For the 2019-20 academic year, the average cost for tuition, fees, room, and board was $21,950 at a four-year public university (in-state) and $49,870 at a private nonprofit university.1
It's easy to see why many families become overwhelmed by college expenses. Providing funds for a grandchild's college education can be personally fulfilling, and it's also a tax-friendly opportunity to pass on wealth.
Outright Gifts
The simplest option might be to give cash or securities to the grandchild or to his or her parent(s). However, any gift over the annual exclusion amount ($15,000 for individual gifts or $30,000 for joint gifts) must be reported on a gift tax return, and it decreases the grandparent's lifetime exclusion ($11.58 million in 2020). This is the total amount an individual can give away without paying gift taxes ($23.16 million for a married couple in 2020).
Cash gifts made directly to students are considered untaxed income under the Free Application for Federal Student Aid (FAFSA) formula, and 50% of student income must be contributed toward college costs. Giving a cash gift to the parent(s) may be less likely to affect the student's financial aid eligibility.
Tuition paid directly to a college is exempt from gift taxes, no matter how large the payment. However, colleges will often reduce a student's institutional financial aid by the same amount. If a grandparent's contribution (in any form) would adversely affect the grandchild's aid package, particularly the scholarship or grant portion, the money could be gifted after graduation to help pay off student loans.
529 Plan Flexibility
Funds invested in a 529 college savings plan accumulate tax deferred, and withdrawals are tax-free at the federal level (and often at the state level) when used to pay qualified higher-education expenses (tuition, fees, room and board, books, computers, and software). In addition, 529 plan funds can now be used to help pay down student loans ($10,000 lifetime per beneficiary).
Grandparents can save by setting up automatic monthly contributions over time, or they can gift a larger lump sum — removing the assets from their taxable estate. Each grandparent can make a single contribution of up to $75,000 (per beneficiary) to a 529 savings plan and avoid federal gift taxes by making a special election on a tax return to spread the amount equally over five years.
How Families Foot the Bill
Source: Sallie Mae, 2019
Families who might qualify for financial aid based on the FAFSA should be aware that grandparent-owned 529 accounts are not counted as a parent or student asset, but withdrawals are considered student income on the FAFSA in the following academic year. Thus, a grandparent may want to delay taking a 529 plan distribution until after January 1 of the grandchild's sophomore year of college because the income won't affect a subsequent year's FAFSA (assuming the student graduates in four years). Parent-owned 529 accounts are counted as parent assets up-front, but withdrawals are not counted as student income.
Most states offer their own 529 plans, which may provide advantages and benefits exclusively for their residents and taxpayers. These other state benefits may include financial aid, scholarship funds, and protection from creditors. Each plan has its own rules and restrictions, which can change at any time.
Funds in a 529 savings plan can also be used for K-12 tuition expenses (limited to $10,000 per year). When 529 plan withdrawals are not used for qualified education expenses, the earnings portion may be subject to ordinary federal and state income taxes and a 10% federal tax penalty. The tax implications of a 529 plan should be discussed with your tax professional.
As with other investments, there are generally fees and expenses associated with participation in a 529 plan. There is also the risk that the investments may lose money or not perform well enough to cover college costs as anticipated.
Before investing in a 529 savings plan, please consider the investment objectives, risks, charges, and expenses carefully. The official disclosure statements and applicable prospectuses — which contain this and other information about the investment options, underlying investments, and investment company — can be obtained from your financial professional. You should read these materials carefully before investing.