Our clients get excited when talking about their grandchildren. We get excited when they ask questions and express interest in talking to us about them too! Many grandparents want to help fund college education for their grandchildren, particularly if they already have enough money to ensure a comfortable retirement income for themselves. But who should own the asset? How much should be saved? What coordination should occur with the parents? Part of our role is to try to lay some groundwork and discuss the pros and cons because there are many different ways to help cover college education expenses or contribute to plans on behalf of their grandchildren.
Let’s start with who’s asset is it? Most times, when a child is going to go to school, a FAFSA (Free Application for Federal Student Aid) form is filled out. And that’s basically a massive formula that says what kind of aid the student is potentially going to receive based on the parent’s assets, parent’s income, student’s income, and student’s assets. Did you notice that we didn’t mention the grandparent’s income or the grandparent’s assets? And why does this matter? It is really important right off the bat to think about what role the grandparent plays here to not negatively impact that application.
A common scenario that we see is where a grandparent is considering funding an existing 529 plan that their child has for their grandchild’s education expenses. Why should they open a second plan when there’s already an easy way to contribute to one that exists? Because the existing plan is a parental-owned asset and will show up in the expected family contribution and will need to be put towards their college education. We know that is still the intent, but it does potentially impact the amount of grants and other financial aid that is available to their grandchild. Let’s use another example. A grandparent saves $100,000 for the education of the student and it’s all in the parent’s name. Going back to the expected family contribution, that’s $5,640 or 5.64% that’s going to be disqualifying the parents from receiving aid. The more assets and income you have will limit the amount of free financial aid or grants that are available to the student.
What if the grandparent owned the 529 plan? In this case it is the grandparent’s asset. A potential drawback to this scenario is if, for some reason, the grandparent goes through a tough financial time, the money could be clawed back. However, there is somewhat of a loophole when it comes to the expected family contribution for a 529 plan owned by the grandparent with the beneficiary listed as their grandchild (owns the account directly for the grandchild). This completely eliminates that asset from the calculation. But as with everything else we talked about, of course, there are caveats. And there’s one more little stipulation important to note. The asset doesn’t get included in any given year, but the income does. For example, if the grandparent sets aside $100,000 for their grandchild and they take out $10,000 to help pay for education costs in year one, that $10,000 is going to show up as income for the student the following year. That is going to factor into the next year’s FAFSA form where the expected family contribution is assessed again, and therefore less potential aid is available in future years because of that $10,000 withdrawal. If you took out $10,000, then 50% of the student’s income is expected to go towards education above an exclusion. So, there’s good reason to consider the ownership of the plan, and the withdrawal strategy. It’s important to understand the dominoes and try to find the sweet spots that you’re comfortable with.
Then we often get questions on how is that money managed? How do you go about trying to grow that money over time? What role is it going to play over that accumulation period between whenever you started the plan and college years?
There are two different types of plans. There’s the typical 529 plan, investment-based account where you’re putting dollars in it and you have to choose some sort of investment option, which could be as conservative as cash and as aggressive as the stock market. The other option is a prepaid tuition plan where you’re essentially buying college credits at today’s tuition prices that can be used in the future. In this plan, the credits should be rising over time as the cost of college increases, since the cost of college has far outpaced the level of inflation that we’ve seen in the last 15-20 years. Which one’s better? That’s a matter of opinion.
We don’t have the ability to know where the cost of education will go and it’s also different when we’re talking private institutions or public institutions. Who knows where legislation goes too? So, figure out which plan feels better for you based on your viewpoints to those questions. More important than deciding where to invest, is just getting started. So, the savings!
Our other advice is to start early. The time value of that money is important. If you started saving for your grandchild as a baby with a moderate rate of return of 6% over 18 years, $5,000 a year, or break that down $416 a month, for 18 years it will be almost $160,000! That’s potentially $40,000 a year for school for four years. Saving $416 a month isn’t insignificant but it does seem somewhat digestible If you’re talking about making a huge impact to the student over time. Alternatively, if you start saving at age nine, it will take $1,160 a month to get to that same level of savings of $160,000. Or if you only started the $416 at age nine, It’s only $60,000 of savings. Time value of money – those are vastly different numbers, no matter how you’re going to save, doing it early is key.
There are also options for helping a student already in college. The grandparent can write a check to cover that tuition bill directly to the college. And therefore, that doesn’t show up in any calculation anywhere. By the way, if you’re making the check directly to the institution, then that’s not a gift for IRS gifting purposes either. It’s never going to the child but is rather on behalf of or for the benefit of the child, so it skirts those gifting rules. There are certainly situations that we come across every year in helping our clients where we pretty much say that their legacy plan is set, and their job now is to efficiently get rid of their assets. This is a really nice way to do it because it doesn’t go against that annual gift exclusion. It’s an easy and quick way to get money out of your estate.
You could also incentivize the gift. “If you continue to get good grades, if you work hard in this way, and you reach your goal of getting this job, then I’m going to help you pay back any student loans.” This is another meaningful way to make your gift that maybe wasn’t the on the front end of trying to leverage your savings into growth over time. Some people like to help their grandkids get started in another way. This idea fits when somebody comes to us, and the student may be 16 or 17 years old already. In this case maybe we’d suggest funding a Roth IRA for them, or helping with a home down payment, or some other way outside of college savings to help them get started on the right foot. An ancillary benefit could be teaching them fiscal responsibility by working with us.
Here are some final thoughts. What if you have multiple grandchildren? A grandparent-owned account can only have one beneficiary. So, if you have five grandkids, you will need five different accounts. You can, however, change the beneficiary on a 529 plan once every 12 months. You may want to consider one 529 account if you’re grandchildren are far apart enough in age. Because then you are still getting that growth over time, without having to start multiple accounts. It’s just another small thing to note with 529s that you can essentially, in perpetuity, keep changing the beneficiary and it can last forever. If at some point you pass away and now you pass the ownership on to your child, if there’s money still in it for their grandchild, you can keep passing it on until spent. This a nice feature that is completely different than any typical retirement account or non-retirement account. But we would also caution people that the last thing you want is to have money leftover in this account, because if you can’t withdraw it for qualifying educational expenses, you will owe a 10% penalty on the growth of the account.
In summary, the big takeaways are:
- Think about how you want to prioritize helping them. On the front end, in real time or on the back end?
- If it’s saving on the front end, have a broader conversation and coordinate efforts with the parents.
- On the back end, there are different ways to make gifts other than education.
- Be smart about who’s going to own the asset and who’s income it will be prior to filling out the FASFA form.
And if it sounds like a lot, give us a call. We’ve been through it more than a couple of times.
Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. This information is not intended to be a substitute for specific individualized tax advice. We suggest that you discuss your specific tax issues with a qualified tax advisor.
A Roth IRA offers tax deferral on any earnings in the account. Qualified withdrawals of earnings from the account are tax-free. Withdrawals of earnings prior to age 59 ½ or prior to the account being opened for 5 years, whichever is later, may result in a 10% IRS penalty tax. Limitations and restrictions may apply.
Any example is hypothetical and is not representative of any specific investment. Your results may vary.
Prior to investing in a 529 Plan, investors should consider whether the investor’s or designated beneficiary’s home state offers any state tax or other state benefits such as financial aid, scholarship funds, and protection from creditors that are only available for investments in such state’s qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.
Tracking # 1-05166785