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COLLEGE SAVINGS 101

Grandparents' 8 top college-fund plans

Joe Hurley is the founder of Savingforcollege.com LLC, and a certified public accountant.

by Joseph Hurley

Parents putting together a list of potential college-funding sources for their child would typically include 529 plans, non-529 investment accounts, grants, scholarships and loans. The list might also include expected earnings from the student's part-time or summer job, along with money redirected from vacations and other discretionary expenditures.

Most likely, the list will not include grandparent gifts. Understandably, most parents don't expect that kind of help, believing that the responsibility for handling college costs rests squarely on their own and their child's shoulders.

However, studies have demonstrated a desire on the part of many grandparents to help pay college costs for their grandchildren or at the very least a willingness to chip in upon request.

Even a small amount of money can make a big difference. "Even just a few Social Security checks set aside into a college fund each year could pay for a semester or two of the grandchild's college education down the road," says Kevin McKinley, a registered investment adviser in Eau Claire, Wis., and author of "Make Your Kid a Millionaire."

Where the minds and motivations coincide, the next question is: What is the best way for grandparents to fund college? Below are some of the options along with their major advantages and disadvantages.

  1. Pay tuition directly to the college
  2. Advantages:
    • It's easy. You send the money straight to the school to pay tuition.
    • There is no gift tax under a special tax-code exception, regardless of how much is paid directly. (This makes it great for a grandparent looking to reduce a large estate.)
    Disadvantages:
    • Financial aid formulas treat the direct payment by a grandparent as a dollar-for-dollar reduction in aid eligibility (the worst case) or as student income, which reduces aid by 50 percent (the best case).
    • Any payments for room, board or books do not qualify for the gift-tax exception.
    • The grandparent could pass away before the child gets to college with no assurance the money will be used for that purpose, and leaving it exposed to estate taxes.

  3. Pay off student loans after graduation
  4. Advantages:
    • The grandchild's financial aid eligibility is not affected.
    • The grandchild remains "invested" in his or her college education through graduation.
    • The grandparent can adjust the amount of help based on the grandchild's job and family situation after college.
    • Up to $2,500 in loan interest may be deductible by the student each year without itemizing.
    Disadvantages:
    • Loan payments made on behalf of the grandchild are considered gifts for gift-tax purposes.
    • The grandparent could pass away before loan payments begin.

  5. Make loans directly to the grandchild
  6. Advantages:
    • The grandchild's financial aid eligibility is not affected.
    • A promise to "forgive" the loan after graduation helps to motivate the student.
    • A grandparent can charge a relatively low interest rate under IRS family-loan rules.
    Disadvantages:
    • In some cases, demanding repayment can be uncomfortable, and collection can be difficult.
    • Interest on the loan is taxable to the grandparent but not deductible by the student.

  7. Contribute to a 529 plan
  8. Advantages:
    • Tax-free earnings offer the best opportunity to keep up with tuition increases.
    • Eligible expenses include tuition, fees, room and board, books, supplies and computer technology.
    • A special five-year election allows up to $65,000 in a one-time contribution to a 529 plan without exceeding gift-tax exclusion limits.
    • A state income tax deduction or credit for contributions may be possible, depending on state rules.
    • Money stays targeted for college even if the grandparent dies.
    • The beneficiary can be changed to a different grandchild or other family member at any time, and the grandparent can even revoke the money if desired.
    Disadvantages:
    • Any earnings withdrawn for nonqualifying purposes are subject to income tax and a 10 percent penalty.
    • The power to revoke means funds are normally counted in determining eligibility for Medicaid.
    • Most 529 plans charge an ongoing management fee, making them slightly more expensive than mutual fund investing.

  9. Contribute to a Coverdell Education Savings Account, or CESA
  10. Advantages:
    • Earnings are tax-free for college and through 2010 for K-12 expenses.
    • Unlike 529s, CESAs permit self-directed investing.
    Disadvantages:
    • Annual contributions from all sources cannot exceed $2,000 for any one child.
    • Age and income limits further restrict usage. Most CESAs require that a parent or guardian be responsible for the account, even when funded by a grandparent.

  11. Make gifts into a Uniform Transfers to Minors Act, or UTMA, account
  12. Advantages:
    • Cash, stocks and other types of property are easy to transfer into a UTMA.
    • Investment income is shifted to the child's tax return.
    Disadvantages:
    • Gifts to the UTMA are irrevocable. The child assumes full control of the funds upon reaching a certain age.
    • The "kiddie tax" caps the income tax advantage of child-reported earnings.
    • The gift-tax annual exclusion of $13,000 may restrict how much is gifted.

  13. Establish an education trust
  14. Advantages:
    • The trustee remains legally obligated to carry out the grandparents' wishes as specified in the trust agreement.
    • The agreement can restrict the grandchild's access to trust funds regardless of age.
    Disadvantages:
    • Legal and accounting fees for establishing and maintaining the trust can be high.
    • Careful drafting is necessary to minimize gift-tax consequences.
    • Gifts are irrevocable.
    • Income accumulated in the trust income is taxed at high rates.

  15. Purchasing U.S. savings bonds
  16. Advantages:
    • U.S. savings bonds are safe and simple to purchase at your local bank or at TreasuryDirect.gov.
    • Interest income is exempt from state taxes.
    Disadvantages:
    • The amount that can be purchased each year is capped at modest levels.
    • Interest earnings may not keep pace with tuition inflation.
    • Interest is subject to federal taxes upon bond redemption; the exclusion for educational use does not apply when the grandchild is not the grandparent's dependent.

For more information, see the "Grandparents" section on Savingforcollege.com.

Posted July 1, 2009

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