. Rather, any income or capital gains generated are taxed to the beneficiary. However, this may be more advantageous than income or gains being taxed at the donor’s tax rate, and the account can be invested in tax-efficient vehicles, such as index funds. Another potential drawback, depending on the child, is that the beneficiary takes control of the assets when he or she reaches the age of majority. Custodial accounts, once established, are irrevocable; ownership cannot be changed or transferred to another beneficiary. Finally, custodial accounts can have more of an impact on need-based financial aid eligibility compared to 529 plans, as they are assessed at the 20% rate for student-owned assets when calculating the EFC.
Coverdell Education Savings Accounts (ESAs)
Like 529 plans, ESAs afford tax-free growth, although contributions are not tax deductible, as they can be in selected instances for 529 plans. A key advantage compared to 529 plans is that ESAs can be used for any education level, not just college and postgraduate education. However, contribution eligibility starts to phase out at income levels of $95,000 for singles and $190,000 per couple, and total contributions per beneficiary cannot exceed $2,000 per year.
Trusts are an option for those who want control and flexibility and the opportunity to provide a more lasting legacy. Trusts can be funded with many types of assets, not just cash, and with no contribution limit. However, once again, one must be mindful of annual and lifetime gift tax exclusions, as well as potential generation-skipping transfer (GST) tax ramifications if the trust benefits grandchildren.5 Unlike 529 plans or ESAs, which have more rigid rules, distributions from trusts are ultimately decided by the grantor and whatever is permitted under the trust document.
The biggest drawback of trusts is that they can be complicated—and costly—to establish and administer. While we do manage education trusts, we have not encountered many of them over the years, likely because they are a more complex option.
Paying Tuition Directly
Finally, if able to do so, grandparents can pay for their grandchildren’s college tuition directly. This can be beneficial from an estate planning perspective, if that is a concern, as tuition payments made directly to a college—or any other qualified educational institution, from nursery school to graduate school—are not considered gifts and are thus not subject to the annual federal gift tax exclusion. Further, grandparents can do this in addition to making an annual gift under the gift tax exclusion of up to $14,000, or $28,000 combined for a grandparent couple, to any one individual.
Importantly, this tax break is applicable to tuition only, not to fees, books, supplies, or room and board. Furthermore, tuition payments must be made directly to the educational institution; you cannot reimburse the person whom you wish to benefit. Moreover, you can pay annually or prepay for multiple years—as long as the payments go directly to the institution and are not refundable or transferrable.
One caveat, again, is the potential impact on need-based financial aid eligibility. Colleges might reduce a student’s aid, dollar for dollar, by the amount of the grandparent’s payment. Alternatively, if aid is an issue, a grandparent could help pay off student loans after graduation, although unlike direct tuition payments, such gifts would be subject to gift tax exclusion limits.
For those who have the means, helping to pay for a grandchild’s college education can offer a tremendous personal return on investment as well as potential tax and estate planning benefits. As outlined in this newsletter, there are a variety of savings vehicles and strategies to consider. If you are seeking help in this regard, please know that we have many years of experience in helping grandparents—and parents—examine the alternatives and devise plans that best suit their specific needs and wishes.
1.As of this writing, the only state we are aware of that does not exempt qualified distributions is Alabama, for in-state residents who use out-of-state 529 plans as opposed to Alabama’s state-sponsored plan.
2.Data source: www.savingforcollege.com
3.Under rules established in 2015, which go into effect for the 2017–18 academic year, the Free Application for Federal Student Aid (FAFSA) will use income from two years before the school year starts in calculating aid eligibility. For example, income for the 2017 tax year will determine financial aid for the 2019 school year.
4.Eligible family members are detailed in IRS Publication 970 (Tax Benefits for Education).
5.A special type of trust, under Section 2642(c) of the Internal Revenue Code, may allow one to avoid GST tax. However, there are certain stipulations and restrictions. This trust is beyond the scope of this newsletter, and as with all trusts, should ultimately be reviewed with one’s attorney.