Grandparents Can Help Fund Education: Tips from a Financial Advisor
Grandparents can show their love on special occasions by supporting their grandchildren's education. Many grandparents want to help ensure a bright future for their grandchildren.
Contributing to their education costs is a great way to start. Opening a 529 plan or another type of educational savings account could be a thoughtful and valuable gift.
The first step is to initiate an open family discussion.
Once everyone is aligned, grandparents can explore the most tax-advantageous options for their contributions.
Contributing Wisely
Grandparents looking to support their grandchildren's education can consider 529 college savings plans, which provide a versatile mix of tax benefits, control over the funds, flexibility, and minimal impact on financial aid eligibility.
Advantages of a 529 Plan
Tax Benefits: Contributions to a 529 plan are made with after-tax dollars, but any earnings and withdrawals are exempt from federal income taxes when used for eligible education expenses. This can include up to $10,000 annually for K-12 tuition, $10,000 toward student loan repayments, and certain apprenticeship costs. While there’s no federal tax deduction for 529 contributions, some states offer tax deductions, credits, or other benefits based on where the plan was opened or the contributor’s state of residence.
Flexibility: At the college and graduate level, 529 plans cover a wide range of costs, such as tuition, fees, books, supplies, and other qualified expenses. The funds are also excluded from the account holder's estate for estate tax purposes once the annual gift is made. Starting in 2024, the IRS allows for some 529 funds to be transferred to Roth IRAs under certain conditions, making them a useful tool for retirement planning as well.
Control: Grandparents who open a 529 account with a grandchild as a beneficiary retain control over the funds. They can decide when to make withdrawals or even change the beneficiary if needed. Alternatively, they can contribute to a 529 plan owned by the child’s parent, though this might affect the student’s eligibility for financial aid.
Front-Loading Contributions: In 2024, grandparents can front-load a 529 plan with up to five years' worth of gifts at once—up to $90,000 per grandchild—without incurring gift taxes or affecting the lifetime gift tax exclusion. However, this means no additional tax-free gifts can be made during the five-year period, and if the grandparent passes away within that time, some contributions could be pulled back into their estate.
Minimal Impact on Financial Aid: Recent changes to the FAFSA mean that 529 accounts owned by grandparents are no longer reportable assets, which avoids any negative impact on a grandchild's eligibility for financial aid. However, other forms, like the CSS Profile, may still ask about expected support from relatives. It’s always a good idea to consult with a financial or tax professional to fully understand how these factors might apply to your situation.
Drawbacks to Consider
Limited Investment Choices: While 529 plans offer a variety of investment options, including age-based funds that automatically adjust as the child gets closer to college age, the range of choices is not as broad as in other education savings accounts. This could be a drawback for those who prefer more hands-on investment management.
Penalties for Non-Educational Withdrawals: If the 529 funds are not used for qualified education expenses, the earnings may be subject to federal income taxes and a 10% penalty. This makes it important to carefully plan the use of these funds.
Medicaid Concerns: For grandparents considering Medicaid in the future, owning a 529 account can be problematic. These accounts are counted as the grandparent's assets, which could affect eligibility for Medicaid assistance.
Alternative Savings Options
Parents or grandparents may also consider opening a custodial account, such as an UGMA (Uniform Gifts to Minors Act) or UTMA (Uniform Transfers to Minors Act) account, to save for a child's future. These accounts offer a wide range of investment choices and do not impose contribution limits. However, the child will gain control of the funds once they reach the age of majority, which varies by state but is often 18.
Additionally, grandparents should be mindful of gift tax limits, which are set at $18,000 per recipient in 2024. It’s essential to be prepared to relinquish control of the funds and understand the tax consequences.
Impact on Financial Aid
Custodial accounts may reduce eligibility for student aid since they are considered a student asset and are factored into the Student Aid Index (SAI) at a rate of 20%. This is significantly higher than the 2.6% to 5.64% rate applied to parental assets.
Advantages of Custodial Accounts
● Variety of Investment Choices: Custodial accounts provide a broader range of investment options compared to 529 plans, which can be appealing to those who prefer to actively manage their investments.
● No Contribution Limits: There are no restrictions on the amount or type of assets you can contribute to a UGMA or UTMA account. However, because contributions may have tax implications, it's advisable to consult with a tax professional to understand any gift tax considerations.
Disadvantages of Custodial Accounts
● Loss of Control Over Funds: The custodian manages the account until the child reaches the age of majority, usually 18 or 21, depending on state regulations. At that point, the beneficiary gains full control of the funds and can use them for any purpose, which may be concerning if the money is not used wisely or for educational expenses.
● Reduced Student Aid Eligibility: Custodial accounts are considered student assets, which are assessed at a higher rate (20%) for financial aid purposes compared to parental assets (2.6%–5.64%).
● Potential Tax Liabilities: Earnings from interest, dividends, and capital gains in a UGMA or UTMA account are reported under the child’s Social Security number. For the 2024 tax year, unearned income between $1,300 and $2,600 is taxed at the child's rate, while unearned income above this threshold is taxed at the parent's marginal rate. The standard deduction for minors in 2024 is the greater of $1,300 or earned income plus $450, up to a maximum of $14,600. It's important to understand how these investments are taxed under the "kiddie tax" rules.
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Also, unlike 529 plans, the assets in a UGMA or UTMA account count as part of the custodian's estate. This includes the parent or grandparent's estate for tax purposes until the child receives the funds.
Additional Savings Options
Coverdell Education Savings Accounts (ESAs) offer another avenue for saving for educational expenses, providing tax-deferred growth and potential tax-free withdrawals if the funds are used for qualified education costs, from kindergarten through college. However, these accounts come with certain eligibility requirements and contribution limits.
Advantages of Coverdell ESAs
● Versatility: Coverdell ESAs can be used to pay for a wide range of educational expenses, from kindergarten through college, making them a flexible option for families.
● Tax Benefits: Earnings and withdrawals from a Coverdell ESA are tax-free when used for qualified education expenses. However, if you plan to claim an American Opportunity Credit or Lifetime Learning Credit, you must use those credits for different expenses than those covered by the ESA withdrawal in the same year. Additionally, once contributions are made to a Coverdell ESA, the funds are excluded from the contributor's estate for estate tax purposes.
● Broader Investment Choices: Coverdell ESAs offer a wider selection of investment options than many other education savings plans, appealing to investors who want more control over their investment choices.
Disadvantages of Coverdell ESAs
● Low Contribution Limits and Potential Confusion: The annual contribution limit for a Coverdell ESA is $2,000 per beneficiary, regardless of the number of accounts. This limit can be reached quickly if multiple family members contribute, and exceeding it can result in penalties. To avoid this, clear communication among family members is essential.
● Age Restrictions: Coverdell ESAs must be set up for beneficiaries under 18, and contributions made after the beneficiary reaches 18 may incur a 6% penalty tax. Additionally, the funds generally need to be used by the time the beneficiary turns 30, or they must be withdrawn within 30 days of the beneficiary's 30th birthday.
● Income Limitations: There are income restrictions on who can contribute to a Coverdell ESA. For the 2024 tax year, the ability to contribute phases out for single filers with a modified adjusted gross income (MAGI) of $95,000, ending at $110,000. For joint filers, the phase-out begins at a MAGI of $190,000 and ends at $220,000.
● Limited Control: Most Coverdell ESAs are managed by the child's parent or guardian, which means a grandparent might lose the ability to transfer the funds to another beneficiary or withdraw them for other purposes. However, grandparents are still allowed to open a Coverdell account themselves.
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Coverdell ESAs offer unique benefits, but it's crucial to consider the limitations and requirements to determine if they are the right fit for your family's educational savings strategy.
Finding the Best Strategy for You
Parents and grandparents might find it beneficial to combine features from different savings plans by opening a custodial 529 plan, also known as a UGMA/UTMA 529 account. This type of account blends elements of both custodial accounts and traditional 529 plans but comes with its own unique rules.
Unlike a standard UGMA or UTMA account, a custodial 529 plan requires that the funds be used for qualified college expenses once the student assumes ownership; otherwise, penalties may apply. Additionally, a custodial 529 is treated as a parental asset for financial aid purposes, even when the student takes control of the account, which is different from a traditional custodial account that is always counted as the child’s asset.
Contribution limits for a custodial 529 plan follow the rules for traditional custodial accounts, adhering to the federal annual gift tax exclusion, which is $18,000 per recipient for 2024. However, unlike a standard 529 plan, accelerated gifting (contributing five years' worth of gifts at once) is not an option with a custodial 529 plan.
Alternatively, grandparents can opt to pay tuition directly to the educational institution. For estate planning, this method is advantageous because such payments are not considered gifts, allowing grandparents to still use their annual gift exclusion to give up to $18,000 to the same grandchild. However, this approach forfeits the years of tax-free growth that a 529 plan or Coverdell ESA could offer.
Bottom Line
For many grandparents seeking a tax-efficient way to help fund their grandchildren’s education, 529 plans can be an appealing option, but they might not be suitable for everyone. It's important to carefully assess your family’s unique financial situation and discuss the options with your loved ones. Consulting with a financial advisor can also help you navigate the choices and make the best decision.
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Disclosures:
This information is an overview and should not be considered as specific guidance or recommendations for any individual or business.
This material is provided as a courtesy and for educational purposes only.
These are the views of the author, not the named Representative or Advisory Services Network, LLC, and should not be construed as investment advice. All information is believed to be from reliable sources; however, we make no representation as to its completeness or accuracy. Please consult your Financial Advisor for further information
