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Sending the grandkids to college: Is it really possible?

by Susan Wright | Contributor
June 28, 2022

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Leaving a legacy is something that many people consider - and there are numerous benefits for doing so. One way for individuals or couples to do something memorable for loved ones - either when they are living or after they have passed on - is to help with higher education funding for their grandchildren.

There are several ways to set up an education funding strategy, and because everyone's goals and time frame can differ, not all methods will be right for all donors and recipients across the board.

With that in mind, it's important to understand how various college funding strategies work, and from there to make a determination regarding which may be best for you, given your specific objectives. Having more knowledge regarding educational funding for grandchildren can also allow you to see how it may (or may not) fit in with your overall estate and financial planning.

The impact of paying for your grandchildren's college expenses

Over the past several decades, the tuition cost at colleges and universities has skyrocketed. The cost of attending college can span beyond just the price of the tuition and fees, though. Other expenses can also include the following:

  • Room and board
  • Books
  • Supplies (such as computers, tablets, notebooks, calculators, etc.)
  • Transportation
  • Personal expenses (including clothing, toiletries, personal items, etc.)

In its 2021 report, “Trends in College Pricing and Student Aid,” the College Board reported that a moderate college budget for an in-state student who is attending a four-year public college in the 2021-22 school year averaged $27,330. This, however, is just an average.

For out-of-state students who attend public colleges or universities, the average price tag comes to more than $44,000, and for those who are attending a private college, the average cost is closer to $55,000.

Given these astronomical figures, there are many students who must rely on loans for paying their tuition. Otherwise, college may be out of the question for them. This is one reason why many individuals and couples who wish to assist their loved ones financially do so through college funding.

But, while going this route can certainly be a wonderful gift - and a great method of leaving a legacy for future generations - there are also some potential downsides if not properly planned ahead for. These could include adverse tax implications and having a negative impact on financial aid that the student is (or is not) eligible to receive.

Items to consider before moving forward with paying for a grandchild's college costs

While there are a number of enticing benefits that both you and your grandchildren can attain if you pay for some or all of their higher education expenses (which includes setting money aside in one or more college savings plans), there are some key factors to consider before you move forward, such as:

  • The best method and type of college savings plan or strategy to use
  • Gift taxes that may be incurred
  • Eligibility (or ineligibility) for student financial aid programs
  • Attendance at trade school or other “non-traditional” educational entity
  • If the grandchild/beneficiary does not attend a higher education institution at all in the future

Which method, plan or strategy is right for you?

There are many different ways that you could go about funding a grandchild's future college education. Each of these may have different tax implications, funding limits and other parameters to be mindful of. Some of the most common methods of setting up a college savings plan for a grandchild can include:

  • Lifetime gifts
  • Inheritance
  • UTMA account
  • 529 college savings plan
  • Coverdell account
  • Life insurance

Lifetime gifts

One way to help a grandchild (or grandchildren) with college education expenses is to provide them with financial gifts. Each year, the IRS allows an annual gift tax exclusion whereby you may gift up to a specified dollar amount ($16,000 in 2022) to any number of individuals. If you are married, you and your spouse together may double the amount of the gift. (So, for 2022, this total would come to $32,000.)

However, due to the high cost of college tuition and other expenses, even $32,000 per year may not cover everything that is needed. One way around this is for you, as a grandparent, could be to make tuition payments directly to the educational institution. These direct payments to the college or university are exempt from gift taxes, so there is no need for you to file a gift tax return - even if the amount exceeds the IRS annual gift tax exclusion.

Therefore, by paying the school directly, you could remove a substantial amount of money from your taxable estate, while at the same time helping one or more of your grandchildren achieve their dream of a college education - without having student loan debt to contend with for many years in the future.

It is important to note, though, that the tuition gift tax exclusion only applies to payments of actual tuition. Therefore, funds that you gift to a grandchild (or other individual) that go toward payments for books, supplies and even room and board, won't qualify for this exclusion. Also, tuition payments that are made by you that go directly to the college or university can reduce the student's eligibility for need-based financial aid programs.

Inheritance

Leaving money to grandchildren as an inheritance is yet another potential method of assisting them with the cost of higher education. These personal funds can typically be used for any need or want that the student has - like tuition, food or even transportation (such as the purchase of a bike, scooter or other vehicle).

As with other college funding strategies, though, there are both benefits and drawbacks to using inherited funds. For instance, depending on the amount of money that the student inherits, it may have an effect on their eligibility for student loans. The same is true with regard to the student obtaining grants.

UTMA account

UTMA stands for Uniform Transfers to Minors Act. These types of accounts allow elders to save money and invest it, while also maintaining full control of it until the child becomes an adult. These accounts can also allow you to transfer financial assets to a minor without establishing a trust.

As compared to some other types of financial savings plans, such as the 529 plan, an UTMA account can have more of an impact on the student's potential financial aid. In this case, when completing the FAFSA (Free Application for Federal Student Aid) form, an UTMA account is reported as the student's asset, and in turn, reduces their financial aid eligibility by 20% of the value of the account.

In addition, UTMA accounts also do not offer the same types of tax-related benefits that some other college savings plans like the 529 do. For instance, contributions to an UTMA are made with after-tax dollars, so they won't reduce the donor's (in this case, the grandparent's) income tax base in the years of contributions.

529 college savings plan

two college students studying in the court yard of their university due to a 529 college savings plan

A 529 college savings plan is a type of tax-advantaged account that is designed for helping to pay for education costs for a child, grandchild or other beneficiary. There are two types of 529 plan options. These are a:

  • Prepaid tuition plan
  • Savings plan

A prepaid tuition plan allows a 529 account holder to make advance contributions for tuition at certain colleges and universities. With these plans, the current cost of the school's tuition can be “locked in” - even if the student does not attend the institution until a time in the future.

The money that is inside of 529 savings plans is allowed to grow tax-deferred. Also, the withdrawals from these plans are tax-free - but only as long as the funds are being used for qualified education-related expenses. These can include room and board, tuition, books and school supplies.

It is important to note that even though parents and grandparents are oftentimes the owners of 529 plans, anyone is eligible to open such an account. In addition, because 529 plans are state run as versus federally, the rules can differ from one state to another.

Coverdell account

Another possibility for college savings that grandparents may use to assist their grandchildren with the cost of higher education is the Coverdell Education Savings Account. (These accounts were formerly known as Education IRAs.)

In some ways, Coverdell accounts are similar to 529 plans, such as:

  • Tax-deferred growth of the funds in the account
  • Tax-free withdrawals when the money that is accessed from the account is used for education-related items and services

However, Coverdell plans impose a lower annual contribution limit than 529 plans have. Therefore, it is possible that even if the financial vehicles in the account perform well, there may not be enough to cover a large percentage of the student's needs. In addition, the Coverdell Education Savings Account is only available to families that fall below a certain annual income level.

Life insurance

Even though many types of college savings accounts can provide you with at least some tax-related benefits, they can also be a bit limiting. Because of these limitations, there is a different college funding alternative that you may consider. That alternative is life insurance.

While life insurance is typically purchased for the death benefit that it provides for beneficiaries so that they can replace lost income and pay off debts - such as a home mortgage and the insured's funeral and final expenses - permanent life coverage (i.e., the type of life insurance that offers both a death benefit and cash value) can essentially “cover all the bases” when it comes to funding college costs for a grandchild (or other individual). And in doing so, the insured does not have to die in order for the student to benefit from the policy.

For instance, the funds that are in the cash value component of a permanent life insurance policy are allowed to grow on a tax-deferred basis. This means that there is no tax due on the gain until the time of withdrawal - and this, in turn, can help the value to increase more than that of a comparable plan that is fully taxable (with all other factors being equal).

Tax-deferred versus fully taxable account

a graph showing the difference between tax deffered and fully taxable accounts with the x-axis representing years and the y-value representing dollar ammounts ranging from $100,000 to $300,000 incrementing by $25,000

Although other college savings plans may also allow funds to grow in a tax-advantaged manner, there are a several additional benefits that life insurance can offer, such as:

  • No annual maximum funding limit.
  • No gift taxes to contend with - even if the policy's premiums exceed the amount of the annual gift tax exclusion each year.
  • Opportunity to access tax-free loans (rather than taxable withdrawals).
  • Ability to spend the funds on anything, not just education-related costs.
  • Self-completing plan. This means that if the insured dies, the income tax free death benefit can be paid to the beneficiary so they still will have funds available to use toward their education or for any other need or want. Compare this with other college savings plans where, if the one who is funding the account passes away after only a few contributions have been made, the amount of money in the account could fall far short of what the student actually needs to pay their education expenses.

The impact of gift taxes

The impact of gift taxes should be included in any college funding strategy for a child, grandchild or other loved one. Overall, though, tuition payments that are made directly to an educational institution are usually exempt from gift taxes - even if the amount that is paid in tuition is more than the IRS-mandated annual gift tax exclusion ($16,000 per individual and $32,000 per married couple making a gift in 2022).

In any case, though, you may gift away $16,000 (in 2022) to as many individuals as you wish (and twice that amount if you do so with your spouse) without having to file a gift tax return - and these funds may be used for anything that the recipient wishes - including the payment of college tuition or related expenses.

How your funds could impact the student's financial aid eligibility

As discussed above, many of the strategies that are used for assisting your grandchildren with college funding can have a negative impact on their eligibility for financial aid. So, depending on the situation, without a plan in place to fill in these college expense “gaps,” it could make paying for college even more challenging for a student.

Note that the formulas that are used for determining the financial aid needs of students do not include life insurance cash values. Therefore, even if a life insurance policy contains a substantial amount of money in its cash value, it will not negatively impact the student's eligibility for obtaining college loan funds.

Can funds still be used for trade school or another “non-traditional” entity?

There are some instances where funds in a college savings account may be used for education other than that which is received at an official college or university. For instance, the funds that are in a 529 savings plan may be used to pay for costs that are related to “traditional” schooling, as well as the cost of various apprenticeship programs. The same is true of money that is accessed from a Coverdell educational savings account.

Likewise, money that is received as an inheritance or a gift by a student may also be used as they wish, without having a negative impact on the tax status of the funds. Life insurance death benefit proceeds, as well as either withdrawals or loans from a policy's cash value do not have limitations on what they are used to purchase - including education through a trade school or other similar institution.

What happens if your grandchild does not attend college in the future?

Depending on the type of college savings plan that you choose to use to benefit your grandchildren, you could receive some nice tax-related benefits on the contributions as well as on the growth that takes place inside of the account, the withdrawals - or all of the above.

But what happens if you have a college savings plan set up, and your grandchildren decide not to continue their education at a college, university or other type of institution?

In this case, you can typically still access the money. However, you may be subject to tax and other penalties. As an example, if you have money in a 529 college savings plan, but your grandchild opts not to attend college, then the options are to either liquidate the 529 account - and in turn, be taxed on the gain - or to transfer the money to another beneficiary who is attending (or who is going to attend) college.

It is possible that you may also incur an additional 10% penalty from the IRS if the money is not used for eligible educational expenses. Although, there are some situations where the 10% withdrawal fee is waived, such as:

  • Military academy. If the recipient of the funds in the account goes to a military academy, the funds may be withdrawn penalty-free.
  • Scholarship. If the student receives a scholarship from the educational institution that they attend, the equivalent amount of that scholarship may be withdrawn without penalty.
  • Disability. If the beneficiary of the funds has been diagnosed with a disabling condition, then money may be accessed from the account in order to pay for at least some of the costs that are related to that disability.
  • Death. In the unfortunate event that the potential recipient dies, the account holder is allowed to withdraw the funds without incurring a penalty. Alternatively, the account may instead be transferred to an eligible relative of the beneficiary who can then use the money for their educational expenses.

How education funding can tie into your overall estate and financial plan

A good solid estate plan should ideally make the best use of all of your assets. Therefore, education funding could play an integral role in your overall estate planning. Due to the tax-advantaged nature of various college savings strategies, you have the opportunity to increase the value of these accounts so that your grandchildren and other loved ones have the financial wherewithal to move forward with the knowledge that they need for achieving their life plan.

It is estimated that children who know that they have a college savings plan in their name are six times more likely to attend. Therefore, making a financial commitment to a child's or grandchild's academic success is one of the best possible gifts that you can give to them. This, in turn, could truly inspire your loved ones for moving toward their dreams.

Taking the next step to get your plan in place

If one of your financial goals is to assist your grandchildren with paying for college or other education-related expenses, it can be beneficial to work these objectives into your overall retirement and estate planning.

Before committing to any type of college education funding plan, though, it is recommended that you first discuss your goals, time frame, risk tolerance and other parameters with an experienced financial professional. That way, you can obtain professional assistance in narrowing down which type of account - if any - is right for your particular situation.

Alliance America can help

Alliance America is an insurance and financial services company dedicated to the art of personal financial planning. Our financial professionals can assist you in maximizing your retirement resources and achieving your future goals. We have access to an array of products and services, all focused on helping you enjoy the retirement lifestyle you want and deserve. You can request a no-cost, no-obligation consultation by calling (833) 219-6884 today.

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