How to Pay for a Grandchild’s Education

Perhaps the best use of any excess wealth you have is to pay for a grandchild’s education. There are many ways to do that, and I have covered them extensively in the past. In this visit I’d like to explore three of the better tax-advantaged strategies. You might be able to deduct at least a portion of education expenses.

Longtime readers know I was among the first to explain college savings plans, also known as Section 529 plans. These can be a great deal with significant tax benefits. Keep in mind that these are different from prepaid tuition plans.

Section 529 plans let you put in an account for anyone’s benefit money that qualifies for the annual gift tax exclusion. Even better, you can use up to five years of tax-free gifts in one year. That means you can put up to $50,000 per child tax free in an account in one year, or $100,000 from both spouses. You can deposit a total of about $168,000 into each child’s account.

The money in the account grows tax-deferred. When it is withdrawn for college expenses, earnings are taxed as ordinary income but at the student’s tax rate.

The money and its earnings are out of your estate and free of estate and gift taxes. But you can get the money back at any time, or change the account to another individual’s name if, say, the child decides not to go to college. There is no tax penalty for taking the money back, and most plans charge a penalty of only 10% of earnings. That’s of earnings, not the account value.

The plans are run by states. You generally choose how the account is invested from among mutual funds offered by the state plan. But you often aren’t allowed to change the investment choices once selected. Many plans accept money from residents of any state and allow the money to be spent at colleges in any state.

Many states allow tax deductions for contributions made to their own plans by their residents. Some even make withdrawals of earnings exempt from state income taxes.

But be aware of some differences.

First of course are the fees deducted from your account. These vary greatly, and can depend on the investments you select. When the same firm offers funds in different plans, the fees can be different. There can be layers of fees imposed by both the investment funds and the state. You need to read the materials closely to determine all the fees.

The investment options also vary. Some states manage the investments themselves. Others use outside firms such as Fidelity, Vanguard, and TIAA-CREF. You might be able to choose your asset allocation, or the state might mandate an asset allocation based on the child’s age. Some offer only certificates of deposit through the College Savings Bank.

Check withdrawal rules. If a state raises its fees or changes its investment options, you want to be able to move the account to another state at little or no cost. The IRS rules let you make a move to another state without penalty if you change the name of the account to another family member. That’s no problem if there is more than one child or grandchild involved.

States can impose tougher rules. Also, some states require withdrawal by a certain point, such as by the time the individual is age 30 in Iowa.

If you want maximum flexibility and benefit, read all the provisions. For more on the plans, check www.collegesavings.org or call 1-877-277-6496. Also, check my March 2000 issue.

Buying the student’s college housing also can be a tax bonanza.

The easiest strategy is to buy a small unit such as a condo, let the grandchild live there rent free, and deduct mortgage interest and real estate taxes as a second home. After the student graduates, sell the unit for what you hope is a profit that is taxable as a long-term capital gain. The cash you have tied up is the down payment and expenses over the four years.

If you are willing to do a bit more work, buy a group home and make it a rental unit. The grandchild can live there rent free and act as manager – collecting rents, overseeing regular maintenance and repairs, and finding other tenants. You might be able to also pay the grandchild to do some of this work, depending on pay scales in the area. Those wages would be deductible by you and mostly tax free to the grandchild. Also, reasonable trips to visit the property (and coincidentally your grandchild) can be deductible.

If all works out, the rents will pay your expenses. With depreciation and other expenses you might get a tax loss. After the grandchild graduates, sell the property. Again, this might be at a long-term capital gain.

Not everyone wants to use this strategy. You don’t want to buy if the college has a weak real estate market that is likely to stay that way. Your grandchild must have the maturity to handle the management duties while keeping up with school work. You also need to pay able to buy the property at a good price. As they say, real estate profits or losses tend to be locked in when the property is purchased.

The third strategy is for those who want to benefit a charity and could use a tax deduction, in addition to wanting to help a grandchild through college. It is known as the tuition unitrust or college charity unitrust.

Here’s how it works. You transfer, say, $100,000 to the trust. If you transfer appreciated property instead of cash, you avoid capital gains on the property. The trust is scheduled to pay out a percentage of its value each year to the grandchild. A 30% annual payout would be about $75,500 over five years, with a $30,000 payout the first year and a declining amount each following year. After the trust term, whatever remains in the trust goes to a charity you named. The student pays taxes on the income distributions from the trust.

The exact amounts the grandchild and charity get depend on the investment return of the trust. It could be more or less than these projections.

You get a tax deduction for making the contribution. IRS tables are used to value the charity’s share of the trust, and therefore your deduction. If you contribute $100,000 to a five-year trust, you’ll get a tax deduction of about $19,650, or a net tax benefit of about $6,000 in the 31% tax bracket. The charity will get about $33,000, depending on the investment returns.

There are many ways to help a grandchild pay for education. In this visit I’ve given you three very different strategies with different amounts of complexity. Pick the one, or the combination, that works best for you.