Grandparents’ Gifting for College Education
by Dawn Brown
Within families, each generation wants the next to be better off. It is no wonder, then, that many grandparents want to help their grandchildren by assisting with college education costs. Particularly now, when parents may have stretched budgets, this financial help can be very welcome.
Grandparents have many options when making gifts for college. However, before considering these options, grandparents need to consider their own financial position. Grandparents need to ensure that they are financially secure for their retirement before starting college savings funds. They certainly do not want to be in the position of giving money and then finding out several years later that they do not have enough to support their own retirement or pay for their own medical care, including long-term care. By determining their own financial needs ahead of time, they will have a better understanding of how much they can safely give without jeopardizing their own situation. (A financial planner can help with this.)
Recently, we helped a grandfather set up seven 529 plans (529 plans are described below), one for each of his grandchildren. We based asset allocations on their ages, which ranged from one to 12, with the younger ones having more aggressive allocations. We also worked with him on determining the contribution level for each grandchild, taking into account his total desired contribution for each year and his goal of equalizing the total amount to be received by each grandchild.
Determining Amount to Contribute
Once grandparents know they have the financial security to meet both their future expenses and contribute to a grandchild’s education, they need to consider how giving will impact their tax situation. Gift laws, in general, tax the person making the gift, not the person receiving it. However, most people making gifts never have to pay taxes on them.
Unless the total amount given to any one person in any one year exceeds what is called the annual exclusion (currently $13,000 for single tax filers and $26,000 for married joint filers who choose to split the gift), it does not count as a taxable gift or require a gift tax return to be filed. Furthermore, under current law, each individual can make up to $1 million in total taxable gifts in his or her lifetime before paying gift taxes. Any amounts over $1 million are currently subject to tax at a rate of 35%. Some 529 plans provide a state tax deduction for contribution to plans.
Keep track of any contributions made, since 529 plans are only required to issue tax Form 1099 for distributions, not contributions. However, contributions will be listed on the statements for the periods they are received. (Consult a tax professional if you have questions about how the gift laws apply to your personal situation.)
Grandparents should also think about how gifting for college fits into their overall estate plan. Are they giving money now instead of leaving an inheritance? Are they treating all the grandchildren equally, or have they decided to help those whose parents need help the most? Whatever the decision is, grandparents should consider communicating their intentions to family members.
The amount to contribute to a college fund will depend, in part, on how much the parents and student are contributing, and, as mentioned earlier, how much the grandparents can afford to give without harming their own retirement security. Some savings tools, such as Coverdell accounts (described below), have maximum annual contribution amounts per beneficiary. Hence, coordination of contributions is important; otherwise, an excise tax has to be paid on the excess contribution.
Is the goal to fully fund college costs? According to Collegeboard.com, the average cost to attend a public college in 2009–2010 was $7,020. A private four-year college cost was considerably more expensive, averaging $26,273. Schools like Harvard in Cambridge and Columbia University in New York City were even higher at $52,000 and $54,000, respectively, though financial aid may be available.
Over the past decade, the cost of tuition and fees has increased by about 5% annually. It is hard to predict where a child will go to college, but knowing the cost and rate of increase can help determine how much is called for in gifts. Projections can be run to see how much needs to be saved each year to meet the goal.
Financial aid consists of grants, scholarships, loans and work-study aid. The balance is expected to be paid by the student and his or her family—this is often referred to as the Expected Family Contribution EFC. The EFC calculation is determined by the federal government or the school providing the aid. It is calculated each school year and considers both the child’s and parents’ incomes and assets (see Table 1).
|The Expected Family Contribution (EFC) toward college costs is calculated based on the following percentages.|
|Parents||from 22% to 47%||up to 5.6%|
At the federal level, the financial aid form FAFSA (Free Application for Federal Student Aid) does not ask about grandparents’ savings for the child. However, it is possible that an individual school could ask and use that in their decisions about financial aid.
According to the Trends in Student Aid 2009 report from the College Board, more than 50% of financial aid is in the form of loans. Grants account for about 40% of aid. The average debt per borrower attending a four-year college was about $22,700 in the school year 2006–07, up from about $19,300 in 2000–2001. This reflects a 15% increase over six years.
With loan aid and debt levels increasing, gifts from grandparents will be helpful. However, if gifts are made directly to the child, they can have a large impact on financial aid, since the child’s assets are a larger part of the expected family contribution. The savings accounts that can be used to save for college are subject to their own rules in connection with financial aid.
Common College Savings Plans
UGMA/UTMA accounts are custodial accounts set up for a minor child to own assets (Uniform Gifts to Minors Act/Uniform Transfers to Minors Act). The funds in the account are classed as an irrevocable gift to the child—once the money is given, it cannot be taken back. All of the assets in the account must be used for the benefit of the child. When the child turns 18 or 21, depending on the laws of the specific state, he is eligible to take full control of the account and use the funds as he chooses. (Until the child reaches the specified age, the custodian who set up the account controls it.) There is no favorable tax treatment for using UGMA/UTMA accounts as savings vehicles for college. In addition, because the child will become the owner of the account, these assets will count as being 20% available toward the cost of college and may reduce the amount of financial aid the child receives. One advantage of UGMA/UTMA accounts is the large amount of investment flexibility that they provide.
Coverdell Education Savings Accounts
A Coverdell Education Savings Account (formerly known as an Education IRA) is established specifically to pay qualified education expenses. This currently includes kindergarten through 12th grade, but this provision (to cover qualified expenses for grades K–12) is set to expire at the end of this year. Contributions to these accounts can be made up to age 18 and all funds must be distributed by the time the child reaches age 30. The current maximum annual contribution limit to a Coverdell account is $2,000 per beneficiary. This is scheduled to fall to $500 in 2011 unless Congress moves to maintain the higher limit. This is a low contribution level and must be coordinated with any amounts being contributed to a Coverdell by someone else for the same beneficiary. As a result, the potential benefit is limited. If the contribution is exceeded, the beneficiary owes a 6% excise tax on the excess for each year it remains in the account.
Another benefit that expires at the end of this year is the ability to use Coverdell funds and claim a Hope Credit or Lifetime Learning Credit in the same year.
Withdrawals from these accounts are federal-tax-free when used for qualified education expenses, but earnings on amounts not used for qualified expenses are taxable and are subject to a 10% penalty. As with the UGMA/UTMA accounts, the investment choices for Coverdell accounts are varied.
529 College Savings Plans
Section 529 college savings plans fall under two main categories, prepaid plans and savings plans. According to a College Board Trends study, about 85% of 529 assets are in savings plans. Assets within all 529 plans grow tax-free, and all qualified distributions are tax-free.
Prepaid plans allow you to prepay the cost of college at an in-state public college years in advance, enabling the student to benefit if college costs grow faster than the amount saved. If the child decides to attend a private college, the funds can be used toward those costs, but will likely cover a lower portion of the tuition costs. Usually, either the student or the person funding the account is required to be a state resident to open one. Prepaid plans may be backed or guaranteed by the state. Read through the plan details prior to opening an account. About 20 states offer prepaid plans, but five of these no longer accept new applicants.
Another type of prepaid plan, the Independent 529 Plan, applies to private colleges, with 274 schools currently participating. These plans provide wider flexibility than the in-state prepaid plans. If the child decides not to attend one of the participating colleges, he can roll the funds into a 529 savings plan. The investments available in the Independent 529 plan are currently from TIAA-CREF. Later this year, Oppenheimer Funds will become the investment manager.
The 529 savings plans are better known and more widely preferred to the prepaid plans. These plans are run by the states, which choose an investment manager through whom the investment choices are offered. Funds saved in a 529 savings plan can be used at accredited colleges throughout the United States and even at some foreign institutions, with all investment earnings being tax-free as long as the account funds are used to pay qualified college expenses (tuition, room and board, etc.). Some states also offer tax benefits for residents contributing to 529 plans.
Instead of annual contribution limits, 529 savings plans have overall contribution limits that are determined by each state. These generally range from about $250,000 to $350,000. All contributions are classified as gifts to the beneficiary of the account. However, for financial aid purposes, when a child owns a 529 plan, it is counted as the parents’ assets, not the student’s. This gives 529 savings plans an advantage over UGMA/UTMA accounts.
The 529 savings plans also benefit from a special gift tax rule that allows five years of gifts to be contributed in one year. In other words, a grandparent can contribute $65,000 in one year and count it as five equal installments of $13,000, keeping each one within the annual exclusion limit. (However, grandparents who choose to do this may not get the full benefit of a state tax deduction for four out of five years.)
There is no current limit on when the assets must be withdrawn from these plans, and the beneficiary may be changed to another family member (including a sibling, parent or first cousin). However, if funds are withdrawn and not used for qualified education expenses, the earnings will be taxed and will be subject to a 10% penalty. Exceptions are made if the student dies, becomes disabled or receives a scholarship.
The 529 savings plans offer limited investment choices—usually age-based options that automatically become more conservative as the child gets closer to college age, or a selection of individual choices. Investment changes may be made only once a year or with a change of the beneficiary.
In addition to their own 529 plans, some states offer alternatives through a financial advisor. Before choosing a plan sold through an advisor, be sure to understand the fees and compare them to the state’s direct plan. Also, people are not bound to their own state’s 529 plan (although there may be tax advantages to staying in state). Grandparents are wise to look at the options offered by different states, focusing in particular on fees and investment choices.
Some grandparents may be more familiar with savings bonds than some of the accounts mentioned above. Though some EE savings bonds and I Bonds may be eligible for favorable tax treatment if used for education, they have to fulfill certain criteria. To be excluded from income when redeemed, the bond must be used to pay for qualified education expenses for yourself, your spouse or a dependent. In addition, if your modified adjusted gross income is more than $85,100 for filing single or $135,100 for filing married, the interest is not excludable.
For grandparents who surpass the income levels or cannot claim their grandchild as a dependent, one of the aforementioned accounts may be a more beneficial option.
Choosing a Plan
In sum, different types of college savings accounts offer different advantages: The 529 plans and Coverdell accounts offer better tax benefits than UGMA/UTMA accounts, as well as a financial aid advantage. The Coverdell and UGMA/UTMA accounts offer wider investment choices, but the Coverdell also has the most restrictive contribution limit.
A combination of accounts can be established to achieve more flexibility; just be sure that you understand the rules applicable to each.
Investments within these plans should be age-appropriate. Accounts for the benefit of infants can generally be invested more aggressively than those for teenagers, as you have more years to deal with market fluctuations. Sample, age-appropriate allocation strategies are presented in Table 2.
|Newborn to 4||80%||20%|
|5 to 10||65%||35%|
|11 to 15||45%||55%|
|16 to 18||25%||75%|
|19 or older||0%||100%|
In UGMA/UTMA and Coverdell accounts, choices can be made from the universe of stocks, bonds, mutual funds or exchange-traded funds. The choices for 529 plans are restricted to those the investment manager decides to offer in the plan.
Pay the University Directly
Another gifting option, particularly for affluent grandparents whose grandchildren are ready to enter school, is to pay the money directly to the school. Contributions that are made directly to college for tuition do not count against the $13,000 annual gift exemption or the $1 million lifetime exemption. One caveat is that a direct contribution to the school could have a negative impact on financial aid.
College Savings Accounts: Advantages and Disadvantages
Advantage: Provides more investment choices
Disadvantage: Irrevocable gift, may reduce amount of financial aid
Coverdell Education Savings Account
Advantage: Offers more investment choices and a financial aid advantage
Disadvantage: Has the most restrictive contribution limit
Section 529 College Savings Plan
Advantage: Offers better tax benefits and a financial aid advantage
Disadvantage: Investment options are limited
Coordinate Tax Credits
Tax credits are available for education and should be coordinated with distributions from plans to preserve their benefits. The American Opportunity Credit, which effectively replaced the Hope Credit in 2009 and 2010, provides up to $2,500 for each of the first four years of college. The American Opportunity Credit goes away in 2011, bringing back the Hope Credit with its limit of up to $1,800 for each of the first two years of college. The Lifetime Learning Credit provides up to $2,000 per tax return for undergraduate and post-graduate studies. These credits cannot be combined, and if withdrawals are made from a Coverdell or 529 plan to pay qualified expenses, the credit cannot be claimed for those same expenses.
Giving Non-Financial Help
Finally, there are other ways that grandparents can give to their grandchildren that do not involve finances but time. Grandparents can help search for scholarships or help grandchildren study and improve their SAT scores. Both grandparent and grandchild will likely appreciate the time spent with each other.