Strategic Educational Funding

Custodial Accounts

Another way to consider paying for college is through a Custodial Account (UTMA/UGMA). This account is similar to an individual investment account but gifts made to it are held in trust until the child reaches the age of trust determination (age 18 or 21 depending on the type of account and state in which it is held). There are several drawbacks associated with this type of account. The assets in a custodial account are considered as the students’ and may count against them if they apply for college financial aid. Investment income generated by the custodial account must be reported on the child’s tax return and is taxed at the parents’ rate. And finally, it’s most important to consider that the funds in a custodial account are irrevocable and once the child reaches adulthood, they are free to spend the funds as they choose.

Direct Payments

Federal gifting rules allow a parent or grandparent to make a direct gift of up to $14,000 per year to anyone without paying gift taxes on it. This amount will not be deducted from the lifetime federal gift and estate tax exclusion and one can make as many gifts of $14,000 or less as a person deems fit. Married couples can give $28,000 per recipient without any gift tax ramifications, though they must report to the IRS that they have combined gifts. If however, funds are paid directly to a qualified educational institution, there is no limit to the amount a person can give. This type of direct payment will incur no gift tax and nothing will be deducted from an exclusion amount but this applies only for the part of the gift paid directly to the institution. If the gifter also wishes to cover other costs such as books or room and board that must be paid separately, a regular gift must be made to meet these costs.

Best Strategies for Young Parents

For Parents, savings strategies must fit the family and the finances. The downside to contributing a monetary gift in the form of a custodial account is that anything in the account will belong to the child upon entering adulthood; therefore it is important for young parents to consider how the child might use the money when he or she comes of age. For this reason, a 529 might be a better choice for a parent to put into place now for a young child’s educational savings plan. Investing in a 529 will allow parents to deduct money from their estate tax free and it better ensures that the money will be used to finance education.

However, if the grandparents of the child might help finance a future education, it might be in the best interest of all parties involved for parents to simply open a joint separate account where money intended for education can be earmarked. Then if the grandparents help out financially the money saved is for other priorities. Direct gifting to the child can be made to finance other college expenses such as books or room and board.

Best Strategies for Grandparents

Regardless of the method a person chooses to employ, there are non-financial issues to consider. Is college right for the child? Will giving a gift to a child 10-15 years from now still be desirable as well? While it is admirable to give the gift of education to grandchildren, one should also consider the unintended consequences of promising to pay for grandchildren’s education. If a promise has been made to pay for education, is this giving a signal to the parents that they don’t need to save for their children’s education? Since they know this major expense will be covered, will this be creating a sense of entitlement or inhibiting their motivation to succeed?

Recent reports have found that 80% of millionaires are first generation (not inheritors), and that many millionaires tend to live beneath their means while their inheriting children are more likely to spend more than they earn and not save. Many who inherit considerable wealth lack discipline if they were brought up in too nice of an environment. Rather than allowing young parents to believe they don’t have to save for their child’s college expenses due to an expected educational gift, it is highly recommended to set aside money and pay it directly to the institution when the grandchild reaches college age. This way there are no expectations by the parents and they have time to set aside money of their own for the same purpose.