Grandparents Helping with Ever-Rising College Costs

As the cost of a college education continues to climb, many grandparents are stepping in to help. This trend is expected to accelerate as baby boomers, most of whom went to college, become grandparents and start gifting what could be trillions of dollars over the next few decades. Helping to finance a grandchild’s college education can bring great personal satisfaction and is a smart way for grandparents to pass on wealth without having to pay gift and estate taxes. So what are the best ways to accomplish this?

Outright Cash Gifts
A common way to help with college costs is to make an outright gift of cash or securities. But this method has drawbacks. If you gift the money directly to your grandchild, he or she might spend it on something other than college. Second, a gift of more than the annual federal gift tax exclusion amount ($12,000 for individual gifts, $24,000 for joint gifts) might have gift tax and generation-skipping transfer tax (GSTT) consequences (GSTT is the tax imposed on gifts made to someone who is more than one generation below you).

Another drawback to outright gifts is that the gifts become assets of the student, and the federal government treats student assets more harshly than parent assets for financial aid purposes. Students must contribute 20% of their assets each year toward college costs, compared to 5.6% for parent assets.

529 Plans
A 529 plan can be an excellent way for grandparents to contribute to a grandchild’s college education while simultaneously paring down their own estate. There are two types of 529 plans: college savings plans, which are individual investment-type accounts whose funds can be used at any accredited college in the United States or abroad, and prepaid tuition plans, which allow prepayment of tuition at today’s prices for the limited group of colleges (typically in-state public colleges) that participate in the plan. Grandparents can open a 529 account and name their grandchild as beneficiary (only one person can be listed as account owner, though), or they can contribute to an already established 529 account.

A big advantage of 529 plans is that under special rules, grandparents can make a joint lump-sum gift of up to $120,000 ($60,000 for individual gifts) to a 529 account and completely avoid federal gift tax, provided a special election is made to treat the gift as if it were made in equal installments over a five-year period and grandparents don’t make any additional gifts to their grandchild during this time.

Significantly, this money is considered removed from the grandparents’ estate, even though one grandparent can still retain control over the funds if he or she is the 529 account owner. But there are two things to keep in mind here: (1) if a grandparent contributes money, makes the special election, and then dies during the five-year period, a portion of the gift is recaptured into the estate for estate tax purposes; and (2) funds in a grandparent-owned 529 plan can still be factored in when determining Medicaid eligibility, unless these funds are specifically exempted by state law.

Of course, grandparents can contribute smaller, regular amounts to their grandchild’s 529 account instead. Contributions grow tax deferred, and withdrawals used for college expenses are completely tax free at the federal level (and often at the state level).

Another interesting feature of 529 plans is that under current law, grandparent-owned 529 accounts are excluded by the federal government’s financial aid formula–only parent-owned 529 plans count. So a grandparent-owned 529 plan won’t impact a grandchild’s chances of qualifying for aid (however, there’s no guarantee this will be the rule in the future because Congress periodically tinkers with the financial aid rules).

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about specific 529 plans is available in each issuer’s official statement, which should be read carefully before investing.

Pay Directly to the College
Another excellent way for grandparents to help their grandchildren with college costs is to pay the college directly. Under federal law, tuition payments made directly to a college aren’t considered taxable gifts, no matter how large the payment. But this is true only for tuition–room and board, books, fees, and the like don’t qualify for this benefit. Aside from the obvious tax advantage, paying tuition directly to the college ensures that your money will be used for education. Plus, it removes the money from your estate.