Helping Grandchildren with College Expenses While Avoiding Taxes

Take-Away: With the looming possibility of a sudden drop in an individual’s applicable exemption amount, coupled with a sudden increase in the federal estate tax rate, wealthy individuals should explore ways to reduce their taxable estates while the current transfer tax exemption exists through lifetime gifts. One easy way to reduce a grandparent’s taxable estate is to help fund a grandchild’s higher education expenses.

Background: As a ‘refresher,’ there are several ways to encourage a grandchild’s higher education though lifetime gifts, gifts that would use some of the grandparent’s available applicable exemption amount (while it exists.). One way is to provide financial assistance to their grandchild to pay for their future higher education expenses. This may be particularly appealing for Baby Boomers, many of whom went to college, and who want to see their grandchildren also attain a higher education degree. However, all grandparents would prefer to provide that financial assistance without paying a gift tax, if possible. Now may be the best time ever for grandparents to consider making gifts to encourage their grandchildren to pursue a higher education while their large lifetime gift tax exemption is available.

As grandparents scramble to take advantage of their gift tax exemption before it disappears, consider some of the following ways a grandparent might assist with a grandchild’s higher education costs.

Direct Annual Exclusion Gifts: An outright gift of cash or securities to the grandchild, or to a Uniform Transfer to Minors Act account established for the grandchild, would be covered by the federal gift tax annual exclusion, up to $15,000 a year per grandchild. [IRC 2503(c).] A married couple could thus fund up to $30,000 a year towards a grandchild’s college education costs gift tax-free and generation skipping transfer tax-free.

Minor’s Trust: The same gift could be made to an irrevocable trust established for the grandchild, either a minor’s trust [IRC 2503(b)] or a crummey trust with a withdrawal right held by the grandchild or an adult acting on behalf of the grandchild. A minor’s trust satisfies the present interest requirements for an annual exclusion gift. A minor’s trust has some limiting conditions, the most important of which is that the grandchild beneficiary must have full access to the minor’s trust corpus upon attaining age 21 years, although that trust can continue after that age if the grandchild fails to timely exercise his or her withdrawal right upon turning age 21 years.

Crummey Trust: With a crummey trust the grandchild, or an adult acting on the grandchild’s behalf, possesses the right to withdraw the transfer of assets to the trust, but the withdrawal right is limited to a narrow period, e.g. 30 days. The failure to timely exercise the withdrawal right leaves the assets in the trust subject to the trust’s terms. As a result, with the transfer of assets to a crummey trust the duration of that trust can last a much longer period than with a minor’s trust when the grandchild possesses right to withdraw all the minor’s trust assets upon attaining age 21.

Drawbacks:

UTMA: A gift to a Uniform Transfer to Minor’s Act account will be available to the grandchild once emancipated, and there is no obligation imposed on the grandchild that he or she must use the UTMA assets under their control to pay for any education expenses.
Trusts: Administrative expenses are always associated with using a trust, whether or minor’s trust or a crummey trust, including the cost to establish and fund the trust and annual accounting and tax reporting fees.
FAFSA: A cash gift to a student will be considered untaxed income by the federal government’s financial aid application, i.e. the FAFSA; student income is assessed on the application at a rate of 50%, which can negatively impact the student’s financial aid eligibility.
One way around this FAFSA drawback is for the grandparent to give the cash gift to the student’s parent instead of directly their grandchild. Gifts to parents do not need to be reported as income on the FAFSA. Another alternative is to wait to make the direct gift to the grandchild until after the grandchild graduates from college, and then gift the cash or securities to the grandchild to repay their outstanding school loans.

Direct Payment of Tuition: Tuition payments made directly to a college or university are not even treated as taxable gifts. [IRC 2503(e).] This transfer may appeal to a grandparent more than a direct gift to their grandchild, or the transfer of assets to a Uniform Transfer to Minor’s Act account, because the direct payment ensures that the tuition payment will be used for the grandparents’ intended purpose, i.e. for education. Since the direct tuition transfer, which can be of an unlimited amount, is not treated as a taxable gift to the grandchild, the grandparents will still be able to make an annual exclusion gift to, or on behalf of, their grandchild, to pay for non-tuition expenses associated with the college education, e.g. room, board, books, transfers to and from the college.

A few colleges and universities will even accept a direct prepayment of several years of tuition, but there can be no refund of the prepayment if the grandchild fails to attend that college or university.

Drawbacks:

Prepayment Risk: If the grandparent prepays tuition directly for more than one semester or year, the risk exists that their grandchild drops out of school. The prepaid tuition will not be refunded.
Scholarship Risk: Some colleges and universities will reduce a student’s institutional financial aid by the amount of the grandparent’s direct tuition payment. Accordingly, it is wise for grandparents to inquire of the college or university how a direct tuition gift will affect their grandchild’s financial aid, or a scholarship or grant. If the direct tuition payment does impact the grandchild’s financial aid, consider a gift of funds to the grandchild after graduation to assist in the payment of the grandchild’s outstanding student loans.

IRC 529 Accounts: This may be the best way for grandparents to encourage a grandchild to attend college, while at the same time reduce the size of the grandparents’ taxable estates. Contributions to a 529 account grow tax deferred, and withdrawals from the 529 account used for the grandchild-beneficiary’s qualified education expenses are completely tax-free at the federal level, and usually at the state level as well.

Participation in a 529 account is not restricted by income level, and lifetime 529 contribution limits are usually very high, e.g. $300,000 (529 account limits vary from state to state.) The assets used to fund the 529 account are removed from the grandparents’ estates, even though the grandparent retains control over the funds.

Specifics: Two Types of Accounts: There are two types of 529 accounts: (i) a savings plan; and (ii) a prepaid tuition plan.

Savings Plan: With a savings plan, the funds can be used to pay not only tuition but also room and board, books, fees, software supplies, etc. These funds can also be used to pay pre-K tuition expenses up to $10,000 per year.
Prepaid Tuition: With a prepaid tuition plan college tuition credits can be purchased at today’s price, for use in the future at a limited group of colleges and universities that participate in the plan.
One Account Owner: A grandparent can open a 529 account and name a grandchild as the 529 account beneficiary; there can only be one person listed as the 529 account owner. Successor owners are usually identified as part of the 529 account opening process.
‘Front-end’ Loading the 529 Account: The key feature of a 529 plan is that a grandparent can make a single sum gift to the 529 account up of to $75,000, [i.e. 5 years of annual exclusion gifts] or married grandparents could fund the grandchild’s 529 account with a lump sum contribution of $150,000 [5 times the annual exclusion gift amount for each grandparent.]
If a lump sum gift is made in that maximum amount, the grandparent cannot make any additional annual exclusion gifts to the grandchild for the next five calendar years. If the grandparent dies during that 5-year period, a portion of the prefunded annual exclusion gift amount will be ‘recaptured’ and returned as a part of the grandparent’s taxable estate.
Revocable Gift: Unlike most other asset transfers, funding a 529 account is the equivalent of a revocable gift by the transferor. The grandparent decides if distributions should be made from the account and in what amount. If the grandparent needs funds later in life, the grandparent can withdraw the 529 account assets, albeit subject to income taxation and a 10% penalty since the funds were not used for higher education expenses. To that extent, transferring funds to a 529 account is equivalent to a revocable gift by the donor.

Drawbacks:

Cash: Contributions to a 529 account are only in cash. Consequently, if the grandparent wants to fund 529 accounts, other assets will have to be first liquidated, probably causing a gain to be recognized, so that cash can be contributed to the 529 account.
Taxation: Distributions from a 529 account for non-qualified higher education expense are heavily taxed, in fact they are doubly taxed. The income tax is with respect to the earnings on the 529 account and a 10% penalty imposed since the distribution is for non-higher education expenses.
FAFSA: Grandparent-owned 529 accounts do not need to be listed as an asset on the federal government’s financial aid application. However, distributions or withdrawals from a grandparent-owned 529 account are reported as untaxed income to the grandchild, and this income is assessed at 50% by FAFSA.
In contrast, if the parents owned the 529 account, the 529 account is reported as a parent-owned asset on the FAFSA and assessed at 5.6%. Distributions from a grandparent-owned 529 account are treated as student income to the grandchild.
One way to ‘finesse’ this deemed income rule is for the grandparent to delay directing a distribution from the 529 account until any time after January 1 of the grandchild’s sophomore year of college, as subsequent FAFSA’s will rely on 1040 tax returns from prior years.
While the 529 account could be used to assist the grandchild to pay down student loans, there is a $10,000 limit on the use of 529 funds to directly repay school loans.
College Financial Aid: Most colleges and universities treat 529 accounts differently for purposes of determining financial aid for the student from their own sources and endowments. As a generalization, parent-owned 529 accounts and grandparent-owned 529 accounts are treated pretty much the same, i.e. equally, because colleges and universities simply require a student to list all 529 accounts for which he or she is named as a beneficiary.

Conclusion: As many wealthier individuals currently face the fear of losing their large applicable exemption amount through Congressional action, (or come January 1, 2026) they should consider transferring their wealth now. Helping a grandchild obtain a college education usually appeals to grandparents, while relieving their children of the anxiety of saving for future college education costs and expenses. Grandparents can use their gift tax exemption now to reduce their taxable estate, either through lifetime gifts, sheltered by their large applicable exemption amount, directly to their grandchild or an education trust set up for that grandchild. Or a grandparent might consider ‘front-end’ loading a 529 account with up to $75,000 per grandchild. If their grandchild is already attending a college or university, a direct payment of tuition by the grandparent will not even be treated as a taxable gift. Gifts, now, for future education needs, may appeal to many families for a variety of reasons, including the tax savings enabled by such gifts.