Grandparents looking to help their grandchildren defray college costs have a variety of options. But no good deed goes unpunished! Let’s look at a couple of options and some of their pros and cons.
Make Payment Direct to School
Because of a special exemption in the tax code, any tuition (not room and board, books, etc.) paid by a grandparent is not subject to gift tax (or gift tax limits). However, there is a negative effect on the student’s financial aid eligibility: the tuition payment can be treated as dollar-for-dollar reduction in aid OR as student income the following year reducing aid eligibility by 50% of the gifted amount.
Open and contribute to a UTMA/UGMA account
The reduction in financial aid eligibility is a little less (around 20% of the account value) and a fairly wide variety of assets can be easily transferred into these accounts. But there are considerations too: the grandchild/student gains access and control upon reaching a state-specific age of majority – and at that point the assets can be used however they wish. Also “Kiddie tax” on unearned income could be an issue for these accounts, where amounts of passive income above a certain threshold can be taxed at their parents’ marginal rate.
Open and Fund a 529 for Child
529 plans offer tax-free earnings and withdrawals when the money is spent on qualified higher education expenses (tuition, books, supplies, etc). Similar to payments directly to the school, while the assets don’t affect financial aid, the amounts withdrawn for education expenses are considered student income and reduce aid in future years. It is often suggested that grandparents with 529 plans for their grandchildren wait until the last semester of college, when no more FAFSA forms are needed, to use 529 assets.
Contribute to a Parent-Owned 529 Plan
Depending on the financial aid from FAFSA above, the most favorable option may be for the parents to open a 529 and the grandparents send their gift there. Withdrawals from the 529 have no effect on FAFSA aid. The gift, however, is seen as a parental asset, which can reduce financial aid eligibility (although only by a maximum of 5.64%).
These are certainly only some of the more popular options. If you are curious about digging into this more deeply, please reach out to me.
Note: Content in this material is for general information only and not intended to provide specific advice or recommendations for any individual. Prior to investing in a 529 Plan investors should consider whether the investor's or designated beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's qualified tuition program. Withdrawals used for qualified expenses are federally tax free. Tax treatment at the state level may vary. Please consult with your tax advisor before investing.