Jean Carter: Hello. I’m Jean Carter, an ACTEC Fellow from Raleigh, North Carolina. And with me is Michael Barker, an ACTEC Fellow from Richmond, Virginia. Our topic today is paying for college for grandchildren or nieces and nephews. And Michael, before we start, perhaps we should define the topic a little better. What exactly are we talking about on paying for college? Do I have to worry about taxes when paying for college for my child?
Michael Barker: Jean, that’s a great question and a good place to start, because paying for your own child to go to college is fairly easy from a tax perspective. Because parents are deemed to have an obligation of support for their children, so, most payments for college expenses would not constitute gifts for gift tax purposes. So, really this topic is focused on making payments to support others to go to college, such as grandchildren, as you’ve said, nieces and nephews, friends, whoever it might be that is not your child, and doing so in a tax-efficient way. I should also say, Jean, that we’re not talking about charitable planning, we’re not talking about making gifts to the institution for charitable purposes. We’re really just focused on the gift tax aspects of planning for college.
Jean Carter: So, specifically we’re talking about a gift tax efficient way for me to pay for college for my grandchild or niece and nephew or someone else. Correct?
Michael Barker: That’s right Jean. And we can sort of walk through a menu of options to consider doing that. And maybe the right place to start is the easiest thing to do, which is to make a gift. If you have an adult grandchild, for instance, who’s 18 or older, who's starting college and you want to pay some of those expenses, that’s easy. You can transfer assets to that adult. And from a gift tax perspective, each individual has what is referred to as an Annual Exclusion Amount. The annual exclusion under current law in 2022 is $16,000 per year, per donor, per recipient. So, in other words, a married couple could give a beneficiary $32,000 in any given year, without having any gift tax consequences. And you can make those types of gifts year after year after year. And that covers a lot of what most people are trying to do.
Jean Carter: Definitely that would. What if my grandchild is still four years old and I want to start building up for college? What do I do?
Michael Barker: If your beneficiary is a minor, and a minor cannot own assets, then you’ve got to find a different type of account for the recipient money to go. A couple of options. One, maybe not the most efficient but a simple one, make a gift to the child’s parent. And say: “Hey, set this aside for little Susie and, in 15 years when she goes to college, I want you to use it for that.” That would be easy, but if you want something that’s a little more direct and a little more controlled you might consider a custodian account.
Sometimes these are referred to as UTMA accounts (Uniform Transfers to Minors Act), so you might see that referenced. A custodian account is very simply an account for a minor, that’s managed by an adult. So, you can transfer assets from your account to a custodian account, you can appoint yourself, your spouse, or anyone else; a child’s parent, if you think that’s appropriate, as custodian to manage the money, to invest it on behalf of the minor. It can be used to pay tuition or other things, for the benefit of the minor. And then anything left over when the child reaches adulthood, either at age 18 or 21, depending on the jurisdiction, those assets go outright to the beneficiary.
Trusts and 529 Accounts
Jean Carter: Well, that’s a great way to get ahead on it. Are there others?
Michael Barker: Yes. I think that’s a really simple approach. Another option that’s more complex, might be involving using an Annual Exclusion Trust. And these types of trusts have some more complexity. They’re better for bigger, more sustained gifts over time. And there’s a lot of complexities that are going along, they’re sort of outside the scope of what we’ll talk about today. But just know that long-term trusts might be a good planning opportunity for larger gifts. But if you’re focused on more directly educational expenses, one thing that a lot of people use is what’s called a 529 plan, sometimes it’s referred to as a qualified tuition program. These are state-run programs. Many states, but not all states, have 529 plans.
Essentially, these are accounts for the benefit of a student, a minor, that you can transfer assets to and the big benefit of these 529 accounts is that the assets will grow when the investments appreciate over time. All that growth happens tax-free, and there’s no tax on distributions out of the 529 plan for the benefit of the beneficiary when he or she eventually goes to school, and those monies are used for college costs.
The other benefit of 529 plans, is that many states have a state income tax credit to encourage savings. So, when you make a donation to a 529 plan to benefit your niece or nephew, for instance, you personally can take an income tax credit in many states. There are usually some limits on those, but worth considering. The other benefit of 529 plans is that you can frontload five years worth of annual exclusions.
So, I mentioned earlier that the annual exclusion amount is $16,000 a year. When you’re contributing to a 529 plan, that amount is $80,000 a year or $160,000 for a married couple, which can go a long way toward solving college expenses.
Coverdell ESA, Coverdell Educational Savings Account
Jean Carter: That’s great. I also heard a mention of a Coverdell account.
Michael Barker: Yeah, Jean. Coverdell accounts (Coverdell Educational Savings Accounts) are very similar to 529s. They’re not state-run programs, but they are found at any bank or financial institution. And it’s a similar idea so far as appreciation can grow free of tax. There are some limitations on who can contribute to a Coverdell account, and what types of contributions can be made in terms of the size. Coverdell accounts are generally designed for the middle class and the upper-middle class individuals, and so if a person’s adjusted gross income for any year is above $110,000 or $220,000 for a married couple, if it’s above that then you can’t contribute to a Coverdell account. If it’s below that amount you can contribute, but only up to $2,000 per year. There are some other rules and limitations if a beneficiary also has a 529 plan, so you’ve got to be really careful when you’re making contributions to a Coverdell account.
Direct Payment for Tuition to a College for a Student
Jean Carter: This is great information, if I had time to do it. But what if the child is already 18 and he wants to go to a private university with $70,000 a year tuition? What do I do now?
Michael Barker: A direct payment to the college. Payments made directly from a person to an educational institution that are used for tuition, not room and board, just tuition, those payments are not deemed a taxable gift. Sometimes these are called 2503(e) gifts. I reference that only because you might see it as you look around on the Internet. There’s an internal Revenue Code section that authorizes those gifts, but a lot of folks use those direct transfers to the institution to pay tuition, because those are not deemed a gift.
Jean Carter: Michael, this has been some very useful information. If I had grandchildren, I’d use it. Thank you so much for telling us about this.
Michael Barker: Absolutely. I’ll maybe make two closing comments, just to wrap things up: one is a caution, and one is a resource. As a caution I always remind folks to be careful with gifts, when a beneficiary might be seeking needs based financial aid because many gifts can impact a student’s eligibility for need based financial aid. So, you wouldn’t want to mess up what they were doing.
Then secondly, a resource. The IRS has a publication called Publication 970 (Tax Benefits for Education). That is a publication that is readily available online and has lots of detailed information about options for planning, from a tax perspective, for college expenses. It can be a useful tool for folks and so I would commend that to your reading.
Jean Carter: This was great. Thank you.
You may also be interested in: