THE GOOD OLE COLLEGE TRY.
Grandparenting is such an awesome sport. Nothing but winning; when a loss appears on the horizon, you call the game and send them home. The holiday season shifts the game into overdrive. As one might expect, M’Lissa has squirreled away little gifts for our first grandchild most of the year. Scotty, the recipient of all this largesse, will likely express more interest in the wrapping paper than the presents inside. Still, Christmas morning will be more fun than a barrel of monkeys. Having lived through this with the kids, I recognize the repeating pattern, this instant gratification through giving. In an effort geared towards more responsible holiday behavior next year, I investigated college funding by grandparents. Here is what I found.
We want long-term happiness for the little ones. Despite what you may have heard, college still ranks among the very best investments towards achieving that goal. This piece is about money so that is a good place to begin. The increased earnings a college graduate makes represents a 15% return on investment, even at today’s higher college prices. That performance far outruns the stock market, the bond market, precious metals or real estate. Economically speaking, it works.
More importantly, studies suggest that a college education greatly contributes to a person’s overall happiness, outside of the economics. (I assume the study’s authors accounted for day’s like yesterday when my Baylor Bears lost 42-3. That did not make me happy). College degree holders report being happier, which may be subjective. The objective data also demonstrates that the college-educated are healthier, live longer and tend to stay in stable marriages. In summary, college funding by grandparents is a great gift.
THE DEBT LOAD.
Like almost anything of economic value, the cost of a college education keeps rising. The average college debt for those who borrowed to pay for college now exceeds $30,000.00. Students who borrow to receive advanced degrees now end up with an average debt of over $70,000.00.
The amounts involved transformed the financial lives of a generation of Americans. People routinely carry student debt into their forties; there is even a sizable chunk of people over 50 still paying student loans. At the high end of the spectrum, the idea used to be that you went to college and graduate school so you could qualify for a mortgage. Today, many people graduating already have the equivalent of a mortgage payment.
A college funding gift for young grandchildren enjoys the power of the clock. Small gifts made early in a child’s life grow into large impacts when it comes time to use those gifts. In other words, the gift of college funding by grandparents is valuable, necessary and powerful.
THE HOW TO.
If you are ready to invest in your grandchildren’s future, there are several ways to do it. Depending on their form, gifts can help or hurt on taxes. Of course, everyone’s financial situation differs. Your gifts should take personal circumstances into account.
As always, my how to advice begins with a simple caveat. The information offered is general; to best use the information, work with an adviser who will help you come to the best decisions for your family. With that out of the way, there are six basic paths to college funding by grandparents:
- Dedicated cash or investments held in your name
- Cash or investments held in accounts designated for the grandchild
- Education Savings Accounts
- Tax-advantaged accounts under IRS Section 529
- Pre-paid tuition accounts under IRS Section 529
- Private trusts.
THE PIGGYBANK APPROACH.
The piggybank approach refers to setting up a separate account that you intend to use for college funding when the time draws near. That account might be as simple as a savings account; it could be a brokerage account; or it could be a limited partnership interest in a complex real estate deal. It also might be an actual piggybank.
Piggybank Pros and Cons.
The clear advantage the piggybank approach holds over every other method is flexibility. You may want to help the grandchildren with college funding; you may also want to keep eating. Using the piggybank approach makes sure you do not give up the ability to use your money for necessities. Also, if the money ends up unused for college or for a particular grandchild, using the money for something else requires nothing of you.
The clear disadvantage the piggybank approach holds in contrast to every other method is flexibility. You may want to help the grandchildren with college funding; you may also want to visit the Riviera and try caviar. If you cannot resist temptation, the “college fund” usually ends up dry.
The piggybank fund is tax-neutral. You receive no tax advantages when you move the money into a segregated amount; you pay normal taxes on interest and gains; and, under present law, you can arrange to use the gift without a gift tax.
When your grandchild applies for school, money in your piggybank will not count against the child for financial aid. Distributions during the child’s college career, however, might reduce financial aid for the following year. For that reason, it sometimes make sense for the parents to make their contributions early in the college career while the grandparents hold back. As the parents’ assets already count against the child for financial aid purposes, holding back the grandparents’ contribution means the child does not get both the parents’ assets and the grandparents’ contributions held against him or her.
The one thing you must do for the piggybank approach is select a method for transferring the money into an account, fund or trust that will pay college expenses if you should not survive. A good estate plan will help you take that crucial step.
The piggybank as a college funding by grandparents approach works best for disciplined savers whose first priority remains a secure retirement.
THE DEDICATED ACCOUNT APPROACH.
Grandparents who can pay for the necessities and for a lifestyle they enjoy might want to consider using “dedicated accounts” as a college funding source. The term dedicated account refers to accounts protected by the Uniform Gifts to Minors Act (“UGMA”) or the Uniform Transfers to Minors Act (“UTMA”).
“Uniform” in the title of these two acts indicates that states enact substantially similar laws, as opposed to a federal law that is exactly the same across all states. As the laws vary slightly from state-to-state, consult an adviser who knows the particular requirements in your state for UGMA and UTMA accounts.
UGMA and UTMA pros and cons.
While not as flexible as piggybank money, you can use dedicated accounts for anything benefitting the grandchild. Setting up the account is relatively easy as most financial institutions that handle these accounts do so routinely. To be more blunt, you do not need a lawyer. The law confines UGMA accounts to traditional publicly-traded investments; you can utilize a UTMA in less traditional vehicles, including real estate or intellectual property.
Transfers to a dedicated account come from after-tax money, so gifts do not reduce current year income tax. Moreover, transfers do count as gifts that could generate a gift tax if not handled correctly, so you need a little more C.P.A. involvement. The I.R.S. attributes income earned by the account to the grandchild or their parent; unlike piggybank accounts, your tax bill will not include those earnings. If either your children’s tax rate or your grandchild’s tax rate is lower than your rate, the transfer can save some taxes. The federal student aid calculation considers account assets as belonging to the grandchild, so the presence of an account will reduce available financial aid.
The biggest downside to dedicated accounts arrives at the grandchild’s passage into adulthood. In most cases, when the grandchild reaches the age of maturity (age 18 or 21 depending on the state) the law vests control of the account with the grandchild. Beneficiaries lacking maturity might not make the best decisions with the money.
UGMA/UTMA accounts as a college funding approach by grandparents best work where the grandparents are financially secure, the grandchild does not depend on significant financial aid; there are alternative uses for the money; and the grandchild will avoid rash financial decisions.
COVERDELL EDUCATION SAVINGS ACCOUNTS.
Education Savings Accounts (“ESAs”) work like a Roth IRA or Health Savings Accounts. Grandparents contribute money to the account and control the account through the beneficiary’s 30th birthday.
The Pros and Cons of ESAs.
You, not the grandchild, controls the ESA. These accounts enjoy tax-advantages on the income they earn after the contribution. Grandparents contribute after-tax dollars, but the account does not pay tax on the income it earns and there is no tax at the time of withdrawal. A portion of the ESA counts against the grandchild’s financial aid status, but less than the impact a similarly valued UGMA/UTMA account would create. While the law limits use of the fund to educational expenses, a wide variety of K-12 private school expenses fall within an acceptable use. You can use a broad range of investments when funding an ESA.
The I.R.S. limits ESA contributions to $2,000 per student, per year. The student must be 18 years or younger and the account needs to be depleted by age 30. Unlike most other options discussed, ESAs cannot fund student loan repayment. Finally, income limits may reduce or eliminate your ability to take advantage of an ESA. For instance, a married couple with income over $220,000 a year does not qualify for ESA contributions.
ESAs as a college funding by grandparents approach works best in the fairly limited situation of holding a high growth, unusual asset. Beyond that, ESAs often help with funding private K-12 education.
529 TAX-ADVANTAGED PLANS.
Section 529 of the I.R.S. code gives these plans their name. While states administer the plans, the rules are uniform across the nation. The more common type of 529 plan involves investing in an account that you and your broker manage towards payment of college expenses, much like you would manage a 401(K) retirement account.
The Pros and Cons of 529 Tax-advantaged Plans.
Once again, you still control the funds after the grandchild reaches adulthood. Like the ESAs, after-tax contributions grow tax deferred in the account and then escape taxation as long as distributions go to qualified education expenses. These plans give you substantial flexibility for changing beneficiaries or delaying distribution if the grandchild ends up not needing the funds in undergraduate, as in the case of a scholarship. Unlike ESAs, the contributor’s income does not limit eligibility. You can contribute much larger amounts to a 529 tax-advantaged plan than to an ESA.
On the other hand and compared to ESAs, 529 plans are less useful for K-12 expenses. The amount of assets held in a grandparents’ 529 plan does not count against the student for financial aid purposes (different for a parents’ 529 plan). However, distributions from a grandparents’ 529 plan can count. So timing when you distribute the income can have a big impact. Again, it often makes sense to exhaust the parents’ assets first. Complicated rules on rollover and recapture apply, particularly with multiple states involved. You need to work closely with an adviser who knows those rules.
If you should need the funds personally after contributing them to a 529 tax-advantaged plan, that can happen. But you will end up paying taxes and a penalty on the withdrawal.
529 tax-advantaged plans as a college finding approach by grandparents work well in a wide variety of situations. Contributors should be reasonably certain of the their own financial security and work in tandem with parental resources.
SECTION 529 PRE-PAID TUITION PLANS.
The same code section that allows for tax-advantaged savings plans also authorizes states to create “defined benefit” benefit plans through which contributors can theoretically guarantee the funding of a child’s or grandchild’s education.
The Pros and Cons of 529 Pre-paid Plans.
Pre-paid tuition plans are very state specific. What happens in Texas, might not happen in South Dakota, so it is hard to generalize. The biggest benefit from enrolling in a pre-paid tuition plan versus a savings plan comes from cost certainty. Most of these plans “freeze” the cost of tuition for you. Like a savings plan, income grows tax free and education distributions escape taxation. Ease of contributions from other family members constitutes another benefit.
On the negative side, the rules regarding participation can be strict. The defined benefit usually applies only to in-state, public schools. If the child attends school out of state, the distributions still fund college expenses, but you lose the benefit of the cost certainty. The whole point of a pre-paid tuition plan is to fully fund tuition payments, so you will greatly reduce financial aid prospects. You also have little control over your investment.
529 pre-paid tuition plans as a college funding approach by grandparents generally do not work too well. You are asserting too much influence on the choice of college. If the parents enroll in a pre-paid tuition plan, however, you can easily contribute.
A private trust involves creating a separate agreement that spells out exactly how you fund a grandchild’s education or other needs. You could fund the trust immediately (a “living trust”) or at your death (a “testamentary trust”). Generally, attorneys draw up the trust.
The Pros and Cons of Private Trusts.
A private trust gives you more flexibility than anything other than piggybank accounts. You can design the trust to have the least impact on financial aid options as possible. Funding and investment options will be completely up to you. Often life insurance is one funding option.
The trust will not by itself be tax-advantaged although it may invest in tax-advantaged instruments. Trusts cost time and money to establish and, if a living trust, to administer.
Trusts as a college funding approach by grandparents generally apply in two scenarios. First, wealthy families may integrate college funding into a broader income tax and estate tax strategy. Second, grandparents who do not feel comfortable making current contributions, but who may have life insurance benefits they wish to use for college.
A lot to consider, but boiling it all down results in this:
- College funding by grandparents is a valuable, needed and legacy gift
- Make sure your gift matches your own retirement needs
- Work with a qualified adviser
- Coordinate your giving and your distributions with the child’s parents