How Can I Best Help My Grandchildren Pay for College in the Future?
Reader Question: I have several young grandchildren. How can I best help my grandkids pay for college in the future?
Getting an early start helping your grandkids pay for college is a smart approach. Most of us are very aware of how much college costs have been increasing in recent history. In fact, if you compare college costs from 1980 to 2020, the price to attend a four-year college full-time increased a whopping 180%! Starting some early savings for your grandchildren can allow you to take advantage of tax favorable investment options and compounding interest. However, it’s also crucial to coordinate your planning with your kids (the parents) and your own retirement needs. We will discuss some favorable ways to save, rules around gifting and note important factors in your own planning and the parents’ planning to keep in mind.
One crucial consideration to address before getting started is whether helping your grandkids with college funding will work in your own long-term plan. Most clients we meet who are close to retirement or who have already retired share at least one common goal- to live the rest of their lives without running out of money or having to rely on their children to take care of them. Choosing to help grandchildren with college costs may decrease the availability of your own assets for various needs such as long-term care. Be sure to first understand your own retirement needs fully so that you can determine an appropriate goal for college funding support. Meeting with a financial planner can help you to get a clearer picture of your own retirement planning and what flexibility you have to help out your grandkids without putting yourself at risk. Also consider that some account types to save for college are very flexible- you can choose to use some of the value yourself if needed with no penalty- while some are rather inflexible with penalties for not using the funding for educational funding.
Let’s first consider the most flexible funding option- a taxable brokerage account. You may very well already have some value in an account like this that you have been using to save for retirement. If you’d like to have a lot of flexibility on how to use your investment without incurring penalties, then this account may be a good option for you. The downside to these accounts is that they do not have any special tax treatment; therefore, you will be taxed on any investment income generated in the account at either your ordinary or the long-term capital gains rate. If this is your preferred approach and you already have an account like this for your own funding, it may make sense to consider setting up a separate taxable brokerage account so that you can adjust the allocation differently from your own and track the total value allocated to your grandchildren’s education.
Another consideration besides tax treatment of the account is any limitations around contributions. With a taxable brokerage account, there is no limit to how much you can invest every year in the account. There are, however, limits on how much you can gift in the future to each of your grandchildren without running into the need to file a gift tax return. As of 2024, the annual gift tax limit is $18,000 per person. This means that for a married couple, you can gift up to $36,000 per person without needing to recognize a potentially taxable gift. Please note that the current lifetime gift and estate tax exemption for Federal purposes is $13.61 ML (double for married couple); however, that could potentially reduce in 2026 if the changes made under the Tax Cuts and Jobs Act of 2018 are allowed to sunset. One way to avoid limiting your gift to the annual exclusion amount and still avoid eating into your lifetime exemption is to make direct tuition payments to an accredited educational institution. This is because there is unlimited tuition gift tax exclusion for educational purposes.
An alternative to using a taxable brokerage account with a lot more tax advantages but a lot less flexibility on use is a 529 savings plan. These plans are specifically designed to invest money that is intended to pay for an education. The largest benefit of using a 529 savings plan is that you can invest money that will grow tax-free if it is used for qualified educational purposes. In this way, 529 savings plans act much like a Roth IRA but specifically for education funding. This tax-free investment can help early contributions to grow even more than they would when subjected to the tax drag of a brokerage account. The downside of the plans is that to get this great tax benefit you need to be sure the funds are used for qualified educational purposes only. If funds are used for non-qualified purposes, then you will have to pay both income taxes and a 10% penalty on any earnings.
Unlike taxable brokerage accounts, there is a limit to how much you can contribute in a given year to a 529 plan. The limit is tied to the annual gift tax exclusion amount, so currently it is $18,000 per year per person. There is also a special election that allows you to contribute up to $90,000 as a lump sum and treat the contribution as if it were spread over a five-year period. This 5-year election must be reported on Form 709 (the gift tax form) for each of the five years. This can be a powerful way to front-load the 529 plan and allow for sizeable tax-free growth.
Because of the tax and penalties associated with using funds from a 529 plan for non-qualified purposes, you may have concerns about over-funding the account. One available option that can help alleviate this concern is the ability to transfer the account to a different family member. For example, if you open the 529 plan for one grandchild who does not end up needing all the funding, you are allowed to transfer the value to another grandchild who does. Another very new option as of January 2024, is the ability to transfer unspent funds to a Roth IRA for the beneficiary as long as your account meets the requirements for doing so. These transfers are limited to the Roth IRA contribution annual limit (currently $7,000 for those under 50) and the beneficiary must have earned income to support the contribution. There is also a total lifetime limit currently in place of $35,000 in transfers. This can be a great option to help your grandchild get an early start on investing if they don’t end up needing all of the 529 plan funding.
One additional concern around using a 529 plan owned by grandparents is if this will affect their grandchildren’s eligibility for financial aid. The good news here is that due to recent changes in FAFSA calculations, funding from grandparent owned 529 plans will no longer have an adverse effect on a grandchild’s financial aid eligibility.
Each state has their own 529 plan, however, you are allowed to use a plan that is not provided by your state if you prefer. If you are subject to state income taxes, be sure to check if you need to use your own state plan to get any tax benefit. Many states provide some sort of subtraction or deduction for contributing to a 529 plan, but whether that benefit is limited to contributions to your own state’s plan varies state to state. For example, here in MN taxpayers can get up to a $3,000 subtraction on their state tax return for contributions to any state’s 529 plan.
As you can see, there are many things to consider when you are planning to save for your grandchildren’s college education. The trade-offs are typically considering various tax advantages versus the flexibility of your funding. When making this decision it is critical to talk with your children (the parents) about how they are planning to save for their children’s education so that you can coordinate your plans with theirs. It can also be beneficial to discuss your plans with a financial advisor so that you can consider how this gifting fits in with your own retirement plan and the best way to accomplish your goals.
Liz Alf is the Principal of Clerestory Advisors and fee-only CERTIFIED FINANCIAL PLANNERTM located in Minneapolis, MN. She is a member of the National Association of Personal Financial Advisors (NAPFA), the Fee Only Network and Wealthtender. She enjoys serving clients with on-going financial planning and investment management services.