Being able to dote on children is one of the advantages of being a grandparent. But some gifts, like a college education, are a bit too big to just be handed out.
For grandparents (or other extended family members) who want to support a child’s education there are a number of methods available for use—each with their own advantages and uses. All provide financial support for the student, of course, but each has its own challenges and tax considerations to be taken into account.
Creating and Funding a 529 Plan
A 529 plan is a savings account that has been qualified by state governments for the express purpose of saving for a child’s education. 529s work a lot like qualified retirement account, except use of funds is limited to educational expenses. Since 529s can take contributions from almost anyone, only one account is needed for each future student. If a child’s parents have already created an account, grandparents do not need to set up a second 529, they can simply add to the parents’ savings.
Tax benefits of 529s vary from state to state, so it is essential that local rules be considered prior to account formation. There are two types of 529 plans: “college savings plans” and “prepaid tuition plans.”
College savings plans are the more common of the two. Once one is created and its beneficiary selected, contributions are made and the investments selected. The investments are permitted to grow tax-free. (Accounts are offered by the state but are not necessarily managed by them; state-appointed managers determine the investment funds available for 529s to use.) Once the beneficiary begins paying for college, funds may be withdrawn to cover any number of school-related expenses.
There are three notable benefits of 529 college savings plans. First, contributions grow tax free, allowing money to compound value quickly. Second, many states offer partial or full state income tax deductions on contributions (if the state has income tax). Third, the account requires that a beneficiary use the money for educational purposes.
The other account type, “prepaid tuition plans,” is much different from college savings plans and is offered by fewer states. Prepaid tuition plans work exactly as their name suggests: they allow an adult to prepay semesters of tuition at a price chained to the tuition’s current cost. If tuition prices are expected to rise, this can significantly decrease the amount of money spent on tuition.
Trusts are another excellent way to set aside money for a child’s education. Though more expensive to establish than a 529, trusts allow their grantors (creators) to have control over when trust funds are distributed and what investments they use to grow. This can be highly beneficial for a grandparent who would like to support a grandchild’s first business venture rather than making them go to college to receive financial help.
Unfortunately, trusts can become much more complex than 529s and do not offer tax advantages to contributions and investment growth. To avoid reducing future estate tax exemption, grantors should limit their yearly contributions to the annual tax-exempt gift amount, which is set by the IRS on a yearly basis. In addition, beneficiaries must be given the legal right to withdraw gifts for 30 days after they are made. Trusts, therefore, take cooperation and understanding between grantor and beneficiary.
The UTMA savings accounts are those allowed by the Universal Transfer to Minors Act. UTMA accounts are meant to hold gifts made to a minor until he or she reaches an adult age (either 18 or 21). To protect minors from sudden tax expenses, UTMAs hold gifts as tax-free for any value they may gain.
Though UTMA accounts are extremely simple to create and fund, they have a risky component. Money in an UTMA passes to a recipient’s sole ownership when he or she reaches the required age.
This means the recipient is allowed to use funds at his or her discretion and are not beholden to spend it on education.
Giving or Paying Outright
Apart from variety of account strategies, individuals can simply mail a check to a college and pay off a student’s tuition for that year or semester. If the tuition is paid directly, it is not considered a gift by the federal government and is not taxed. However, this method can only cover tuition; any further money given to support the child will be considered a gift and will be subject to any gift-tax consequences.
Whatever method grandparents choose to use to help grandchildren pay for college, they need to work in close communication with the parents. The Free Application for Federal Student Aid (FAFSA) takes into account all money held directly (or in trust) by both a student and his or her parents. UTMA and direct gifts put under a student’s ownership can quickly lower the amount of aid the government is willing to give a student. Financial support prepared and controlled by grandparent’s 529s or trusts are usually not taken into account before they are used. However, once support has been given, it will lower the aid a student receives the following year.
To ensure FAFSA is used to its full potential, it can be wise for a grandparent to withhold distributions for college costs until later in the student’s career. For instance, if a grandparent wants to pay for one year of a student’s college education, he or she can wait until the last year when its effects on FAFSA will no longer be a concern. If a grandparent pays for only the first year of college, the student will likely be robbed of federal support the next year, making it difficult for him or her to continue a college education.
When it comes to making a grandchild’s education a priority, grandparents have a host of tools and techniques available to them. By seeking financial advice from Prudential and carefully weighing benefits, adults and students can find the smart way to make college work.