Should you make Direct Gifts to Family to Cover Education Expenses Part of Your Estate Planning Strategy?

Giving directly to adult children or to grandchildren might not be the best Estate Planning Strategy to help pay for education expenses. Direct gifts might deny your adult children tax breaks that are available to reduce the after-tax cost of education. Many of these tax breaks were created in the last few years, so even professional advisers have not fully integrated them into tax, financial and estate planning. The tax law complicates your estate planning, but taking these breaks into account can substantially decrease the family’s cost of paying for education.

If the adult children have high incomes, you can forget about their using many of the tax breaks. The breaks are phased out as income increases. The phaseout level varies by tax break, and some levels will increase in 2003.

Here is a review of the tax breaks and how to use them to help pay for the grandchildren’s education.

The best estate planning strateagy to avoid losing these tax breaks is to keep AGI below the limits. Gifts are not taxable income. Grandparents still can help, but not by giving investment accounts to the parents that might produce enough income or capital gains to make the parents ineligible for the tax breaks.

Coverdell savings accounts.

The name of these accounts was changed from Education IRAs and the benefits increased in the 2001 tax law. Up to $2,000 per child can be put into a Coverdell account each year. There is no deduction for contributions to the account, but income and gains are tax deferred in the account, and they are tax free when withdrawn if used for education expenses. The account must be spent by the time the beneficiary is 30.

Qualified education expenses include tuition, fees, books, supplies, and equipment required for enrollment or attendance. Room and board are included if the individual is at least a half-time student. The expenses can be incurred for undergraduate or graduate level courses and also can be used to purchase tuition tax credits under a qualified state tuition program. Beginning in 2002, the accounts also can pay for elementary and secondary school expenses.

An account balance can be transferred or rolled over tax free from the account of one beneficiary to another of the same family as part of estate planning.

The $2,000 annual contribution limit is phased out when the contributor’s AGI is between $190,000 and $220,000 on a joint return. The nice thing about Coverdell accounts is that virtually any relative can open an account for the benefit of another relative. If your income exceeds the limit, you can give the money to the parents or another relative to contribute to the account.

College savings plans.

There are two types of college savings plans. There is the widely-promoted “Section 529 College Savings Plans,” which I’ve covered in detail in past visits. (See the November 2001 issue or the Grandkids’ Watch archive on the web site.) This plan lets you direct how the account is invested in investment funds selected by the sponsor. The other type is the prepaid tuition plan, described in the next article. There are no income limitations these accounts.

Custodial plans.

These are the traditional savings accounts set up for minors, known as UGMAs and UTMAs. These also have been discussed in detail in past visits. The drawbacks to these accounts are that the income and gains are taxable, and the child gets full legal control over the account balance at age 18 or 21, depending on the state.

Hope and Lifetime Learning Credits.

When the parents might be eligible for these credits, you want to be careful not to trigger ineligibility.

Expenses during the first two years of college are eligible for the Hope Credit. The first $1,000 of expenses and 50% of the second $1,000 of expenses are eligible, giving a maximum credit of $1,500 annually. The Hope Credit can be claimed for each child in college.

The Lifetime Learning Credit can be used for as many years as there are qualified expenses, and there is no limit on the number of students for which the credit can be claimed each year. The credit is 20% of the first $5,000 in tuition ($1,000). In 2003, it is 20% of the first $10,000 ($2,000). The credit is phased out at an AGI of $82,000.

If you are thinking long term, in 2005 up to $3,000 of college costs can be deducted for those with AGI up to $130,000.

Remember, these are credits. They are subtracted directly from the tax due for the year.
Suppose the parents are eligible for the credits. If college expenses are paid from accounts in the children’s names, the credit cannot be used on the parents’ return. If the expenses are paid by the grandparents (whose income is too high to qualify for the credits), neither they nor the parents can take the credits. If the parents are eligible for the credits and the grandparents are helping pay the expenses, the grandparents should save in their own names and give the money directly to the parents to pay the education expenses.

Savings bonds.

Redeem U.S. savings bonds to pay college expenses, and the interest on the bonds is tax free. Normally, interest on savings bonds is tax deferred until the bonds are redeemed. The tax-free status of the interest is phased out beginning at AGI of $86,400 on a joint return.

Deductible interest.

Taxpayers can deduct up to $2,500 of interest paid on student loans each year. The interest deduction begins to phase out when AGI is $100,000 on a joint return ($50,000 on a single return). If the parents and grandparents exceed the income limit, the loans should be in the child’s name and the child should pay the interest, even if they are given the money to make the payments.

Let the grandkids pay.

There are several ways a family can benefit by having the children pay directly for education, with some gifts from the parents and grandparents.
If the adults own securities that have appreciated, it makes sense to give them directly to the children. They can sell the securities and pay a long-term capital gains rate of 8% to 10% if the family has owned the securities for more than five years. The gains might turn out to be tax-free, because if the children write the checks for college they can claim the tax credits described above.

Another estate planning option is to have the children pay at least half their living expenses for the year. That makes them independent. They claim their own personal exemptions, the credits for college expenses, and deductions for loan interest. They aren’t likely to hit the income limits at which those tax breaks are phased out. Be sure to keep track of their annual living expenses and be able to show that the children paid at least half their expenses.