For anyone who hopes to maintain at least a middle-class lifestyle a degree from a higher education institution has become a must. As parents and grandparents we want to see children succeed but may worry how the education will be funded and by whom. As the cost of obtaining a degree has become higher, those who have the means to, oftentimes take the initiative to help pay for education. Whether it’s parents or grandparents, there are many ways to help save and pay for education and those thinking about it should be aware of the different options available to them. The most common approaches include 529 plans, custodial accounts, direct gifting to the individual, and direct gifting to an educational institution.
A 529 plan is an education savings plan where the investment grows tax-deferred and distributions used for qualified post-secondary education are free of federal tax. This type of savings plan allows the owner to easily change the beneficiary and investments as they choose and provides a variety of funding options. In addition to this, 34 states give the 529 owner at least a partial tax deduction for all contributions made to the plan. The owner can contribute to a 529 plan as a gift without incurring penalties by taking advantage of annual federal gifting limits. One of the advantages of these plans includes the fact that 529s can be funded with 5 years’ worth of future nontaxable gifts. While contributions to a 529 are a completed gift (and hence remove the funds from an estate), the owner has access to the funds but any withdrawals will be subject to a tax and a 10% penalty on earnings if the money is not used to pay for education. Those who purchase these plans should also be aware that many plans tend to have high fees and limited investment options.
Another way to consider paying for college is through a Custodial Account (UTMA/UGMA). This account is similar to an individual investment account but gifts made to it are held in trust until the child reaches the age of trust determination (age 18 or 21 depending on the type of account and state in which it is held). There are several drawbacks associated with this type of account. The assets in a custodial account are considered as the students’ and may count against them if they apply for college financial aid. Investment income generated by the custodial account must be reported on the child’s tax return and is taxed at the parents’ rate. And finally, it’s most important to consider that the funds in a custodial account are irrevocable and once the child reaches adulthood, they are free to spend the funds as they choose.
As of 2014, federal gifting rules allow a parent or grandparent to make a direct gift of up to $14,000 per year to anyone without paying gift taxes on it. This amount will not be deducted from the lifetime federal gift and estate tax exclusion and one can make as many gifts of $14,000 or less as a person deems fit. Married couples can give $28,000 per recipient without any gift tax ramifications, though they must report to the IRS that they have combined gifts. If however, funds are paid directly to a qualified educational institution, there is no limit to the amount a person can give. This type of direct payment will incur no gift tax and nothing will be deducted from an exclusion amount but this applies only for the part of the gift paid directly to the institution. If the gifter also wishes to cover other costs such as books or room and board that must be paid separately, a regular gift must be made to meet these costs.
Best Strategies for Young Parents
For Parents, savings strategies must fit the family and the finances. The downside to contributing a monetary gift in the form of a custodial account is that anything in the account will belong to the child upon entering adulthood; therefore it is important for young parents to consider how the child might use the money when he or she comes of age. For this reason, a 529 might be a better choice for a parent to put into place now for a young child’s educational savings plan. Investing in a 529 will allow parents to deduct money from their estate tax free and it better ensures that the money will be used to finance education.
However, if the grandparents of the child might help finance a future education, it might be in the best interest of all parties involved for parents to simply open a joint separate account where money intended for education can be earmarked. Then if the grandparents help out financially the money saved is for other priorities. Direct gifting to the child can be made to finance other college expenses such as books or room and board.
These are a few ways a parent might approach saving for education while keeping their budget and growing family in mind.
1. Consider starting with a monthly savings amount you can afford today and continue as your family grows.
2. When looking at 529s, you might start by taking a look at the New York and Utah plans since they have the lowest fees and most investment options.
3. Most of the 529 plans will allow you to set up an automatic payment to help with your budget.
4. If using UTMA, try to request a set age of 21 for the receiver, it will automatically default to 18 if not.
Best Strategies for Grandparents
Regardless of the method a person chooses to employ, there are non-financial issues to consider. Is college right for the child? Will giving a gift to a child 10-15 years from now still be desirable as well? While it is admirable to give the gift of education to grandchildren, one should also consider the unintended consequences of promising to pay for grandchildren’s education. If a promise has been made to pay for education, is this giving a signal to the parents that they don’t need to save for their children’s education? Since they know this major expense will be covered, will this be creating a sense of entitlement or inhibiting their motivation to succeed?
Recent reports have found that 80% of millionaires are first generation (not inheritors), and that many millionaires tend to live beneath their means while their inheriting children are more likely to spend more than they earn and not save. Many who inherit considerable wealth lack discipline if they were brought up in too nice of an environment. Rather than allowing young parents to believe they don’t have to save for their child’s college expenses due to an expected educational gift, it is highly recommended to set aside money and pay it directly to the institution when the grandchild reaches college age. This way there are no expectations by the parents and they have time to set aside money of their own for the same purpose.
Here are a few ways a grandparent might approach paying for their grandchildren’s education without making promises that can have detrimental effects.
1. Don’t make specific promises to your adult children regarding funding your grandchildren’s college education. Instead, perhaps tell them you hope to help when the time comes.
2. Offer to match college savings your children set aside.
3. Talk about your strategy for saving and paying for college when your children were young.
4. Talk to your grandchildren about why you have chosen to pay for school. Discuss both the financial and educational value reasons.