College Education Planning for Grandkids

As the cost of a college education continues to climb, many grandparents are stepping in to help. Helping to pay for a grandchild's college education can bring great personal satisfaction and is a smart way to pass on wealth without having to pay gift and estate taxes. So what are some ways to accomplish this goal?

Outright cash gifts

A common way for grandparents to help grandchildren with college costs is to make an outright gift of cash or securities. But this method has a couple of drawbacks. A gift of more than the annual federal gift tax exclusion amount — $15,000 for individual gifts and $30,000 for gifts made by a married couple in 2018 — might have gift tax and generation-skipping transfer (GST) tax consequences (GST tax is an additional gift tax imposed on gifts made to someone who is more than one generation below you). Another drawback is that a cash gift to a student will be considered untaxed income by the federal government's aid application, the FAFSA, and student income is assessed at a rate of 50%, which can impact financial aid eligibility.

One workaround is for the grandparent to give the cash gift to the parent instead of the 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 a cash gift that can be used to pay off school loans. 

Pay tuition directly to the college

Under federal law, tuition payments made directly to a college aren't considered taxable gifts, no matter how large the payment. So grandparents don't have to worry about the $15,000 annual federal gift tax exclusion. But payments can only be made for tuition — room and board, books, fees, equipment, and other similar expenses don't qualify. 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, plus it removes the money from your estate. And you are still free to give your grandchild a separate tax-free gift each year up to the $15,000 limit ($30,000 for joint gifts).

However, colleges will often reduce a student's institutional financial aid by the amount of the grandparent's payment. So before sending a check, ask the college how it will affect your grandchild's eligibility for college-based aid. If your contribution will adversely affect your grandchild's aid package, particularly 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

Contributions to a 529 plan grow tax deferred, and withdrawals used for the beneficiary's qualified education expenses are completely tax free at the federal level (and generally at the state level, too). Participation in a 529 plan isn't restricted by income level and lifetime plan contribution limits are high, typically $350,000 and up (limits vary by state).

There are actually two types of 529 plans: savings plans and prepaid tuition plans. A 529 savings plan is an individual investment account where you direct your contributions to one or more of the plan's investment portfolios, similar to a 401(k) plan. Funds in the account can be used to pay total qualified expenses (i.e., tuition, fees, room and board, books, supplies) at any accredited college in the United States or abroad. Funds can also be used to pay K-12 tuition expenses, up to $10,000 per year. By contrast, the less common 529 prepaid tuition plan allows you to purchase college tuition credits at today's prices for use in the future at a limited group of colleges that participate in the plan, typically in-state public colleges.

A big advantage of 529 plans is that under special rules unique to 529 plans, individuals can make a single lump-sum gift to a 529 plan of up to $75,000 and married couples can make a joint gift of up to $150,000 (which is five times the annual gift tax exclusion) 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, and no additional gifts can be made to the beneficiary during this time.

The big draw-back of a 529 plan? The value of a 529 plan owned by a dependent student or one of their parents is considered a parental asset on the FAFSA.  Any parental assets beyond a specific amount will reduce a student's aid package by a maximum of 5.64% of the asset's value.

Life Insurance

Our final solution and often the most missed is the utilization of life insurance cash values to help pay for a student's college tuition. Why is the solution so powerful? 

The cash value of a life insurance policy is not reported as an asset on the FAFSA. The cash value can also be accessed to tax free. 

If a parent or grandparent contributes annually to a life insurance policy for a child without violating the Modified Endowment Contract (MEC) rules, the policies cash value will grow without taxation and the parent can take tax free loans off of the policy when it's time to pay for college tuition. There are no "contribution limits" and you can take loans off the cash value in any manner you wish, provided the policy allows for this. And unlike a 529 plan, if the child decides not to go to school they can take loans tax free from the cash value of the policy for something else, like buying their first home or starting their first business. This is much more flexible than accounts designed only for education. 

Most importantly, this strategy does not impede the child's ability to receive financial aid. 

If you are Interested in any of these education planning options, please contact us at 480-818-8300.