Gifting College to Your Grandchild

Back in the late 1960s, when many of today's grandparents were heading off to college, tuition was measured in the hundreds of dollars. A semester at the University of Iowa cost in-state students $185 in 1968. That same year, Harvard students were shocked by a 20% hike in tuition...to $2,400 a year.

This year, the all-in cost of the U of I for an Iowa resident, including tuition, room and board, and books, is almost $23,000 a year; at Harvard, it’s about $70,000. No wonder more and more grandparents are stepping forward—enthusiastically, reluctantly or somewhere in between—to help pay their grandkids’ college bills.

When Steve Kerr, a retired law enforcement officer in Temple, Texas, thinks of his three-year-old grandson Kieran’s future, he says he hopes the apple of his eye will go to college and study whatever inspires him, without having to take on crushing student loans.

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So Kerr, 63, and his wife, Diane, are establishing a 529 college-savings plan for Kieran. Money they contribute to the account will grow tax-free over the years and can be withdrawn tax-free to pay Kieran’s college bills. Kerr is studying and comparing the costs of various state plans. He’s also weighing whether to manage the investments within the plan by himself or to hire an investment adviser.

The Kerrs plan to contribute what they can afford each year, with the goal of building a war chest to cover about a fourth of the total estimated cost 15 years from now. And there will be no strings attached, such as insisting on a specific school or major. They wish they could cover the entire tab, but they need to consider their own retirement needs, too. That kind of thinking also benefits Kieran, says Kerr, who hopes his grandson will take summer jobs as a teen and contribute to his college bills. “Kids need to take some responsibility for their own education, so they have some vested interest in it,” Kerr says. “Hopefully, he will realize we cared enough about him to give him a little help.”

Grandparents usually have the best of intentions when it comes to gifting a college education to a grandchild. Sometimes they couldn’t afford to cover the full cost for their own children and are pleased to get a second chance. Or they read stories about growing student debt and want to spare a beloved grandchild from that financial burden. They wouldn’t mind if helping with college costs serves to remind grandchildren, long after they are gone, that their grandparents loved them.

But if you’re considering paying for some or all of a grandchild’s college education, be aware that it’s not simply a matter of writing a check. To make the most of your gift, you’ll need to sift through options ranging from 529 plans to making tuition payments directly to a school. If you’re not careful with the timing and coordination of your gift, regardless of the option you choose, you could unintentionally reduce a grandchild’s financial aid award, effectively undermining the value of your gift.

You also need to balance keeping your standard of living in retirement while still helping out with education costs. And there are issues you may never even have considered, such as which grandparent should control the account in the event of a gray divorce, says Jennifer Failla, a certified financial planner with Strada Wealth Management, in Austin, Texas. “There are a lot of details you have to get right,” agrees Mark Kantrowitz, an expert on financial aid and college savings.

You also may face emotional landmines that can undermine the purpose of your gift. Imposing conditions, such as attending your alma mater, can result in resentment instead of gratitude. And no matter how much you love your grandchildren, you shouldn’t be guilted into paying if it puts your own retirement security at risk. “Adult children might think Mom and Dad are loaded, when Mom and Dad really aren’t,” says Sarah Asebedo, president of the Financial Therapy Association, which represents financial planners and mental health professionals who focus on family and money issues. “Sometimes you have to say no.”

Despite the challenges, financial planners say more grandparents are helping fund college educations. A recent TD Ameritrade survey found that one in five grandparents are saving for a grandchild’s education, socking away an average of nearly $2,500 each year. “There’s just been a big, big uptick in grandparents wanting to be more educated in finding out how to help their grandchildren,” says Sean Flynn, a financial planner with Essex Financial, in Southport, Conn.

Your gift can be both meaningful and financially beneficial to you and your grandchild. Start with a family conversation about goals, and make sure you, your adult children and your grandchild are all on the same page, if possible. Then, figure out how to make the best of the funding option you choose. Use some of the workarounds explained below to bypass penalizing your grandchild’s financial aid award and other possible minefields. And keep in mind that contributing to tuition can be a smart estate-planning tool as well.

Start Saving Early in a 529 Plan

If your grandchild is young, having time on your side is a powerful force. That’s why the 529 plan is a popular choice, says Rob Kron, head of investment and retirement education for BlackRock. “It’s a phenomenal account,” he says. “If the goal is to put aside money for a grandchild’s education, there really isn’t a better option out there.”

Say you contribute $5,000 each year starting in the year your grandchild is born and the account grows at an average rate of 6% a year. Thanks to tax-free compounding, your $90,000 in contributions would produce a stash of nearly $164,000 to pay college bills.

Although there’s no federal tax deduction for 529 contributions, most states offer residents a break for contributing to their own state’s plan. Your first decision is whether you want a savings plan—which works much like a 401(k), with your contributions invested in mutual funds—or a prepaid plan, which is not as prevalent but promises to grow at a rate that keeps up with college-cost inflation. But prepaid plans typically cover only the cost of an in-state student’s tuition at a public university and may have residency requirements.

In most states, you don’t have to use the 529 savings plan in the state where you live; Kerr, for example, is considering Nevada’s plan. But a key reason is because Texas doesn’t have an income tax and thus offers no special income tax break for using the Longhorn state’s 529. If your state lets you deduct contributions, your state plan is likely to be your best choice.

Use the 529 comparison tool at Savingforcollege.com, a college finance research website, to weigh each state plan’s fees, total expenses, investment options and performance. Pennsylvania, Nevada and New York, for example, rank highest for performance, based on a plan’s average annual investment returns over the past 10 years, according to the site.

Decide how much to give. In 2018, the annual gift-tax exclusion allows each grandparent to give up to $15,000 to any number of people without triggering the federal gift tax, but there’s a special rule that allows even bigger lump-sum deposits in 529 plans, says Kantrowitz. Although the contribution is considered a gift to the beneficiary, the law lets you deposit up to five years’ worth of gifts at once, as long as you skip gifts to the same grandchild in the following four years. So you could contribute as much as $75,000 individually, or $150,000 as a couple. If you have multiple grandchildren, the limit applies only to each beneficiary.

You need to consider who should own the 529 account and how that can affect future financial aid for your grandchild. If the account is owned by the parent or the student, its value must be reported as an asset on the federal financial aid form known as FAFSA. The worst-case impact is a reduction in need-based aid, amounting to 5.64% of the account balance. If the account is owned by the grandparent, the balance doesn’t show up on the FAFSA but distributions from the 529 will count as untaxed income to the beneficiary, reducing aid eligibility by as much as 50%. So $10,000 in a 529 owned by a parent could reduce financial aid by $564, while a distribution from a grandparent’s account could reduce aid by $5,000, Kantrowitz says.

Still, some grandparents aren’t comfortable with their adult children controlling the account. “They don’t want them buying a big screen TV or a new Porsche, or they know the parents might be struggling to pay the rent,” he says. “I’ve heard of families tapping into 529 plans because there’s no other option.”

Try a workaround. The FAFSA is based on a two-year lookback: Families filing in 2018, for example, use 2016 income and other financial information. So, to avoid triggering the 50% reduction in financial aid, a grandparent could wait until after January 1 of a student’s sophomore year in college to take distributions from a 529 plan, Kantrowitz says, assuming the student will graduate in four years.

If 529 savings would seriously offset financial aid, another alternative is to wait until after your grandchild graduates and then take a nonqualified distribution from the plan to help him or her pay back the loans. Yes, the nonqualified withdrawal would trigger taxes and a 10% tax penalty, but only on the earnings portion of the distribution. Withdrawals will be taxed at the beneficiary’s presumably lower rate. “This works best if you want to provide an incentive for a grandchild to graduate,” Kantrowitz says.

Once you’ve set up your 529 and created a withdrawal strategy, be sure you know your plan’s rules on qualified expenses. Most plans allow tuition, fees, books, and room and board, but there can be limits. Some cover supplies and equipment, such as a computer. Check your plan so that you’re not surprised by expenses that don’t qualify and to be sure you don’t leave money unused in the 529 that could have covered some costs.

Pay Tuition Directly Instead of Saving

If you haven’t been planning ahead, you’ll need a different approach, says Michael Kitces, partner and director of wealth management for the Pinnacle Advisory Group, in Columbia, Md. “For those who just want to pay for college, because grandchildren are already in college, 529 plans don’t help,” he says.

If you have the means, you can write a tuition check directly to the bursar’s office. The advantage: Payment of college tuition directly to the school does not count against the annual gift exclusion. If you write a check of, say, $50,000 to a grandchild’s expensive school, the payment is totally gift-tax-free, Kitces says. To get this special treatment, however, your money must only be used for tuition. Payment for books or travel, for example, would count toward the $15,000 annual exclusion.

Even with this strategy, though, timing matters to avoid undercutting financial aid for which your grandchild may qualify. If possible, wait until the last two years of school, so the payments aren’t reported on the FAFSA. Another strategy: If the grandchild has a 529 account, spend down the 529 money during the first two years, and then write your tuition checks for the final two, Kitces says.

Before you make any kind of direct payment of tuition, however, check with your grandchild’s college about its policies. Some colleges may consider the payment as a resource that reduces eligibility for need-based aid, dollar for dollar.

Other options for helping to pay for college include funding a Coverdell Education Savings Account for your grandchildren. Although the big tax overhaul at the end of 2017 threatened to abolish Coverdells, in the end these tax-favored accounts survived. Contributions are not deductible on the federal or state level, but earnings grow tax-deferred and can be withdrawn tax-free to pay qualifying educational expenses. These accounts limit annual contributions to $2,000.

Grandparents also could set up a custodial account for a grandchild, but once the beneficiary reaches age 18 or 21, depending on the state, he or she would control the account. That means money you dutifully saved for their college education could wind up financing a backpacking trip across Europe. Plus, a custodial account counts as a student asset, which reduces financial aid by 20% of the account’s value.

And a child’s ambitions may change, so you need to think about other uses for the money if he or she doesn’t go to college or drops out. You have the flexibility of naming a successor beneficiary for a 529 account or moving the money into another grandchild’s plan.

Once you figure out the finances, deal with possible family issues, says Rick Kahler, president of the Kahler Financial Group, in Rapid City, S.D. If you give the oldest grandchild $10,000 and, 13 years later, the youngest is heading off to school, remember you’ll need to increase your contribution. “I encourage people to index for inflation,” Kahler says. If you need help, consider hiring a financial therapy planner. Find one at Financial Therapy Association.