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Grandparents with the financial resources to help pay for their grandchildren’s college education can potentially lower their own tax liability while spreading the wealth.
Indeed, while no specific tax breaks exist for generous grandparents, there are several gifting strategies they may want to consider that could reduce the size of their taxable estate.
But how they give can also impact the student’s eligibility for financial aid (at least until the new financial aid formula takes effect in 2024), or worse, impact their own ability to qualify for Medicaid later in life.
“Grandparents should give consideration to how they assist their grandchildren with college expenses,” said Scott Moffitt, a financial professional with Summit Financial Group in Loveland, Ohio, who specializes in college planning.
Before they give, he said, grandparents should consult a financial professional or tax expert to minimize any unintended consequences. (Need a financial professional? Let us know)
Pay tuition directly to school
Wealthy individuals who are mindful of staying below the lifetime estate and gift tax exemption limit ($12.92 million per person as of 2023), for example, should think twice about giving their “grands” a chunk of cash for college, said Thomas O’Connell, president of International Financial Advisory Group in Parsippany, New Jersey.
By writing a check directly to the college to cover their grandchild’s tuition, instead, that money would be removed from the donor’s taxable estate and would not be counted towards their lifetime gift and estate tax limit.
According to the Internal Revenue Service, tuition that you pay for someone else is exempt from the federal gift tax.1
There is no limit to how much you may contribute towards your grandchild’s tuition, said O’Connell, but the special gift tax exclusion only allows donors to pay for college tuition. It does not cover books, supplies, or room and board.
As such, if you are looking to provide a full ride, you can separately give up to the annual gift tax exclusion limit to each college-bound grandchild to cover the rest of their tab. That limit is $17,000 per year in 2023, or $34,000 for married couples where the spouse donated too.
One word of caution: If you pay tuition directly to your grandchild’s school, it may have a negative impact on the student’s eligibility for financial aid, if needed. It all depends on the college or university. (Learn More: College financial aid primer)
Savingforcollege.com reports financial aid formulas may treat the direct payment as a dollar-for-dollar reduction in aid eligibility for the following year. The tuition payment might otherwise be treated as student income on the next year’s Free Application for Federal Student Aid (FAFSA), which would reduce aid eligibility by 50 percent of the amount paid. But that’s about to change.
The FAFSA has undergone significant revision and beginning with academic year 2024-2025 students who fill out the form will no longer be required to report any financial support they receive from friends and extended family members, including distributions from grandparent-owned 529 college savings plans. (Learn more: College tuition: Big changes for the FAFSA)
Start your own 529 college savings plan
Contributions to your grandchild’s 529 college savings plan are treated as a gift to the beneficiary for tax purposes but qualify for the $17,000 annual gift tax exclusion.
Grandparents (or anyone) who prefer to make a larger one-time contribution can gift up to five years’ worth of the annual gift tax exclusion limit up front, said Moffitt. That does not mean they can contribute more tax-free than those who gift annually, however. Individuals who choose to make five years’ worth of gifts in a single year would not be eligible to make annual exclusion gifts to that grandchild again until the five years is up.
The MassMutual College Cost Planning Calculator can help you determine how much your grandchild may need for college.
Money in a 529 plan grows tax free while in the plan, and distributions are also tax free if used for qualified education expenses.
Under current rules, the earnings are subject to ordinary income tax, plus hit with a 10 percent penalty if the money is withdrawn for any other purpose. The penalty, not the income tax, is waived in certain cases, including if the beneficiary dies or becomes disabled, receives a scholarship, or attends a U.S. Military Academy, according to the IRS.
The new Secure 2.0 Act, however, will add some flexibility, allowing unused money in a 529 account to be rolled over to a Roth IRA beginning December 31, 2023, subject to the following limitations:
- The 529 must have been maintained for at least 15 years.
- The account owner can only rollover amounts (and related earnings) contributed more than five years prior to the rollover.
- Rollovers are limited to the Roth IRA annual contribution amount ($6,500 in 2023).
- There will be a $35,000 cap on rollovers over the course of the beneficiary’s life.
Importantly, the modified adjusted gross income limit for annual Roth IRA contributions will not apply to 529 rollovers.
Despite the Roth IRA rollover option, generous grandparents may instead opt to open a 529 in their own name for use by their grandchild, said O’Connell.
Why? Contributions to the account are removed from their taxable estate and would not be counted as a student asset on the FAFSA while it remains invested. Once the money is used to pay for college costs, however, it is fair game for financial aid calculations, which could have an adverse outcome on the student’s financial aid eligibility the following year. This is because distributions from a 529 plan owned by someone other than the student or their parents are generally considered to be student income.
Here again, however, that will change with the 2024-2025 FAFSA. Grandparents no longer need to worry about the impact of their financial support on need-based financial aid eligibility. (Discover more: Ultimate college guide)
Just be sure to keep an eye on the coming bills and your account balance. Savings in a 529 account must be used in the year the expense was incurred. If you over-save, any earnings not used for qualified education purposes will not only be taxed at your ordinary tax rate, but hit with the 10 percent penalty. If you have other grandchildren, however, you can avoid the penalty by transferring any remaining funds in your 529 account to that grandchild’s name for use in covering their own college expenses.
Another important point for grandparents who opt to open a 529 in their own name is that the money in their account may be considered an available asset when testing for Medicaid eligibility, the federal-state health insurance plan for low-income and disabled individuals. Depending on their state of residence, those assets may need to be spent down before they would qualify for benefits. An elder law attorney can help guide you.
Permanent life insurance policy
Permanent life insurance, a category that includes whole life and universal insurance, is primarily designed to provide a death benefit to your beneficiaries. Because they also offer a cash value component, however, such policies could also help fund your grandchild’s college education, said Moffitt.
Assets in a life insurance policy are generally excluded from financial aid formulas, according to the U.S. Department of Education. If they cash out the policy, however, those funds can be considered on the FAFSA. Keep in mind, though, that private financial aid may have different rules for whether funds can be excluded.
Flexibility is another perk. While 529 plan assets must be used for qualified education expenses, or incur taxes and a 10 percent penalty, the cash value in your permanent life insurance plan can be used for whatever you wish, including college tuition, the down payment on a first-time home, or supplemental retirement income. (Related: Understanding cash value)
“Cash value life insurance does not count as an asset on the financial aid forms,” said Moffitt in an interview. “Additionally, the distributions may be income tax free if set up properly.”
Policyowners are responsible for repaying a policy loan, either personally or out of the policy’s proceeds when the death benefit is paid out or the policy lapses. Be forewarned: Interest will accrue on outstanding loans. If the policy lapses, the total policy debt (loans plus unpaid accrued interest) is considered a taxable distribution. (Learn more: Gifting life insurance)
Policy owners should be aware, too, that taking partial surrenders and/or loans will reduce their policy's cash value and the future death benefit. Excessive borrowing or accruing loan interest may significantly erode policy values over time, and may cause the policy to lapse.
Again, it is wise to consult a financial professional to determine whether permanent life insurance can help meet your financial goals and to explore alternatives.
Irrevocable trust
Wealthy grandparents can also potentially set up an irrevocable trust with college tuition money and name their grandchild as the beneficiary. (The child’s parent would generally be named the trustee if he or she is still a minor).
In doing so, the assets are permanently removed from the grandparent’s estate, which reduces the tax implications to their future heirs, and is disregarded for Medicaid eligibility purposes, as long as the transfer is made at least 60 months (5 years) before the grandparent needs the program. (Related: Situations where a trust can be a solution)
(Any money transferred to the trust within the last five years would be subject to the “look back rule,” which may disqualify the donor from Medicaid eligibility for a period of time).
Here again, however, it can impact the student’s ability to secure need-based financial aid, as most trusts are counted as a student assets in the financial aid process, according to FinAid.org.
Another negative? While the trust creator can set forth rules and guidelines for use of the trust assets, and a timeline for when the funds should be distributed, they lose control of those assets, which some individuals find tough to swallow, said O’Connell. Anyone considering putting money into an irrevocable trust must be certain they will not need that money in the future.
Conclusion
Grandparents who are looking to pay for their grandchildren’s education costs — either in part or in full — are welcome in any family.
To maximize their generosity, however, and prevent unintended consequences to financial aid and Medicare eligibility, they perhaps should speak first to a financial professional.
“These strategies are neither good nor bad,” said O’Connell. “It just depends on what is appropriate based on their individual goals and objectives.”
Discover more from MassMutual…
How to help your grandchildren handle money
Getting the most out of your 529 plan
Need financial advice? Contact us
This article was originally published in September, 2016. It has been updated.
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1Internal Revenue Service, “Frequently Asked Questions on Gift Taxes,” Oct. 27, 2022.