In the face of rapidly rising education costs, many parents and grandparents are grappling with the best way to prepare for future college expenses. In the first part of this two-part series, we explored paying college costs directly and using custodial accounts. Here we explore how 529 accounts and irrevocable trusts can be used to help plan for college tuition.
Method 3: 529 College Savings Accounts
529 plans are college saving plans sponsored by states or educational institutions. In many ways, an account under a 529 plan is similar to a Uniform Transfers to Minors Act (UTMA)/ Uniform Gifts to Minors Act (UGMA) account (see Part 1 of this series); it is simple to establish and requires no legal fees. 529 plan contributions qualify for the federal gift tax annual exclusion and can be made or discontinued at any time.
However, there are important distinctions.
- Investments in a 529 plan grow income tax-deferred and become income tax exempt if used for qualified higher-education expenses.
- As the account's owner, the parent or grandparent has complete control over whether and when to disburse the funds – even after the child reaches age 21 – and can shift funds between children and/or grandchildren. (N.B. An additional tax may apply if the funds are moved to a different generation than that of the original beneficiary.)
- The parent or grandparent can make up to five years' worth of annual exclusion gifts in one payment, which will not be subject to federal gift or GST tax, allowing a larger pool of assets to be invested earlier.
- A majority of states offer a credit or deduction against state income taxes for 529 plan contributions.
These features have helped the 529 plan become one of the most popular ways to finance higher education since it was introduced 30 years ago.
Despite the benefits, there are some disadvantages associated with the 529 plan.
- Withdrawals are subject to federal income tax and a 10% penalty on earnings if assets are not used for qualified higher-education expenses, including tuition, fees, room and board and books at accredited colleges and vocational and postgraduate schools in the U.S.
- While custodians can invest UTMA/UGMA accounts in any asset type, 529 plans are restricted to investments offered by the plan sponsor – typically mutual funds, such as age-based model portfolios.
- A 529 plan may charge a modest enrollment fee and/or an annual administrative fee that is automatically deducted from investment returns.
- Since 529 plan contributions are subject to the federal gift tax, the donor to the account generally uses the annual exclusion to fund the account, meaning that the parent or grandparent will be unable to make a separate annual exclusion gift to that student in the same year.
Taxpayers seeking to minimize estate taxes may prefer to use another method that does not "waste" the annual exclusion on an educational expense that can be paid gift tax-free (that is, by paying tuition directly to the college or university).
Method 4: Irrevocable Trusts
Many parents and grandparents choose to establish irrevocable trusts to pay for future educational expenses, despite the additional complexity and cost. An irrevocable trust requires an attorney to draft it, and it may need to report and pay income taxes annually.
Nevertheless, irrevocable trusts can offer significant tax and other benefits while preserving flexibility in investments and distributions. If a trust has multiple beneficiaries, the parent or grandparent can make large lump-sum gifts that represent annual exclusion gifts for each one. For example, in 2016, a married couple with five grandchildren could transfer up to $140,000 ($28,000 multiplied by five) in annual exclusion gifts to a trust for their grandchildren.
Gifts to irrevocable trusts cannot be taken back; however, trusts can be drafted to allow flexibility and to give the trustee discretion with respect to when to distribute trust assets. For example, the trust could be established for multiple beneficiaries and for any purpose, not just educational expenses. Therefore, the parent or grandparent could directly pay the child's tuition and use the trust funds for other purposes, such as assisting the child in purchasing a first home. Additionally, the trust's investment earnings can be taxed to either the parent or grandparent or the trust itself.
Despite the administrative requirements and additional legal costs, the tax advantages and flexibility irrevocable trusts offer are attractive to families seeking to minimize estate taxes.
Summing Up the Options
Each method described offers unique advantages. Parents and grandparents who value simplicity, investment control, the ability to make separate annual exclusion gifts and the freedom to change their minds may prefer to pay tuition directly to the school.
