Estate Planning Strategies for Tax-Wise Funding of Grandchild’s Education

Grandparents and their adult children agree: A critical concern for both is how to pay for the education of the grandchildren. The grandparents, of course, can help. By using the tax law effectively in your estate planning, you can help pay for a grandchild’s schooling with the lowest cash outlay possible.

Last year, Congress created the Education IRA. These IRAs are highly touted, especially by politicians, but they aren’t much use to you. The IRA funds can be distributed tax free only when they are used to pay for secondary education. Private schools below the college-level don’t count.

More importantly, the maximum annual contribution per beneficiary is only $500, and contributions cannot be made after the beneficiary reaches age 18. If the maximum is contributed each year beginning when the child is born, by age 18 the IRA might have enough to pay for a year of college, depending on where the student goes. Also, there is an income limit on contributors. A contributor who files a joint return can contribute the maximum only if adjusted gross income is under $150,000; for a single taxpayer the AGI must be under $95,000.

Also, if the Education IRA is used, the new tax credits for education expenses are limited. Parents generally are better off using the Hope scholarship tax credit and the Lifetime Learning credit than counting on an Education IRA.

If you want to set aside money in your estate planning for the grandchild to use for education expenses in the future, the best solution is a taxable investment account in the grandchild’s name.

The first benefit is that no taxes are due as long as no income or capital gains are realized by the account. The investments can be left to grow and compound tax deferred for years. That means you can invest in a portfolio of stocks that don’t pay dividends or in mutual funds that make low annual distributions. The gains will compound from year to year without being depleted by taxes.

The second benefit is that when taxes are paid they might be paid at the lowest possible rate. Under the kiddie tax the first $600 of investment income is tax free, and the next $600 is taxed at the child’s rate, usually 15%. (These levels are indexed for inflation each year.) Investment income above those levels is taxed at the parent’s top rate.

But once the child turns age 14, all investment income is taxed at the child’s tax rate. The money could be invested in your name or the parents’, but then capital gains taxes would be paid at a maximum rate of 20%. The grandchild should be in a lower tax bracket and could pay capital gains taxes of 10%, cutting the tax rate on the family in half.

The graph shows the importance of this advantage. One account is in the child’s name, and the other is in the grandparent’s. Each account receives $2,000 annually and has an 9% annual compounded return. When the child hits age 18, enough is taken out of the accounts each year for four years to have $25,000 after taxes.

As part of your estate planning, you can put the money in a custodial account under the Uniform Gift to Minors’ Act to ensure that the child won’t spend the money on a new car in high school. But that allows the child to have full control of the account at age 18. You are better off setting up a trust to hold and invest the money. That way, you can writes limits controlling when the grandchild gets control of the money and how it is used.

If it is too late to set up an account for the future, you can make tax-free gifts to pay for education expenses as they are incurred. You know that annual gifts of $10,000 per recipient can be made tax free ($20,000 if spouses give jointly). But most people don’t know that unlimited tax-free gifts for education purposes are allowed if the payments are made directly to the education institution. That means you can pay for as much education as you can afford without incurring gift taxes or triggering taxes on your children or grandchildren.

There are many estate planning strategies available to help pay for a grandchild’s education. But you’ll be better off ignoring the new methods set up by Congress and using the tried-and-true strategies.