It can be stressful to know whether or not to help with college and if so, how. The cost of a college education can be staggering, and it’s tough to know when a gift could affect your grandchild’s federal student aid. Here in Prescott, the full cost of Embry-Riddle Aeronautical University is somewhere around $250,000! No wonder we’ve received so many questions from clients lately wondering if “Trump Accounts” could help them fund education. While I don’t think Trump accounts will make a meaningful difference, there’s a lot you can do to help.
Fortunately, in 2020, Congress made it easier for grandparents to contribute to their grandchildren’s college educations by passing the FAFSA Simplification Act. While its name isn’t as catchy as the “Big Beautiful Bill," it does enable grandparents to contribute to education expenses without harming their grandchildren’s student aid, provided they follow some key rules. This is excellent news, especially since so many people have worked hard to retire well and be generous with their families. Here are two main points from the FAFSA Simplification Act:
· Grandparent-owned 529s are no longer counted when calculating student aid (unless your grandchild happens to attend one of the few private institutions that awards aid via the College Scholarship Profile).
· Direct tuition payments from grandparents are no longer counted when calculating aid.
529s are still king.
Now that grandparent-owned 529s don’t affect student aid, they are one of the best ways for grandparents to prepare for education expenses. Most people don’t know that there’s no annual limit on 529 contributions. Though states do impose aggregate limits, they’re usually in the hundreds of thousands. You can add a lot to your 529s and never withdraw, making them a flexible option. What’s more, most states, including Arizona, give a tax deduction, often with a cap, for 529 contributions. So, you could find yourself enjoying a triple tax benefit: a state income tax deduction in the current year, tax-deferred growth, and tax-free withdrawals for qualifying education expenses.
When considering a grandparent-owned 529, it's important to remember this key point. Even though there’s no annual limit on how much you can contribute to a 529, the gift tax still applies. I know what you’re thinking, “The government taxes gifts too?!” Sorry, yes, there is a gift tax on asset transfers to others when you don't get equal value in return. The good news is the government doesn’t tax you on small gifts. The current annual gift tax exclusion is $19,000 per person. The way the law is written, you and your spouse can each give away $19,000 to an individual per year without gift tax. That means a married couple can give away $38,000 to an individual each year. If you really want to supercharge your giving and avoid the gift tax, you and your spouse could each give $19,000 to as many people as you want. So, if you have three grandchildren, you and your spouse could give each of them $38,000 for a total tax-free gift of $114,000 each and every year! If you're considering whether to fund a 529 instead of simply giving your grandchildren $19,000 annually, it's up to you, but I believe there are three compelling reasons to utilize your annual gift tax exclusion for a 529 instead.
With a 529, you maintain ownership of the account for as long as you want. You don’t ever have to give the funds to your grandchild, unless he or she’s pursuing training or education that you want to support. Just giving $19,000 to a child or young adult that hasn’t yet learned how to manage large amounts of money could be a very effective way to turn $19,000 into… well, ash. It’s also important to remember the key points from the FAFSA Simplification Act I mentioned above. Namely, grandparent-owned 529s are not counted against the student when calculating student aid. By contributing to a 529, you can contribute to their education without triggering the gift tax or reducing student aid. If you give your grandchild $19,000 and they deposit it in their bank, it will be counted against them.
Finally, contributing to a 529 can be compelling because of a very cool carveout in the tax code. Okay, so I know you think I’m a total nerd because I just used the words "cool" and “tax code” in the same sentence, but please, bear with me. You can “superfund” a 529, which means you can put five years' worth of annual exclusions per child and per spouse in a single calendar year. That means you could put $95,000 if you’re single and $190,000 if you’re married into your grandchild’s account. You can also superfund as many 529 accounts as you want. For example, if you have three grandkids, and you’re married, you and your spouse can put $570,000 into three 529s in one year without triggering the gift tax and without affecting their student aid. You can superfund a 529 every five years. Which means, if you have the cash and plan ahead, you can just about fund any education without gift taxes or harming student aid.
But what if Junior doesn't go to college?
This uncertainty is the concern that leads to 529s being chronically underutilized. While nobody wants to be painted into a corner, 529s are much more flexible than people realize. Understanding the rules concerning 529s will allow you to determine for yourself whether the tax benefits of a 529 outweigh its limitations.
First, remember that Congress has allowed 529s to cover various education costs, not just college. A 529 can be used for kindergarten through 12th grade tuition as well as trade school and even apprenticeships after high school graduation. If Junior doesn't attend college, you can still make excellent use of a 529.
If your grandchild joins the military or starts working after high school and never has a use for the 529 you funded, you still have options. You can change the beneficiary to any other person you want. The most common option is to assign the account to the next oldest grandchild, but you could assign it to a niece, a nephew, a godchild, or any other person that would benefit from education.
If it’s important to you that the original beneficiary of the 529 benefits from the funds, even if they don’t pursue education beyond public high school, you still have two options. You can either roll the funds into a Roth IRA in their name, and the funds can continue to grow tax-free for their future. If that’s too much trouble, you can just hang onto the 529 and leave it to them when you pass. There’s never a time when you’ll be forced to pull funds out of the 529 and pay a penalty.
What if I Just Want to Give Them Money for College?
If the 529 still seems too restrictive or complicated and you’d just like to help pay that big tuition bill, that’s fine; just make sure they get you a sweatshirt from the bookstore and give the tuition money directly to the school on their behalf. As I stated above, the FAFSA does not count tuition paid by grandparents against students when calculating student aid, so make sure the tuition money stays out of their personal accounts and their parents’ personal accounts.
If you’re wondering where you should pull the funds from to make a large tuition payment, it’s important to remember that money in an IRA is often the least tax-efficient way to give money as an inheritance. The law currently states that beneficiaries, like your kids or grandkids, have to empty their inherited IRA within 10 years of inheriting it. Any money pulled out of an IRA is counted as taxable income. This means that if one of your kids earns $150,000 per year and needs to withdraw $200,000 from the IRA you left them, in order to empty the account within 10 years, you will have pushed them into a much higher tax bracket, potentially affecting them year after year.
To avoid leaving your heirs a “tax bomb," using funds from your IRA (within reason) to pay your grandchild’s tuition can be a way to bless them during your life and preserve other assets that can be inherited with little to no tax consequences. Since pulling funds from your IRA has significant tax consequences, it’s particularly important to consult your accountant and financial advisor to make sure nothing is overlooked.
Conclusion
Even though Trump Accounts don't allow large contributions, the government has made it easier for grandparents to make significant contributions to their grandchildren’s college educations. Grandparent-owned 529s are now a tax efficient and surprisingly flexible way to save meaningful sums for college, thanks to new regulations. But if a 529 isn’t a good fit, don't worry, you can still contribute. Just make sure you make tuition payments directly to the school and talk to your accountant to make sure you’re giving in a way that’s tax efficient.
This blog is not intended to be tax advice; rather, it is intended to be educational. Since every person’s situation is different, be sure to consult an accountant and financial advisor on how best to support your grandchild’s college aspirations.