Paying It Forward Never Goes Out Of Style – College Savings Plan
Tuesday, October 25, 2016
Several weeks ago, a client asked us how he could start a college savings plan to best help a grandchild with their college expenses, which prompted this month’s Imagine That! newsletter.
Whether your intentions are to help pay for an education, a wedding, a home or something else, what is the best way of doing this? This article will just focus on financial support for education. In a future article, we will tackle the topic of financial gifts for other needs and how to do so in the most tax-effective way possible.
Let’s see what options are available, which may offer tax advantages to both you and the student, and may offer you some control over the money before they actually use the gift.
529 College Savings Plan
The most common way to establish a college fund is with a 529 College Savings Plan. Unfortunately, it may inadvertently work against you and the student for whom you wish to help.
These college savings plans are named after Section 529 of the Internal Revenue Code. There are two different available plans—a prepaid plan and a savings plan:
- The prepaid plan allows you to purchase tuition credits at today’s rates to be used in the future. Currently, 13 states offer prepaid plans (CA does not currently offer a plan).
- In addition to the state offered prepaid plans, there is also a Private College 529 Plan, which covers 280 private schools, including 20 California private schools. Two local schools in the Private Plan are the University of San Diego and Point Loma Nazarene.
- The savings plan is similar to a 401(k) Plan or IRA in that your contributions are invested in mutual funds or similar investments. These plans allow you to create a college fund with investments that match the time horizon for when the money will be used.
The benefits of the 529 College Savings Plan include:
- The earnings grow federally tax free and withdrawals are not taxed, as long as the money is used for “qualified” higher education expenses, such as tuition, fees, room and board, books and school supplies.
- An individual can contribute up to $70,000 ($140,000 for a married couple) without incurring gift taxes by treating the contribution as if it had been made over a five-year period.
- You control the assets in the college fund.
- You can transfer unused assets to other family members.
- Some states offer tax deductions and even tax credits for 529 College Savings Plan contributions.
There are three primary disadvantages of a grandparent-owned 529 College Savings Plan:
- When a grandparent withdraws the college funds for their grandchild, it will be counted as student income for the grandchild on the following year’s FAFSA (Free Application for Federal Student Aid). Student income is assessed at 50%, which means that if a grandparent pays $10,000 of college costs, it will reduce the student’s eligibility for aid next year by $5,000.
- If you withdraw the college funds for an unqualified expense, you will pay federal and state taxes on any investment income, plus a 10% penalty.
- Because Section 529 College Savings Plans are run by state-chosen investment managers, the investment options are limited to the mutual funds offered within each unique plan.
Coverdell Education Savings Account
Similar to a 529 College Savings Plan, a Coverdell Education Savings Account (ESA) allows money to grow federally tax deferred and the proceeds can be withdrawn tax free for “qualified” education expenses. Not only can it be used for higher education expenses like the 529 College Savings Plans, but it can also be used for elementary and secondary education. The main drawback with these accounts is that the contribution limit is only $2,000 per year and there are income limits, which are based upon your adjusted gross income.
A custodial account under the Uniform Gift to Minors Act or the Uniform Transfer to Minors Act provide more flexibility than a 529 College Savings Plan or Coverdale ESA since you have more flexibility in terms of what you can invest in. The child also has more flexibility because they do not have to use the money for qualified education expenses. Depending on your state and wishes, the assets will belong to the child at age 18, 21, or 25.
Although the earnings in a custodial account do not grow federally tax deferred and there are no qualifying free withdrawals, there is a new tax benefit. Under the 2016 tax code, the first $1,050 of investment earnings are tax free and the next $1,050 are taxed at the child’s tax rate, which is usually lower than your tax rate. To avoid triggering a gift tax, keep your contributions to the custodial account at $14,000 or less per year ($28,000 per couple). Because the custodial account is treated as an asset for financial aid purposes, you need to ensure that you do not jeopardize a child’s financial aid eligibility.
If you desire more control over the assets, then a trust account is a good choice to consider. The two most popular options are a Section 2503(c) Minor’s Trust (named after the section of the Internal Revenue Code upon which it is based) and a Crummey Trust (named after D. Clifford Crummey, who was the first taxpayer to use this type of trust):
- The income in a Minor’s Trust can accumulate or may be used by the child, but once they reach age 21, all of the assets in the trust must be distributed to the child.
- Under a Crummey Trust, anytime you make a contribution to the trust, the child has a certain period of time (usually 30-60 days) to withdraw the contribution. If the child does not withdraw the contribution, then the trustee has the power to make distributions from the trust for the child’s benefit.
- To continue to qualify for the gift tax exclusion, some clever people combine these two trusts by creating a “hybrid” trust, where it acts like a Minor’s Trust until the child turns age 21, and then it converts to a Crummey Trust.
Similar to a custodial account, keep your annual contributions to $14,000 or less ($28,000 per couple) to avoid paying gift taxes. The cost of hiring an attorney to draft the trust document makes this a more expensive option. A potential disadvantage is that the trust account is treated as an asset for financial aid purposes.
Investment-Grade Life Insurance
Another effective way to provide for college funds is an “investment-grade” life insurance contract.
It should be structured to maximize growth in cash values and have minimal death benefit – staying just within the IRS guidelines of what qualifies as life insurance for the amount of premiums contributed.
Having the “guideline minimum death benefit” keeps the internal costs for term insurance, commissions and other charges lower, and allows more money to be invested into the accumulation portion.
The advantages of investment-grade life insurance include:
- The cash value accumulations are not included in the calculation of financial aid, and may be retained for supplemental retirement benefits if they are not needed for education funding.
- There are no income restrictions and no limits on the amount of funds which can be placed into the insurance contract other than the IRS guidelines mentioned above.
- You retain control over the money.
- With proper plan design, the unique borrowing features of these contracts keep gains in the contract from being taxed – either during accumulation or upon accessing the funds in the contract via low or zero net interest cost loans.
The primary disadvantages of this approach are that it is more complicated for some, and it requires time to compound funds in the contract. While this approach is more complicated than a 529 College Savings Plan, the greater sophistication and results of this funding instrument make it extremely advantageous in many situations.
Over $1.3 trillion in outstanding student loans is having a paralyzing impact upon the financial stability of graduates.
Helping a grandchild, niece, nephew receive a good education, without being a slave to student loans for many years, may be one of the greatest gifts you can give to another. Don’t be surprised if someday your act of kindness is repaid by those you have helped, as they in turn help another generation in the same way.
Paying it forward never goes out of style …
PS: If you found this article helpful and would like to read more about a specific topic in a future Imagine That! newsletter, please leave a comment below and let us know!