This past year, we have had several clients who have wanted to help their grandchildren by making financial contributions toward their college tuition. Confusion arises for grandparents as to the proper way to set up college funds for grandchildren. It can be difficult since the answer will depend on each grandchild’s family and their specific financial aid position. A simple error could cost a grandchild thousands of dollars of financial aid and hurt the ones who probably need the money the most. Currently, grandparents can help their grandchildren by using different saving vehicles such as U.S. Saving Bonds, Coverdell Saving Accounts, 529 plans and gifting strategies.
What grandparents and their advisors often do incorrectly is use a cookie cutter approach to solve the college affordability problem. Due to the financial diversity of many families, the grandparents need to understand the financial aid positioning of each grandchild to maximize both their resources and the potential financial aid that each specific grandchild could receive.
Grandchild’s financial aid positioning
The free EFC calculator on our website will enable a family to calculate an estimate of their financial aid position. If your EFC number is close to or less than the cost of the college, a student may receive need-based aid. The cost of a college is also called the cost of attendance and includes tuition, room, board, books, travel, and personal living expenses. For some elite colleges, that total cost is approaching $70,000 per year.
Need based aid can come in the form of scholarships, grants or other forms of financial aid. Why is this number important in relation to the gifting for the grandparent? Need based financial aid is determined by the student’s EFC or Expected Family Contribution. If you subtract the cost of attendance from the Expected Family Contribution, your result is the student’s need at a college. This will vary by college.
If a student is not going to receive any need-based aid, the risk of making a mistake by gifting is reduced significantly. If the student will be receiving need-based aid for college, any taxable event could be counted as income for the student and may reduce their current and future financial aid. This is why understanding the financial aid position is so important.
Listed below are the various saving plan options that grandparents can consider.
US Saving Bonds
US Saving Bonds are a common college saving vehicle purchased by grandparents as an initial college saving fund. Two things need to be considered when purchasing a US Savings bond. The first is how the bonds should be titled and the second is the income limits of the grandchild’s parents. The bonds should be titled using one of the child’s parents name and social security number. The income limit will vary based on how the family files their taxes at the time when the money will be used for college.
If the bonds are not titled in one of the parents name and the income exceeds the annual limit of the tax filer at the time when the bond is cashed, then the tax-free benefit will not be attainable. This is a limitation of U.S. Saving Bonds. U.S. Bonds can be converted to a 529 Plan if you feel that the future income limitation may become an issue.
Coverdell Saving Accounts
The Coverdell Saving Account can be set up as an investment option to establish a broader educational funding program. A Coverdell Saving Account is also often called an Educational IRA.
There are two major advantages to establishing a Coverdell Saving Account. The first is that the money can be used for elementary, secondary school and college tuition for qualified educational expenses. It also offers the broadest investment flexibility since the investor is not limited to a fixed portfolio and can invest the money in many types of investment vehicles.
There are two major limitations to this college saving option. There is a $2,000 dollar per beneficiary per year limit from all resources. There are also income limits to participate in this plan and this will vary based on the tax filing status of the child’s parent.
Grandparent-owned 529 plan
The most common solution recommended by financial professionals is a 529 Plan, as they provide a good option for saving for college. A 529 Plan is a great way for a grandparent to help a family member while still keeping control of their money. The money in a 529 Plan grows tax-free if used for qualified educational expenses. Some states offer an income tax deduction for contributions to their plans. One benefit is that different investment options exist within these plans, both on a risk-level and age-based portfolio basis. The 529 plans are usually categorized as either prepaid or savings, although some of them have elements of both. It is important for the grandparent to gift this money correctly.
Analyzing the financial aid position of the family will determine if the gift will jeopardize any eligible future financial aid. Timing of when to use the money needs to be managed if the student qualifies for need based financial aid. As a grandparent liquidates the account this becomes a taxable event and may appear as income on the student’s tax transcript. This means if it is not properly liquidated then the grandparents’ 529 plan could result in a reduction of the student’s need based financial aid and again possibly hurt the grandchild who may need the financial help the most.
Another great advantage of the 529 Savings Plan for grandparents is that money placed in the plan is considered a completed gift which may help for estate planning. Please remember, any gift from a grandparent who may qualify for Medicaid should evaluate the look back period before the investment is made.
When choosing a 529 plan, the state of the parents and the state of the grandparents should be part of the decision. This will depend on each family’s situation but in some cases gifting the money to the parents can be an advantage since the parent’s state plan may have additional benefits such as an income tax deduction or a pre-paid program that the grandparent’s state plan does not offer. A grandparent may also need to consider the stability of their child’s marriage before making this decision. If you gift the money to your child for them to open the 529 account, it becomes their money. If a divorce or a financial crisis arises, they have access to that money and decisions on the use of this money may change from your initial intention. If a grandparent uses this option, it will raise the parents EFC since they would need to report this money as an asset in the financial aid process.
Pay directly to college
Another option is for grandparents to send a check directly to the college. This occurs frequently when a grandparent tries to reduce assets for estate-planning purposes. Tuition is one of the few items that can exceed the gift tax limits if the money is paid to the college directly. We do not usually recommend this option until you know the financial aid position of the student.
If the grandchild qualifies for need based financial aid, the school could reduce the student’s financial aid by the amount received from the grandparent. If could possibly reduce financial aid dollar for dollar. It is also not considered a taxable gift for the grandparent while the 529 plan is.
There are more advanced strategies of gifting strategies that can be considered related to tax harvesting. The receiver could be the parents, the child, or both, depending on the amount of the money. Please seek the advice of your financial advisor or tax expert before using these advanced strategies.
For some grandparents setting up a trust is done for estate planning or asset protection reasons. If the child or grandchild is listed as a beneficiary of the trust than their portion of the trust value will need to be reported as an asset under both financial methods.
Many trusts are setup for complex personal reasons. Others are set up as a simple solution for estate planning. This type of investment disregards the financial aid position of the individual family members. If this is not considered in the goal planning of the trust, it may hurt the grandchild who needs the funds the most. This should be discussed with an estate attorney before designing the trust.
There are many options available for grandparents when creating a college saving plan for their grandchildren. When reviewing your options evaluate retirement and financial aid timing before you make a decision. Creating a priority list of your own goals will improve this decision process. Getting the proper advice and making the right decision will enable you to create a saving plan and help your grandchild pay for college. Another interesting article to read is titled, “The Best Ways to Help a Grandchild with College” written by John Wasik.