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 benefits of the 529 College Savings Plan include:
There are three primary disadvantages of a grandparent-owned 529 College Savings 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Plan, a Coverdell Education Savings Account (ESA) allows money to grow federally tax deferred and the proceeds can be withdrawn tax free for “qualified” education expenses.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.

Custodial Account

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.

Trust Account

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):

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 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 …

Imagine That!


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!