Retirement Watch Lighthouse Logo

Guide to Helping with a Grandchild’s Education

Last update on: Jun 23 2020
guide-to-helping-with-a-grandchilds-education

College costs are escalating, even at public universities. USA Today recently described how the slowing economy is reducing donations to colleges and causing state governments to cut funding. The result is that tuition is climbing faster than ever – as much as 40% at some institutions. Students, parents, and grandparents need to maximize both their own resources and available financial aid.

In the last few visits we explored many ways to help pay for a grandchild’s (or child’s) higher education. In this month’s visit, I’ll summarize and wrap up what we learned so that you can put together the best plan for your family.

The traditional advice is to put money in the grandchild’s name in either a trust or an UGMA/UTMA account. That takes advantage of the grandchild’s lower income-tax bracket (now as low as 10%), allowing the family to accumulate more after-tax wealth for education.

But this strategy can come back to hurt you because of the financial aid formula. Under the formula, a student is expected to spend on college expenses each year up to 35% of assets held in his or her name. But the parents are expected to contribute only up to 5% of their assets each year. (A coalition of 28 private colleges announced they no longer will make this distinction.) Grandparents aren’t expected to contribute anything.

A financial aid award is computed by subtracting expected contributions from the parents and student from the annual cost. If $20,000 is in the student’s name, up to $7,000 must be spent on college expenses before the student is eligible for any aid. In the parents’ names, only $1,000 counts against aid. In the grandparents’ names, none reduces financial aid.

That’s important if financial aid is a possibility. Also working against the traditional rules are the recently-created Section 529 savings plans. These attractive savings vehicles were enhanced in the 2001 tax law.

Here’s how to mesh the financial aid rules, the new vehicle, and the traditional advice.

  • If the parents’ income and assets make financial aid unlikely, use the traditional rules or 529 plans. There are no bright line rules for the cut off. But if the parents’ income exceeds $200,000, aid is unlikely except at the most expensive institutions. Income under $100,000 means at least subsidized student loans are a possibility. Income between $100,000 and $200,000 is the gray area in which aid depends on each family’s particular situation and assets can be structured to make aid more likely. 
  • When financial aid is unlikely, grandparents’ or parents’ best bet might be Section 529 savings plans instead of the traditional UGMA or trust. We’ll explore and compare these two options in more detail in upcoming visits. But I’ll hit the highlights now. 

    The advantages of 529 plans are numerous. Contributions up to $10,000 from each person are gift-tax free. A special rule allows up to five years of tax-free gifts to be made in one year. That means up to a $50,000 tax-free gift from each person the first year. Earnings compound tax-deferred in the accounts. Under the 2001 tax law, distributions that are used for qualified college expenses are tax free after 2001.

    Perhaps best of all is that you can switch the beneficiary or even get the money back (after up to a 10% penalty) for any reason. That counters a big disadvantage of the UGMA/UTMA accounts.

    The disadvantage of a 529 plan is that the state agency that created the accounts determines the investments. Sometimes the accounts are invested in bonds. But most plans have the accounts invested in a mix of mutual funds determined by an outside money manager such as Fidelity, Vanguard, or TIAA-CREFF.

  • A 529 plan is a good idea even if financial aid is a possibility, because the account is considered an asset of the parents or grandparents, whichever made the contributions. If the grandparents created the account, none of the assets are counted against financial aid at most institutions. If the parents created the account, only up to 5% annually is considered to be spent on college expenses. 
  • If you will invest in the student’s name to take advantage of lower tax rates, UGMA/UTMAs are easy to set up and maintain and have low costs. You have control over the investments. But the assets become the child’s without restriction at age 18 or 21. If you will be putting a sizeable amount of money in the student’s name, it is better to set up a trust with limits on how much money will be distributed at different stages of the student’s life. 
  • Investments outside the student’s name and 529 plans should be invested to maximize long-term after-tax returns. That means selling stocks or mutual funds as infrequently as possible to let gains compound tax-deferred and to qualify for the lowest tax rates. You also should consider tax-efficient mutual funds, such as J.P. Morgan Tax-Aware U.S. Equity
  • The student should apply for financial aid at least the first year. Even if the only aid offered is subsidized loans, these are a good deal. The federal government pays interest during enrollment, no payments are due until after graduation, and the interest rate is below market rates. This is the most likely aid for middle class parents. It makes sense to borrow using these loans even when the parents or grandparents have the money to pay all expenses. 
  • Regular student loans (unsubsidized Stafford loans) are worth taking even when the family has the assets to pay and the loans are not subsidized. All payments are deferred until after graduation, the interest rates are low, and the family can leave its money invested until after graduation. There are flexible, attractive repayment terms that make it advisable for the family to keep its money invested and stretch out payments over up to 10 years. 
  • The PLUS loans for parents generally are not as attractive as home equity loans. If you have enough equity, it probably is better to borrow against that than to take a PLUS loan. 
  • Coverdell Education IRAs were enhanced in the 2001 tax law. The main improvement is that the maximum annual contribution is increased to $2,000. The big advantage of Education IRAs under the new law is that they can be used tax free to pay for primary and secondary school expenses. The IRAs still aren’t as attractive as 529 plans for college.

bob-carlson-signature

Retirement-Watch-Sitewide-Promo

Log In

Forgot Password

Search