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A Grandparent’s Guide to Helping Pay for College Education
It is no secret the cost of higher education has increased dramatically over the years. This year, the average tuition for an in-state public university is about $30k/year and many top-tier private colleges now have sticker prices over $70k/year. And while financial aid offered by institutions has increased over time, the expected contribution by families is growing, too.
As shown in the chart below, salary growth has dramatically lagged tuition growth. As a result, parents and students are taking on more debt every year (now totaling over $1.4 trillion) to cover the gap left after contributing what they’ve saved and what they can pay out of their current income.
Grandparents who are willing and have the capacity to help fill that gap have many options and strategies available to them; but if not done carefully, this act of generosity can have some unintended impacts on the student’s financial aid eligibility, and on your tax liability.
Most families will rely on need-based financial assistance to help reduce their Expected Family Contribution (EFC), while others know well in advance that they will not qualify for financial aid based on their income and asset levels (generally, families with combined income over $250k/year and assets over $1 million will not qualify for financial aid, but some factors including the number of children in college at one time could make them eligible). Before selecting a strategy to support the scholar in your family, you’ll want to know where they stand with this.
If you’re inclined to start saving early and often for your grandchild’s education, there are a few notable types of savings accounts that you can choose from. Their features, benefits, and drawbacks are listed below:
Custodial Accounts (UGMA/UTMA) — These are easy to set up and inexpensive to administer. Grandparents can fund them with cash or transfer existing shares of stock or mutual funds into them. They are self-directed, so investment options are extensive and not limited to a preselected menu of funds. In 2018, annual contributions of $15,000 ($30,000 if split between spouses) or less are not subject to gift taxes. Custodial accounts are owned by the parent/grandparent while the child is under the age of majority, but the account becomes theirs when they reach that age. At that point, there is no guarantee the funds will be used for eligible college expenses and not on a new Harley Davidson. Perhaps the most important thing to be aware of with custodial accounts is the potential triggering of the “Kiddie Tax”, wherein any unearned income generated from the investments in the account over $2,100/year is taxed at higher rates associated with trusts and not at the child or parent’s likely lower tax bracket. Lastly, the balance of the account is viewed as a student asset on the FAFSA and will reduce the student’s eligibility by 20% of the account value.
Coverdell Education Savings Accounts (ESAs) — These are not as popular now as they once were, primarily because contribution limits have remained very low at $2000/year. The primary benefit is that the funds grow tax-free and can be withdrawn tax-free as long as the withdrawal doesn’t exceed the student’s qualified education expenses for that year. The account is owned by the parent/grandparent; however, there are some income restrictions that can affect the ability to contribute the full $2,000/year, with a phaseout starting at $190,000/year for married couples filing jointly.
529 College Savings Plans — These have emerged as the most popular account option for several reasons. Grandparents can open a 529 in their name as the owner with the grandchild as the beneficiary, or they can simply contribute to the parent’s 529 plan. 529 plans provide tax-free growth and withdrawals when the funds are used for qualified education expenses (tuition, room and board, books, computers, etc.) and up to $10k/year for K-12 private or religious school expenses. The $15k/year gift tax rules apply, but owners can elect to do a 5-year contribution of $75k as an initial deposit. These limits are doubled to $30k and $150k if the gifts are split between spouses. Every state sponsors a different plan, and plans can vary between states in terms of the tax credits, deductions, matching grants/contributions, investment options and expenses involved. 529 plans also have limited investment options determined by each state, and most will limit the number of trades or portfolio adjustments you can do each year. Funds held in a 529 owned by a grandparent will not affect a grandchild’s financial aid eligibility during their initial FAFSA submission; however, once a distribution is made to pay college expenses, that amount will be counted as student income on the following year’s FAFSA submission. For this reason, it is important to delay using grandparent-owned 529 funds for as long as possible. If the grandparent contributes funds to a parent-owned 529, which is counted as a parent asset (smaller impact) on the FAFSA, it can only reduce the aid eligibility by a maximum of 5.64% of the account value. Funding a 529 plan can also serve a useful estate planning purpose, as the funds are removed from the owner’s estate yet the assets still remain in the owner’s control, unlike they would if moved into an irrevocable trust.
In addition to traditional college savings accounts, grandparents can help pay for college in other ways too. Some of these include:
Paying tuition directly to the institution — This is a very simple and direct way to help. There is a tax-code exemption that allows individuals to pay tuition (not other related expenses) without being subject to the gift tax restrictions. Similar to paying tuition out of a 529 plan, this will impact the child’s financial aid eligibility as it will be treated as student income on the following year’s FAFSA.
Establish a loan for your grandchild — Grandparents can loan up to $10,000 interest-free, and loans over $10k only require a minimum interest rate determined by the IRS which is typically very low. The loan terms can be customized; however, if the loan is forgiven in the future, the grandchild may end up owing income tax on the amount of the debt forgiveness.
Pay off the student loan balance upon graduation — This strategy will not impact the student’s financial aid eligibility during their years of enrollment; but the loan payments will be considered gifts, so the amount given over $15k ($30k from married couples) will be subject to the gift tax. This amount, while helpful, will not come close to covering even one year of tuition, fees, room and board at current tuition levels.
Regardless of the route you choose, a trusted advisor can help you make the right choices during both the savings years and the distribution years. If you’d like to explore how to support your family’s future scholars in the context of your personal financial picture, we’d love to help. Call H.M. Payson at 207-772-3761.