Often, our clients who have grandchildren ask us for guidance on tax-efficient strategies for helping to fund their grandchildren’s education.
As with any financial decision, there are tax and other ramifications for everyone involved — the grandparents, the adult children and the children whose higher education is being funded.
The first step in this process is to speak with your adult children to find out what plans they might already have in place for their children’s education. You want to be sure you are helping in a way that aligns with their vision.
The second step is to work with your financial advisor, once you know what your adult children have in mind, to set up a plan that works for everyone involved. Some of the tax implications regarding college funding differ by state, so you want to make sure you consult with an advisor in the state where you live.
Here are just a few strategies for funding your grandchildren’s education, along with some of the pros and cons of each.
1. A 529 plan is the most common type of college savings account
The 529 college savings plan is a popular choice for many people because it offers some great tax advantages, as well as control, flexibility and minimal impact on grandchildren’s ability to qualify for student aid. The gains on 529-fund investments build tax-free, and the beneficiaries (the children) pay no tax on withdrawals from the account as long as they use the funds for qualifying educational costs.
As a grandparent, you can open a 529 and maintain total control over it, deciding when to make contributions. Or you can make contributions to a 529 account that’s owned by your grandchildren’s parents, in which case they maintain control of the account.
These plans aren’t just for four-year colleges and universities; students can also use 529 funds for qualifying two-year associate degree programs, trade schools and vocational schools — both in the United States and abroad. You also can use a 529 plan to pay for education at a private high school. Please consult with your advisor because there are various state laws and restrictions to work around when doing so.
Some of our clients hesitate to set up 529 plans because they aren’t sure their grandchildren will pursue higher education. Not to worry. If you set money aside in a 529 plan and end up not being able to use the money for your grandchild’s education, you can change the beneficiary to another child or relative. You also have the option of using that money to fund your own education if you decide to return to school for a degree!
Also, did you know you can establish a 529 plan before you even have grandchildren? You can set up a plan and name yourself as the beneficiary. And then, when grandchildren come along, you can name them as the beneficiaries. Now, that’s planning ahead!
How a 529 plan affects a student’s financial-aid eligibility
One downside of a 529 plan is that if you save money in a 529 plan for your children, it can affect their ability to receive need-based financial aid; however, this money will not affect their ability to qualify for merit-based financial aid. If the child’s parents are high earners, this probably won’t be an issue because they aren’t likely to qualify for financial aid anyway. The great news is that a 529 plan that’s set up by a child’s grandparents does not affect need-based financial aid (or merit-based aid). Colleges and universities do not include money that is set aside in a grandparent’s 529 plan in a grandchild’s Student Aid Index (SAI) calculation.
Tax implications of a 529 plan
Now, when it comes to taxes, the contributions you make to a 529 plan are after-tax, but earnings on the plan, and withdrawals, are federal-income-tax-free when used for qualified education expenses. This includes up to $10,000 in tuition expenses for elementary, middle school or high school education. Also, students can spend up to $10,000 from a 529 account to repay qualified student loans and expenses for certain apprenticeship programs. Although there are no federal deductions for 529s, some states do offer deductions on in-state plans.
Your grandchildren can use 529-plan funds accredited educational institutions for tuition, books, fees, supplies and other qualified expenses. In addition, once the annual gift has been made to the 529 plan, that money is no longer considered to be part of the parents’ or grandparents’ estate, for estate-tax purposes. As of January 1, 2024, the IRS began allowing 529-to-Roth IRA transfers under certain conditions.
One of the best benefits of saving for your grandchild’s future college education with a 529 plan is that your contributions are considered gifts for tax purposes. In 2024, gifts totaling up to $18,000 per individual will qualify for the annual gift-tax exclusion. If you and your spouse have three grandchildren, you can jointly give $108,000 without gift-tax consequences because each child can receive $18,000 in gifts from you and $18,000 from your spouse. The annual gift-tax exclusion amount includes non-529 gifts, so be sure to include any cash or property gifts in your total.
If your total gifts to one child will be more than $18,000 in 2024, the excess amount will count against your lifetime estate and gift-tax exemption, and you must report it on Form 709 when you file your taxes. In 2024, individuals can gift up to $13.61 million without paying federal estate or gift tax (up from $12.92 million in 2023). There is no joint gift-tax return, so you and your spouse must file separately.
Also in 2024, individuals may contribute as much as $90,000 to a 529 plan, but they have to treat the contribution as if it were spread over a five-year period. This is called the “five-year election,” and you must report it on IRS Form 709 for each of the five years.
Critical information to know if you’re on Medicaid
Another “con” that’s important to know about with 529 plans is that grandparents who own these accounts for their grandchildren could possibly lose their Medicaid assistance.
When Medicaid evaluates a grandparent’s means, assets you have in a 529 plan for your grandchildren are considered to be assets. If you needed to go to a nursing home, you would have to exhaust all the money in that 529 account before Medicaid will pay your nursing-home bills. Not only that — if you spend the money in your grandchild’s 529 account for your own medical bills instead of your grandchild’s college education, it will trigger deferred taxes, plus penalties of 10 percent (or up to 20 percent in some states).
Are 529 plans FDIC-insured?
A September 2023 Saving for College study found that there are 29 different 529 plans offered by 21 states that offer investment options insured by the Federal Deposit Insurance Corporation (FDIC), including high-yield savings accounts and bank certificates of deposit (CDs). FDIC-insured investments are suitable for families who want to preserve capital in their 529 plan without taking on excess risk. Your advisor can help you determine which plans are FDIC-insured.
You can see why it is incredibly important that you work with your financial advisor! You want to make sure you help your grandchildren in a way that does not put your own finances in jeopardy.
2. One alternative to a 529 plan is a custodial account
The 529 plan isn’t for everyone. Again, your advisor will guide you in selecting the plan that’s best for you and your family.
One alternative to 529 plans is custodial accounts. Typically, the parents are the custodians, and the children are the minors. Depending on where you live, there is a certain “age of majority,” which is age 18 in some states and age 21 in others. That’s the age at which those assets will automatically become the minor’s.
These accounts give minor children the ability to save and invest money for the future. However, a potential disadvantage of a custodial account is that once the child reaches the age of majority, he or she can spend the money on anything at all — a car of something else —and not necessarily on educational expenses.
Another downside is that these accounts will be counted toward the student’s financial-aid calculation.
A more official name for custodial accounts is “UGMA/UTMA,” which stands for “Uniform Gifts to Minors Act/Uniform Transfers to Minors Act.” This is a brokerage account for investing in stocks, bonds, mutual funds and other types of assets. One “pro” about these accounts is that there are no income or contribution limits, and there are no early-withdrawal penalties or restrictions for how the student can use the funds.
3. Another alternative to a 529 plan: A Roth IRA
Another alternative to a 529 plan is to set up a Roth IRA in your grandchild’s name. To do so, the child (not you) must have earned income from a job during the year for which a contribution is made. As the grandparent, you can fund the annual contribution, up to the maximum amount, but only if the child has earnings. The IRS doesn’t care where the money comes from as long as it does not exceed the amount your child earned.
For example, if your grandchild earns $500 from a summer job, you can make a $500 contribution to the Roth IRA with your own money, and your child can do something else with his or her earnings. If your child is a minor, depending on the state of residency, many banks, brokers and mutual funds will let you set up a custodial or guardian IRA. As the custodian, you (the adult) control the assets in that account until your child reaches the age of majority, at which point the assets are turned over to him or her.
The downsides of this strategy are that the earnings requirement could limit the amount you can gift to your grandchild, and again, your grandchild will become the owner of the money once he or she reaches the age of majority.
Caution: Do not jeopardize your own retirement!
It is an incredibly generous and helpful gesture when grandparents set aside money for their grandchildren’s higher education. However, we have seen too many grandparents put their own retirement funds at risk in an effort to help their grandkids. Please be careful about this! Your grandchildren, and your adult children, still have years, even decades, to continue earning money. If you are nearing, or in, retirement, your earning years have most likely come to a close.
We urge you, again, to help your grandkids in a way that does not jeopardize your own financial future. We are here to help. Please call on us to discuss the strategy that’s right for you, your children and your grandchildren.
