The Holy Grail for many taxpayers is to deduct college expenses paid for a grandchild or a child. With a little estate planning, you can do just that using an Estate Planning Strategy known as the college unitrust. It can make a lot of sense if you have a charitable intent to go along with the desire to help pay for higher education.
To learn how this tool works, let’s first review the basic charitable remainder trust, a valuable tax and estate planning tool we’ve discussed in past visits.
You create a trust that will pay income to you or a designated beneficiary for a period of years. After that, the amount left in the trust is paid to a charity you picked. Because this is a trust that ultimately benefits charity, you get a tax deduction for donating money or property to it. The deduction won’t be the full current value, because payments from the trust will go to you or another noncharitable beneficiary. But you will get a partial deduction to reflect the present value of the amount the charity will receive. The deduction depends on current interest rates, the length of the income payout period, and IRS present value tables.
You get an additional tax benefit when appreciated property, such as stocks or mutual funds, instead of cash is donated to fund the trust. That’s because you won’t owe capital gains on the appreciation. The trust can sell the property without incurring taxes on the appreciation. That means you benefit from the full value of the property instead of its after-tax value.
You set the income payout from the trust, and that should be set as a percentage of the trust value each year instead of a fixed amount.
That’s the basic trust. Here’s how this can be designed to help fund higher education.
You create a charitable trust that will pay the student-beneficiary you designate 30% of the trust’s asset value annually for four or five years. You donate $100,000 of appreciated stock or mutual funds to the trust. You name any charity you like as the charitable beneficiary of the trust.
When you make the contribution to the trust, you owe no capital gains taxes. That’s a savings of 20% of the gains. If the gains were $20,000, you saved $4,000 in taxes that would have been incurred if you sold the property and used the after-tax proceeds to pay for college. In addition, you’ll get a tax deduction. At recent interest rates, the IRS tables give you about a $15,000 deduction for your contribution to the trust. If you are in the 31% tax bracket, this saves you $4,650.
The first year’s payout to the student is $30,000. The first year’s payout would be considered all ordinary income and taxed at the student’s tax rate. After that, the taxes will depend on whether the trust is distributing capital gains, ordinary income, or principal. It will be taxed accordingly at the student’s rate. After the first year, the amount of the payout depends on the earnings of the trust. If a bull market in stocks resumes and the trust is invested aggressively, the payout actually might increase if the trust earns more than 30% annually. If the investment portfolio declines or is invested conservatively, then the payouts will decrease after the first year.
For example, if you put $100,000 in the trust, set a 30% payout, and the trust earns 8% annually on its investments, the distributions for years two through five would be $23,400, $18,252, $14,237, and $11,105. The charity would get $28,872. If the earnings of the trust are something other than 8%, the payouts will be different.
You need some charitable motivation for this estate planning strategy to make sense. It is even more attractive if you have appreciated investment property and want to avoid the capital gains taxes. But if you want to help a child or grandchild pay for education and would like to deduct part of that cost, the college charitable remainder trust is worth a look.