Like any financial goal, planning in advance for the cost of higher education is key.
- Families need to feel confident their student is getting the right academic experience at the right cost.
- The appropriate funding strategy can differ widely depending on both student academics and family finances.
- Parents and grandparents alike have many options to assess when determining how to pay for college and higher education.
As the costs of undergraduate and post-graduate education continue to rise, families are tasked with finding financial resources to pay for their children’s education. Grandparents are also recognizing this financial challenge and are creating plans to help their grandchildren achieve this goal. For both parents and grandparents wishing to contribute, the college planning process can be difficult to navigate. There are many questions to ask determining how to pay for college and higher education: What is the best savings vehicle? Will this savings impact the student’s financial aid eligibility? Can I fund college with gifts I make to my children or grandchildren in trust or outright? Can a grandparent pay tuition directly to a college? What if the student receives a scholarship? What if the child does not attend college?
It often takes an education just to plan for higher education, and stakeholders need to feel confident that their student is getting the right academic experience at the right cost. After all, the investment in a college education can be one of the largest a family will make next to the purchase of a family home. Knowing how to pay for college, and identifying all that is available from application to graduation and beyond, can be difficult when there is so much information to process.
Planning early is key
Like any financial goal, planning in advance is the key to achieving the desired outcome. Many parents and grandparents begin thinking about college planning at the time of the child’s birth, while others put if off until they have built up their financial resources. However, educating yourself early on about the financial process and the various resources available can help you set a strategy that is best for your family situation. The appropriate funding strategy can differ widely depending on both student academics and family finances. Need-based aid may be available but it is not uncommon for families with resources and average incomes to receive minimal or no need-based aid at all. To determine if a family will qualify for financial aid, there are tools that estimate eligibility. The most common tools estimate the expected family contribution and calculate the college’s net price. If the metrics from these tools reveal that need-based aid appears unlikely, then avenues of merit-based aid and scholarships, savings, and/or borrowing—combined with funding out of current income—may be the most likely options for financing higher education. In these circumstances, savings and tax strategies are fundamental. If saving starts early, there is the known benefit of compounded investment returns which can have a favorable multiplier effect. As you begin saving, there are several factors to consider, including the most appropriate investment vehicle to use, the tax implications of each option, and how the account should be titled.
529 College Savings Plans
The Qualified Tuition Program, under Internal Revenue Service Code Section 529, is one of the most widely used savings vehicles. Put into place over 30 years ago, this program allows taxpayers to contribute to an account or pre-paid tuition program. When used to pay qualified education costs at an accredited college, earnings on these accounts are free from federal and state income tax.
The 2017 Tax Cuts and Jobs Act expanded the definition of “qualified education expense” to include up to $10,000 in yearly distributions for tuition at elementary or secondary public, private, or religious schools. In addition to the tax-advantaged savings, some state plans offer their residents income tax deductions or credits on contributions. Unlike other tax-advantaged savings vehicles, there is no income limitation or phase-out for individuals who decide to contribute to this type of plan. Account owners are typically a parent or grandparent (although parties are not required to be related) while the beneficiary is the future student. The account owner maintains control over the 529 account, including the ability to change beneficiaries without penalty provided the new beneficiary is related to the prior beneficiary. The contribution is considered a completed gift and is excluded from the contributor’s estate.
Contributions to the 529 Plan qualify for the annual gift tax exclusion, which is currently $15,000 per recipient; however, there is one unique exception to this limit for qualified tuition plans. The contributor can elect to make contributions larger than the annual gift exclusion (up to five years of annual gifting) without gift tax consequences, provided no other gifts are made to the beneficiary that would be considered annual gifting. These larger gifts to a 529 Plan, often referred to as “super funding,” allow married couples to contribute $150,000 (or $75,000 for a single filer) to a 529 Plan at one instance rather than over a five-year period. Since the gift is accelerated, an IRS Form 709 must be filed at the end of the year as part of the transaction. In many cases, the 529 Plan is a quality savings vehicle for college; however, the benefits must be weighed against the drawbacks (see Figure 1). For example, for high-net-worth families, the contributor must weigh the tax benefits of gifting to a 529 Plan against alternative, more sophisticated wealth transfer planning and gifting
On certain occasions, questions arise when resources have been accumulated in a 529 Plan and the student is awarded a scholarship, or when the student enters a college on an ROTC scholarship with a stipend. With regard to 529 Plans, money in the amount of the scholarship can be withdrawn without a penalty but tax will be paid on the earnings.
Don’t jeopardize need-based financial aid
If the student is eligible for need-based financial aid, grandparents in particular should carefully plan any financial help so that their assistance does not negatively impact the need-based financial aid award while the student attends college. Savings plans such as 529 Plans owned by the grandparent are not considered as part of the federal government’s financial aid application (also known as the free application for federal student aid or FAFSA), yet once these assets are distributed from the 529 Plan for qualified expenses, they are treated on the FAFSA as untaxed income to the student, which can reduce financial aid. This will change the financial resource picture for the student and could adversely impact financial aid. If the grandparent is funding only a portion of college, one option is to delay distributions from grandparent-owned accounts until junior year, after the final financial aid income cycle has ended (there is approximately a two-year lag on income data for the FAFSA). If there are more assets than the student’s remaining semesters’ worth of expenses, a
second option is to change the ownership of the 529 Plan to the student’s parent, as distributions from parental assets have a much lower impact on financial aid. Note, however, that when colleges assess resources, some colleges include parent- and grandparent-owned assets earmarked for the student and require the student to disclose all 529 Plans for which the student is a beneficiary.
Gifting and trust considerations
Another option for grandparents to consider is an outright gift of cash. However, any gifts that exceed the annual gift exclusion may have gift tax and generation-skipping transfer tax consequences. This gift will also be considered un-taxed income for the student for financial aid purposes. An alternative consideration is a tuition payment directly to the educational institution. While the payment could reduce need-based financial aid entitlement if made directly to the college, the tuition payment is not considered a gift and can exceed the annual gift exclusion without gift tax consequences. Direct payments to the institution or savings derived from a 529 Plan not only provide the satisfaction attached to providing education, but these assets are also removed from the estate, potentially reducing estate tax for the wealthy individual or couple.
As families consider various investment vehicles to save for college, some entertain the possibility of setting up a trust. This can provide assurance that the student will have the needed funding for college even after the death of the grandparents or parents who establish the trust. The trust can even be created to support multiple generations. Determining the type of trust and the state in which it is located requires proper planning based on many factors, including the creator’s tax and financial situation and goals for the trust. The trust can be formed to benefit one individual or multiple
individuals. It can be separated into shares or function as a ‘pot trust’ which benefits several individuals. It can be established to fund education only or could be more general in nature. Additionally, trusts can impact the creator’s and beneficiaries’ tax liability including gift and estate taxes. The flexibility and options available within trust planning are specific to each family and must be weighed comprehensively when determining how best to fund education. These unique circumstances often require the consultation of a financial advisor and tax professional.
This article is for informational purposes only and is not intended as an offer or solicitation for the sale of any financial product or service. It is not designed or intended to provide financial, tax, legal, investment, accounting, or other professional advice since such advice always requires consideration of individual circumstances. If professional advice is needed, the services of a professional advisor should be sought. There is no assurance that any investment, financial or estate planning strategy will be successful. These strategies require consideration for suitability of the individual, business, or investor.
To ensure compliance with requirements imposed by the IRS, we inform you that, while this presentation is not intended to provide tax advice, in the event that any information contained in this presentation is construed to be tax advice, the information was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding tax related penalties under the Internal Revenue Code or (ii) promoting, marketing, or recommending to another party any matters addressed herein.