It is no secret the cost of higher education has increased dramatically over the years, with in-state tuition and fees at public universities up 243 percent since 1999. For the 2019-2020 school year, tuition at the University of Maine at Orono is $11,445 for Maine residents and $31,674 for out-of-state students. The price tags of private universities haven’t grown at as high of a rate, but they often cost twice as much as state schools. At Bowdoin, where it’s $71,710 (not including books), the college is candid about the matter. On their Office of Student Aid – Cost of Attendance website page, the headline at the top reads: “No matter your family’s economic situation, this is a big investment.”
Most families would agree. Across the board, while institutions have increased their financial aid offerings over time, families’ expected contributions have also increased. Meanwhile, salary growth has lagged.
As a result, U.S. parents and students are taking on more debt every year (totaling $1.47 trillion at the end of 2018) to cover the balance after paying what they can from savings and current income. To avoid or lessen their grandchildren’s school loan debt, more and more grandparents are pitching in with financial contributions.
Grandparents who are willing and able to help have many options and strategies available; but if not executed carefully, this act of generosity can have unintended impacts on the student’s financial aid eligibility and your tax liability.
Most families will rely on need-based financial assistance to help reduce their Expected Family Contribution (EFC), while others know well in advance that they will not qualify for financial aid based on their income and asset levels (generally, families with combined income over $250k/year and assets over $1 million will not qualify for financial aid, but some factors including the number of children in college at one time could make them eligible). Before selecting a strategy to support a young scholar, grandparents should know where their immediate family stands with this.
If you’re inclined to start saving early and often for your grandchild’s education, there are a few notable types of savings accounts that you can choose from, as well as a few alternative contribution options.
Custodial Accounts (UGMA/UTMA):
Highlights & Benefits:
These are easy to set up and inexpensive to administer. Grandparents can fund them with cash or transfer existing shares of stock or mutual funds into them. They are self-directed, so investment options are extensive and not limited to a preselected menu of funds. And in 2020, annual contributions up to $15,000 ($30,000 if split between spouses) are exempt from gift tax.
Considerations & Potential Drawbacks:
Transfer of account ownership (including intent): Custodial accounts are owned by the parent/grandparent until the child reaches the age of majority in their state, which is either 18, 19, or 21 years old (in Maine, it’s 18). At that point, the account becomes the student’s, and there is no guarantee the funds will be used for eligible college expenses and not on a new Harley Davidson.
Potential “Kiddie Tax” liability: Perhaps the most important thing to be aware of with custodial accounts is the potential triggering of the “Kiddie Tax,” wherein any unearned income generated from the investments in the account over $2,100/year is taxed at the parent’s marginal tax rate. Lastly, the balance of the account is viewed as a student asset on the FAFSA and will reduce the student’s eligibility by 20% of the account value.
Coverdell Education Savings Accounts (ESAs)
Highlights & Benefits:
The primary benefit is that the funds grow tax-free and can be withdrawn tax-free as long as the withdrawal doesn’t exceed the student’s qualified education expenses for that year.
Considerations & Potential Drawbacks:
Low contribution limits: These are not as popular now as they once were, primarily because contribution limits have remained very low at $2,000/year. The account is owned by the parent/grandparent; however, there are some income restrictions that can affect the ability to contribute the full $2,000/year, with a phaseout starting at $190,000/year for married couples filing jointly.
529 College Savings Plans
Highlights & Benefits:
These have emerged as the most popular account option for several reasons. First, they’re flexible. Grandparents can open a 529 in their name as the owner with the grandchild as the beneficiary, or they can simply contribute to the parent’s 529 plan. 529 plans provide tax-free growth and withdrawals when the funds are used for qualified education expenses (tuition, room and board, books, computers, etc.) and up to $10k/year for K-12 private or religious school expenses.
Second, the $15k/year gift tax rules apply; but owners can elect to do a five-year contribution of $75k as an initial deposit. These limits are doubled to $30k and $150k if the gifts are split between spouses.
And finally, funding a 529 plan can also serve a useful estate planning purpose, as the funds are removed from the owner’s estate; yet the assets remain in the owner’s control, unlike they would if moved into an irrevocable trust.
Considerations & Potential Drawbacks:
Limited flexibility: Every state sponsors a different plan, and plans can vary between states in terms of the tax credits, deductions, matching grants/contributions, investment options, and expenses involved. 529 plans also have limited investment options determined by each state, with most limiting the number of trades or portfolio adjustments you can do each year.
Potential FAFSA implications: Funds held in a 529 owned by a grandparent do not affect a grandchild’s financial aid eligibility during their initial FAFSA submission; however, once a distribution is made to pay college expenses, that amount is counted as student income on the following year’s FAFSA submission. Financial Aid offices now look back two years to evaluate a family’s financial situation and eligibility for aid so, if possible, it makes sense to wait to use grandparent-owned 529 assets until the student’s last two years. If the grandparent contributes funds to a parent-owned 529, which is counted as a parent asset (smaller impact) on the FAFSA, it can only reduce the aid eligibility by a maximum of 5.64% of the account value.
In addition to traditional college savings accounts, other ways that grandparents can contribute include:
Paying tuition directly to the institution
This is a very simple and direct way to help. There is a tax code exemption that allows individuals to pay tuition (but not other related expenses) without being subject to the gift tax restrictions. However, like paying tuition out of a 529 plan, this will impact the child’s financial aid eligibility as it will be treated as student income on the following year’s FAFSA.
Establishing a loan for your grandchild
Grandparents can loan up to $10,000 interest-free, and loans over $10k only require a minimum interest rate determined by the IRS, which is typically very low. The loan terms can be customized; however, if you forgive the loan in the future, your grandchild may end up owing income tax on the amount of the debt forgiveness.
Paying off their student loan balance upon graduation
This strategy does not impact the student’s financial aid eligibility during their years of enrollment; but the loan payments are considered gifts, so the amount given over $15k ($30k from married couples) is subject to the gift tax. This amount, while helpful, does not come close to covering even one year of tuition, fees, room and board at current levels.
If you’d like to explore how to support your family’s future scholars, contact your portfolio manager.
We’d be happy to review all the options in the context of your personal financial picture, and devise a plan to maximize the impact of your generous gift.
