Tax-smart ways to pay for your grandchildren’s education

With the cost of education skyrocketing, many people want to contribute to their grandchildren’s tuition costs.  A variety of ways are available to do this, which also have estate-planning benefits.

All these ideas apply not just to grandchildren but to grandnieces, grandnephews, great-grandchildren and others.

The simplest solution is for grandparents to pay the tuition costs directly.  Not only does this provide a benefit to the grandkids, but it also gets assets out of the grandparents’ estate tax free. 

No gift tax is imposed on a direct tuition payment, no matter how large it is.  The gift tax excludes payments made directly to an educational institution on behalf of an individual.  Of course, that means grandparents must make their payments directly to the education institution.  They cant just write a check to their children to be used for the tuition.

Many older people also use techniques discussed below that continue to work (and to provide tax advantages) after they pass away.

Grandparents can make annual gifts during their lifetime to a Section 529 plan, which allow contributions to grow tax-free and then be used for higher – education expenses. Each state has its own Section 529 plan, although you don’t have to invest in your own state’s plan.  You might find that another state’s plan is better for you.  For instance, you might prefer another state’s investment options.  But you might want to stick your own state’s plan, since some states allow an income tax deduction for in-state Section 529 contributions.

Another benefit is that in many states, money in a Section 529 plan doesn’t “count” when calculating financial aid awards under state administered financial aid programs.  Money in a Section 529 plan might “count” under federal financial aid programs or under a school’s own program but even then, often only a fraction of the money will be considered and it will be treated as a family asset not as the student’s own asset.

In any given year, you can contribute up to the annual gift tax exclusion (currently $13,000) to a Section 529 plan without any gift tax liability, assuming you haven’t made other gifts to the beneficiary. 

What’s even better is that you can “front-load” five years of contributions, meaning you can contribute up to $60,000 in a current year.  A married couple could contribute up to $120,000.  This allows grandparents to get a significant amount of assets out of their estate that would otherwise be subject to estate tax if they happened to pass away within five years. 

Section 529 plans also have some drawbacks.  For instance, the money can be spent only on higher education, so you can’t use it to pay expenses for a private school or preschool.

If you’ve made the maximum contribution to a Section 529 plan, you can also contribute to a Coverdell Education Savings Account.  However, the most that can be contributed for any one child is $2,000 total a year.  Also, unless Congress changes the law, after 2010 you can no longer use Coverdell contributions to pay for secondary school, and the contribution limit will decrease to $500 a year.

What’s more, there are income limits on who can contribute.  If a married couple has adjusted gross income of $190,000 (or if a single taxpayer has income over $95,000), contributions are limited or eliminated.  It may be possible for a couple who is “over the limit” to get around this problem by giving $2,000 to a lower-income family member, who can then contribute it to the child’s account. Another option is to provide money in your will for a “health and education exclusion trust” or HEET.  This type of trust allows grandparents to provide funds for their grandchildren’s benefit without triggering the “generation-skipping transfer tax” which is a tax on gifts over a certain limit made directly to grandchildren and great-grandchildren.

Assets contributed to a HEET are not subject to this tax, so long as the HEET also contributes a certain amount of funds to a charity.  If you want to help later generations with education and also provide in your will for a charitable bequest, this can be a good idea.

With a HEET, there’s no limit on how much you contribute.  And it can be used for any type of education.  It can be also used to fund health-care expenses in addition to tuition, and money that remains in the trust can be used for later generations.

However, while assets contributed to a HEET are sheltered from the “generation-skipping” tax, they are not sheltered from the regular estate tax.  Also, a HEET can only pay for tuition.  It can’t pay for a room and board. For example, some people set up a HEET and also contribute to a Section 529 plan because Section 529 funds can be used for the cost of room and board.