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Estate Planning to Provide for the Grandchildren

Last update on: Jun 23 2020
estate planning

Providing for the grandchildren is one of the top concerns of today’s grandparents’ Estate Planning, according to surveys. That spurs ideas for setting aside money for grandchildren to use in the future. Let’s take a look at one not-so-good idea and two good ones.

One heavily promoted idea is a trust for a grandchild’s retirement. You contribute a minimum of $5,000 (there is no maximum) and pay setup fees of $300 per grandchild. The grandchild cannot withdraw money before age 59½, ensuring that the money will be there for retirement and that the power of compounding can cause a modest investment to grow to a large sum.

What’s wrong with this plan? Your trust contribution is invested in a variable annuity. That ensures the account will get tax-deferred compounding until money is withdrawn. But it also imposes an extra layer of fees on the account. In the plan I’ve seen, you pay an annual maintenance fee of 1.5%, plus money management fees on the mutual funds in the annuity. In addition, the promoter of the trust chooses the annuity. You don’t get to choose something like Vanguard’s Variable Annuity with its rock bottom costs.

The trust also has no flexibility. You take the prepackaged, one-size-fits-all trust designed by the promoter. The grandchild cannot tap the money before age 59½ for any reason, including disability or to pay for education.

When the grandchild withdraws money from the annuity, it will be taxed at the highest ordinary income tax rates, not favorable long-term capital gains rates.

A better plan is the one I’ve advocated for years. You put a relatively modest sum in a trust, as modest as $50 per month. The money is invested for the long-term, perhaps in mutual funds that make low annual distributions, which keeps annual taxes low. That provides long-term compounding of most gains with very low annual costs. And the trustee has the flexibility to change the investments if a change for the long-term seems advisable. You probably can get a relative or family friend to serve as trustee for little or no cost. There will be a cost for an annual tax return.

You set trust terms that meet your family’s needs. Distributions can be made for the grandchild’s education, first house, or other pre-retirement needs that appeal to you. The trustee also can be allowed to make emergency payments when the grandchild needs cash. There is no penalty on top of income taxes for distributions at any age, unlike an annuity which has a 10% penalty on distributions before age 59½.

Finally, under current laws when the investments are sold taxes will be paid at the favorable long-term capital gains rate instead of the ordinary income tax rate faced by annuity distributions.

The second good idea is the little-known Section 529 or “college trust plan” recently put in the tax code specifically to pay for a child’s or grandchild’s education. It also doubles as a great estate planning tool.

In a 529 plan, a state sets up a college savings trust. You can make a contribution to the trust to an account for your child or grandchild (or anyone for that matter). The state invests the money, and the gains earned by the account compound tax-deferred. There are no taxes until money is withdrawn from the account. It gets better:

  • Contributions to the trust are considered completed gifts. That means they qualify for the annual gift tax exclusion. No gift taxes are due for gifts of up to $10,000 per donee ($20,000 if spouses give jointly). Also the money is out of your estate, as is the future appreciation.
  • You can put up to $50,000 into an account in one lump sum and have it considered to be the $10,000 annual gift tax exclusion amount for the next five years. You and your spouse can jointly put $100,000 into an account tax-free. (Some of that amount will be included in your estate if you die within five years.) No other vehicle lets you front-load the annual gift tax exclusion like this.
  • You can get the money back when needed, if the state’s plan permits it, as many do. You will have to pay a penalty that varies by state.
  • You retain control of the account and can change the beneficiary. If a grandchild decides not to go to college, you can transfer the account to someone else.
  • When money is withdrawn to pay for college tuition, books, room, or board, the earnings are taxed at the student’s tax rate.
  • The fund can be used to pay for college in any state. This is unlike prepaid tuition plans that are good only at a college within the state, and often only at a public college in the state.
  • Some states give a deduction against state income taxes for contributions to their plans.
  • There is no preset limit on the earnings under most plans. The money is invested in the markets. So if the markets continue to do well, so will your account. On the other hand, there are no guaranteed earnings. Your account could lose money.

These provisions make the plans better than traditional Uniform Gift to Minors Act accounts or prepaid savings plans. You control the account. The grandchild does not take full control at age 18 or 21. You always can get the money back, yet the money is out of your estate if you don’t take it back.

There are three potential disadvantages. One is that the state decides how the account will be invested. In most plans, well-known money management companies such as Fidelity, Vanguard, or TIAA-CREFF invest the money. But you cannot choose the investment funds or the allocation. In a few states the state treasurer invests the money, which means it might be in treasury bills the whole time.

The second potential disadvantage is that Congress might change the rules. This provision was created only in 1997 and hasn’t gotten much publicity. So it is hard to evaluate that risk.

The third potential disadvantage is the account will be used to determine the level of financial aid available to the student. The treatment isn’t clear. But it appears that it will count as a parent’s asset. The means only about 5% of it will be assumed to be available each year to pay education costs. If it is counted as a student asset, 35% will be considered available each year.

The terms, costs, and fees of the plans vary. Most, but not all, have very modest fees.

At last count, 15 states offered these plans, and at least eight of them allow contributions from residents of any state. More plans are in the works

You can shop around for the plan with the best provisions for you. Or you can diversify by opening plans in more than one state. Many other states have plans in the works. The details of the available plans are collected on the internet for comparison at www.collegesavings.org. You might want to stick with plans that will let you transfer to another state’s plan if things change in the future.

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