Helping Your Grandchildren Pay for College
As the cost of a college education continues to climb exponentially, many grandparents are stepping in to assist their grandchildren in the pursuit of higher education.
Funding your grandchild’s college education not only brings you great personal satisfaction; doing so also provides you with a smart, tax-efficient approach for passing your wealth and legacy to the next generation. We have outlined some of the methods you can use to invest in your grandchild’s educational advancement.
Outright Cash Gifts
A common way for grandparents to help grandchildren with college costs is to make an outright gift of cash or securities. However, this method has a couple of drawbacks. A gift that exceeds annual federal gift exclusion amount – $14,000 for individual gifts and $28,000 for gifts made by a married couple – might be subject to the gift tax or the generation-skipping transfer (GST) tax.
Another drawback is that a cash gift to a student will be considered untaxed income by the federal government’s aid application (FAFSA). Student income is assessed at a rate of 50%, so a large gift of cash or securities may impact your grandchild’s financial aid eligibility.
One workaround is for you to give the cash gift to your child instead of your grandchild, because gifts to parents do not need to be reported as income on the FAFSA. Another solution is to wait until your grandchild graduates college and then give them a cash gift that can be used to pay off student loans.
Pay Tuition Directly
Another option is to pay the college directly. Under federal law, any tuition payments that are made directly to a college will not be considered taxable gifts – regardless of the size of your payment – so you won’t need to worry about the annual federal gift tax exclusion.
Aside from the obvious tax advantage, paying tuition directly to the college ensures that your money will be used for the education purpose you intended. In addition, you would still have the option of giving your grandchild a separate, tax-free gift each year.
However, federal law exempts tuition payments only; room and board, books, fees, equipment, and other similar expenses do not qualify. Also, in some situations, the college or university may reduce your grandchild’s institutional financial aid by the amount of your payment.
Before sending a check to the school, ask the college how it will affect your grandchild’s eligibility for financial aid. If your contribution will adversely affect their aid package – in particular, the scholarship or grant portion – consider gifting the money to your grandchild after graduation to help him or her pay off student loans.
529 Plans
A 529 plan can be an excellent way for you to contribute to your grandchild’s college education, while simultaneously paring down your own estate. Contributions to a 529 plan grow on a tax-deferred basis, and withdrawals used for the beneficiary’s qualified education expenses are completely tax-free at the federal level.
There are two types of 529 plans: college savings plans and prepaid tuition plans. College savings plans are individual investment-type accounts; the funds can be used at any accredited college in the United States or abroad. Prepaid tuition plans allow prepayment of tuition at today’s prices for the limited group of colleges – typically in-state public colleges – that participate in the plan.
You may open a 529 account and name a grandchild as the beneficiary, or you can contribute to an already existing 529 account. In terms of contributions to the 529 account, you may elect to contribute a lump sum or contribute smaller amounts over time.
A major advantage of 529 plans is that individuals can make a single lump-sum gift to a 529 plan of up to $70,000 ($140,000 for joint gifts by married couples) and avoid federal gift tax. To do so, a special election must be made to treat the gift as if it were made in equal installments over a five-year period. No additional gifts can be made to the beneficiary during this timeframe.
Example: Mr. and Mrs. Ciccarelli make a lump-sum contribution of $140,000 to their grandchild’s 529 plan in Year 1, electing to treat the gift as if it were made over five years – annual gifts of $28,000 ($14,000 each) in Years 1 through 5 ($140,000 / 5 years). Because the amount gifted by each grandparent is within the annual gift tax exclusion, the Ciccarellis won’t owe any gift tax (assuming they don’t make any other gifts to this grandchild during the 5-year period). In Year 6, they can make another lump-sum contribution and repeat the process. In Year 11, they can do so again.
Significantly, this money is considered to be removed from your estate, even though the grandparent would still retain control over the funds. There is a caveat, however. If you or your spouse were to pass away during the five-year period, then a prorated portion of the contribution would be “recaptured” into the estate for taxation purposes.
Example: In the previous example, if Mr. Ciccarelli were to die in Year 2, his total Year 1 and 2 contributions ($28,000) would be excluded from his estate. But the remaining portion attributed to him in Years 3, 4, and 5 ($42,000) would be included in his estate. The contributions attributed to Mrs. Ciccarelli ($14,000 per year) would not be recaptured into the estate.
If you have determined that you want to open a 529 account for their grandchild, keep in mind that there is a double consequence for early withdrawal. If you need to withdraw money for something other than your grandchild’s college expenses, the earnings portion of the withdrawal is subject to a 10% penalty and will be taxed at your ordinary income tax rate.
Did you know…
- If your grandchild doesn’t go to college or gets a scholarship, you can name another grandchild as 529 account beneficiary with no penalty.
- Many states offer income tax deductions for contributions to their 529 plan.
- A recent survey of grandparents revealed that over half were—or planned on—contributing to their grandchildren’s college education. (Source: Financial Research Corporation)
- Each 529 plan has its own rules and restrictions, which can change at any time.
Regarding financial aid, grandparent-owned 529 accounts do not need to be listed as an asset on the federal government’s financial aid application. However, distributions (withdrawals) from that 529 plan are reported as untaxed income to your grandchild, and this income is assessed at 50% by the FAFSA. By contrast, parent-owned 529 accounts are reported as a parent asset on the FAFSA (and are assessed at 5.6%). Distributions from parent-owned plans aren’t counted as student income.
To avoid having the distribution from a grandparent-owned 529 account count as student income, one option is for you to delay taking a distribution from the 529 plan until after January 1 of your grandchild’s junior year of college (because there will be no more FAFSAs to fill out).
Another option is for the grandparent to change the owner of the 529 account to the parent. Colleges treat 529 plans differently for purposes of distributing their own financial aid. Generally, parent-owned and grandparent-owned 529 accounts are treated equally because colleges simply require a student to list all 529 plans for which he or she is the named beneficiary.
