How to Fund Your Grandchild’s Education
One of the most important questions grandparents ask me as their estate planning advisor is how they can help their grandchildren with college expenses. It’s complex, with tax implications for the clients, and financial aid implications for their grandchildren. Here are five options I give them to start with:
1. Make direct tuition payments. Make the payments directly to the college. This way, you avoid gift and generation-skipping transfer (GST) tax without using up any of your gift or GST tax exclusions or exemptions.
But this strategy is available only for tuition, not for other expenses, such as room and board, fees, books and equipment. So you might combine it with other funding.
A disadvantage of choosing direct payments is that, if you wait until the student has tuition bills to pay, there’s a risk that you’ll die before the funds are removed from your estate. Other options allow you to set aside funds for future college expenses, shielding those funds from estate taxes.
If your grandchild is planning to apply for financial aid, also be aware that most schools treat direct tuition payments as a “resource” that reduces financial aid awards on a dollar-for-dollar basis.
2. Open a state-sponsored 529 plan. A 529 plan is simple and flexible. It allows the donor to contribute funds, with tax advantages, the money grows tax-deferred, and the proceeds are tax-free, if used for education expenses. The donor can keep control of the account, and determine what expenses should be allowed. The financial aid rules are complicated, but generally, the money in a 529 plan is considered as an asset of the parents, so 5.64% is deemed to be available for tuition. If the money in the account is not used for education, it can be redirected to another beneficiary, withdrawn by the donor or given to the beneficiary. If it is withdrawn by the donor or beneficiary, there is income tax and a 10% penalty on the earnings.
3. Start a Roth IRA. Grandparents who own a Roth IRA can name their grandchildren as primary beneficiaries. While the Roth IRA will be included in the grandparent’s taxable estate and so be subject to federal estate tax, in many cases the Roth IRA will pass to the grandchildren tax free if the total estate is less than the unused portion of the unified credit. The grandchildren can then avoid the 10% early distribution penalty and withdraw earnings tax-free even if they are under age 59-1/2. (For all distributions to be tax-free, a Roth IRA must have existed for at least five years before the distribution. Otherwise the earnings that accumulate after the contribution to the Roth IRA will be taxable.) Usually the grandchild must take a distribution of the entire amount by the end of the fifth year following the previous owner’s death. But until the grandchild takes a distribution, the Roth IRA is disregarded as an asset on the FAFSA. Distributions will count as untaxed income on the FAFSA, affecting the subsequent year’s federal student aid eligibility.
4. Set up a Section 2503(c) minor’s trust. Contributions to a Sec. 2503(c) minor’s trust qualify as annual exclusion gifts, even though they’re gifts of future interests, provided the trust meets these requirements:
- Assets and income may be paid to or on behalf of the minor before age 21,
- Undistributed assets and income will be paid to the minor at age 21, and
- If the minor dies before reaching age 21, the trust assets will be included in his or her estate.
When the beneficiary turns 21, it’s possible to extend the trust by giving the minor the opportunity to withdraw the funds for a limited time. After that, contributions to the trust no longer qualify for the annual exclusion, unless you’ve designed it to convert to a Crummey trust. Then, so long as you comply with the applicable rules, gifts to the trust will qualify for the annual exclusion.
5. Create grantor and Crummey trusts. These trusts offer several important benefits. For example, they can be established for one grandchild or for multiple beneficiaries, and assets contributed to the trust, together with future appreciation, are removed from your taxable estate. In addition, the funds can be used for college expenses or for other purposes.
On the downside, for financial aid purposes a trust is considered the child’s asset, potentially reducing or eliminating the amount of aid available to him or her. So keep this in mind if your grandchild is hoping to qualify for financial aid.
Another potential downside is that trust contributions are considered taxable gifts. But you can reduce or eliminate gift taxes by using your annual exclusion (for 2014, $14,000 per recipient; $28,000 per recipient for gifts by married couples) or your lifetime exemption ($5.34 million in 2014) to fund the trust. To qualify for the annual exclusion, the beneficiary must receive a present interest. Gifts in trust are generally considered future interests, but you can convert these gifts to present interests by structuring the trust as a Crummey trust.
With a Crummey trust, each time you contribute assets, you must give the beneficiaries a brief window of time, typically 30 to 60 days, during which they may withdraw the contribution. If a Crummey trust is established for a single beneficiary, annual exclusion gifts to the trust are also GST-tax-free.
As you can see, all of these options have risks and benefits. To determine the best option for your situation, please contact my office for an appointment at (626) 385-6303. We’ll find the best path for you and your grandchildren.