Paying it Forward

Paying it Forward

Help families support education without extinguishing the drive to save

College education has always been a significant expense for families. For the past 20 years, college costs have grown only slightly less than health care costs, far exceeding the growth in overall economic inflation. Today, a private college education can cost $55,000 per year. This figure represents a significant burden for many families. That’s why so many grandparents proudly promise to pay for college education when their first grandchild is born. For years now, estate planning, tax and financial advisors have counseled grandparents to use their annual gift tax exclusion to fund accounts for education, reduce their estate and allow the funds to grow to eventually pay for college education.

The actual experiences of today’s families are informing advisors that it’s time to rethink that approach. It may have been good advice based on tax laws and textbooks, but it’s not working in real life. The grandparents reiterated their promise to pay for college with the birth of each subsequent grandchild, and today many grandparents are realizing the unintended consequences of these promises. Years passed, and the adult children reached ages 35 to 40, but some haven’t saved anything because they didn’t have to worry about paying for college. Many grandparents are beginning to fear that their promises to pay for college have eroded the financial values they thought they’d passed on.


A Disconnect

These education promises are also leading to some awkward conversations as their grandchildren age. Children want to clarify the promise: “Well Dad, did you mean you were going to pay all-in for Johnny? When you said you were going to pay for college, did you mean tuition, room and board and textbooks? Are you willing to pay the $55,000 a year that it’s costing right now?” Often, detailed thought didn’t go into the original promise. Now, nothing’s been saved, and there’s a potential disconnect between the promise and the intent. There may be a miscommunication, but what’s really occurred is that ill feelings begin to brew over a noble intent. The grandparents had the best intentions in mind when they made the promise, but they became frustrated with their adult children. Their children see that their parents are disappointed in them, but they don’t realize what they’ve done wrong.

This is a very unfortunate disconnect because the reason these grandparents are able to offer to pay for college is usually due to years of hard work in a successful career. They put in continual effort, constantly making decisions about what to sacrifice to reach financial success and build savings and wealth. When they realize that the financial values that led to their success aren’t held by the next generation, they’re often both frustrated and worried. Some of these grandparents begin to agonize not about funding their education promise, but about assuring that a legacy will be left to support their children who haven’t pursued personal savings or wealth building of their own. Often, the worry looks like disappointment to the adult children.


Avoiding Promises

As this scenario becomes all too common, advisors can serve families better by counseling against offering up “promises” of future support. For families that already have grandchildren, it’s time to revisit these discussions. First ask, “What have your children heard?” If there’s been a discussion around education funding, does the family think it’s a promise? Do they think it’s a vague intention? Ask families to think back on these discussions to clarify where they stand.

The new guidance is to suggest that grandparents don’t outwardly offer help at all. It’s best to counsel that they don’t even bring up the topic. If the conversation comes up, encourage families to offer, “We really hope to help out someday.” This is often the best approach, as there’s no need to commit to pay ahead of time. It’s especially comforting if the grandparents have any concerns about their own financial position as life unfolds or as the number of grandchildren grows more than anticipated. Additionally, financial aid is completely unaffected if any of the grandchildren may qualify. And, if they do earn any aid or scholarships, the grandparents can still step in with additional support afterwards, if they’re in a position to do so.


Obtaining Maximum Estate Benefit

When the day comes for a grandchild to start college, the grandparents can pay directly from current funds. From an estate-planning point of view, this is the best thing to do because significant sums can come out of their estate every year by paying tuition costs directly to the institution. Such payments don’t count as gifts or reduce the ability to make annual tax exclusion gifts to the grandchild attending college. Textbooks, room and board and other miscellaneous expenses may be included if a payment to a bursar funds a student bookstore card. Many schools today have a student account for use at the bookstore, and a grandparent can directly fund this account if its use is limited to the school. Room and board can also be covered as long as the payment goes directly to the school. Once the student lives off campus and is paying a landlord, the payment doesn’t count as a direct educational expense.

With this approach, there’s no need to pre-fund particular financial accounts for college or share information about accumulated money that may be intended for education. However, many people prefer to segregate savings ahead of time. Here are the most popular funding vehicles and how they might be incorporated into an approach that doesn’t promise education payments.

529 plans. Plans created to fund education under Internal Revenue Code Section 529 are completely tax-free. That is, investments in the plans grow tax-free each year, and all withdrawals for qualified education expenses are tax-free. There’s always some concern that the tax status could change in the future. Additionally, some states offer an income tax deduction for deposits into 529 plans. Most of these tax credits phase out at higher income levels.

From an estate-planning point of view, one of the nicest features of a 529 plan is the ability to deposit up to five years of the annual permitted tax-exempt gifts at once. The current annual exemption is $14,000 per year for individuals, so one individual can deposit $70,000 in a single year, and a couple can deposit $140,000. From a tax standpoint, it counts as the next five annual tax exclusion gifts and gets amortized over the next five years. If the goal is to quickly reduce an outstanding estate, this is a great way to immediately move $70,000 (or $140,000 for a couple) per 529 beneficiary out of an estate, tax-free. Keep in mind that every gift an individual makes to a 529 account is an annual tax exclusion gift to the beneficiary of that account. If the grandchild is the beneficiary, that’s the gift to that child for that year. If an adult child funds an account for his own child, any annual deposit is the gift for that year. Many individuals fund these accounts each year and then forget that it’s counted against their annual tax-exclusion gift for that beneficiary.

One downside of 529 plans is that, often, the investment choices are limited. Additionally, those that are available often have higher than average imbedded fees. Finally, most plans only allow changes to the investment choices once a year. While the promise of tax-free growth has been appealing, unfortunately 529s haven’t met their promise. Historically, many investors in these plans have found that their investment performance has lagged behind any number of choices they could have made outside of the plans, even after paying capital gains taxes. The administrative fees in many plans have also meaningfully reduced performance historically, and plans opened through full service financial firms often have included up-front commission loads on the internal investments, reducing performance further. Due to this experience, a number of state plans have reorganized over the past several years to reduce administrative fees and offer different investment choices. For families that still prefer a 529 strategy, a number of state plans might be attractive. Remember that an investor doesn’t need to live in the same state as the 529 plan he chooses. However, if the investor’s state offers a tax credit, he must invest in his state of domicile to earn the credit. 

It’s difficult to use 529 plans in light of the recent challenges we see with future generations failing to save. These accounts aren’t recommended today unless they offer a tax or estate advantage, as described above. If a family already has established these plans, however, there are a few strategies to still encourage saving among the younger generation. First, grandparents could choose not to communicate to their children the existence of the 529s. This silence rarely happens in practice. Second, they can cease funding the plans and tell their children that the funds may continue to grow from their investments, but the children must save the rest. In the future, the grandparents can still choose to pay for education, but it’s no longer assured. Finally, once a 529 is funded, the money can’t be withdrawn for anything other than education without paying full taxes on the growth in addition to a penalty. However, the beneficiary of a 529 can be changed once a year. The grandparents can choose to combine existing 529s for the benefit of a current student, an adult child who’s pursuing ongoing education or their own benefit if they’re enjoying classes at a local university during their retirement.

UTMA/UGMA accounts. Another popular approach to saving for grandchildren is the use of custodial Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts. Deposits in these accounts are irrevocable and belong to the minor right away, even though the minor can only access them through the custodian. Many people easily open these savings or brokerage accounts and consider them to be college savings accounts. An advantage of these accounts is that there’s no need to inform the children or the beneficiaries that they’ve been opened. As a result, savings in a UTMA/UGMA account can remain private from adult children. Once the minor turns 18 (or 21 in some states), he can withdraw the assets in full. This power isn’t usually a problem if the account is modest in value. If the account was opened at birth, however, and a deposit had been made each year of the annual gift tax exclusion amount for couples, 5 percent growth per year could make the account worth well over $1 million when the minor reaches adulthood. Most custodians who open these accounts don’t intend to give $1 million outright to a 21-year-old.  

The custodian can make withdrawals from these accounts while the beneficiary is still a minor, as long as they’re for the benefit of the minor. Examples might include paying for camp, a new computer or private school. If these steps haven’t been taken and the account has grown quite large, one strategy, if the minor is going to college, is to speak with him before he turns 18 and inform him that the money is for college. The minor isn’t legally bound to use the money that way, but the custodian can try to convince him to do so. If the student has just been accepted to college, the custodian might offer up the funds immediately for the school deposit to emphasize the intended use. If the value of the account exceeds today’s college costs, there’s little a custodian can do to direct how the funds will be used once the minor is an adult. This disconnect is the challenge with UTMA/UGMA accounts.

Family trusts. Another strategy to save for college for a future generation is to set up a family trust. The lead generation can set the exact terms under which withdrawals can take place. The trust can be set up to expand to benefit each new grandchild, and a gift can be made each year for the annual gift-tax exclusion amount for each beneficiary. For example, if there are currently five grandchildren, $70,000 (five times $14,000) can be added each year per individual making the gifts. If a sixth grandchild is born the following year, the annual gift can increase to $84,000 under the current annual gift tax exclusion amount.  

The advantage of this structure is that, while the gifts are irrevocable, the terms of withdrawal can be flexible. Withdrawals can be made for higher education, private school, first homes, entrepreneurial ventures or any other benefit that’s desired for future generations. In a family trust, the gifts grow outside the family estate for multiple future generations without being subject to estate taxes as each generation passes. 

From the standpoint of the goal of encouraging future generations to save for themselves, a family trust need not be communicated to children immediately. Conversely, the existence of the trust can be communicated as a benefit for grandchildren and future generations without disclosing the full terms of possible withdrawals. With this structure, there’s no need for multiple 529 or custodial accounts. Most importantly, when the time comes for a grandchild to attend college, if the grandparents have the means available, they can pay the college directly from the existing estate without touching the family trust at all. The trust serves as a source of funds if necessary, but provides the flexibility to allow the family to reduce their estate further by paying education expenses directly. Additionally, it allows the family to encourage future generations to save for themselves and then step in and offer the pay if the resources and the intent remain. After the grandchildren have been educated, the funds that remain in the trust can be used for the current or future generations for other benefits outlined in the trust documents.


Communication Advice

The challenges that successful families are experiencing today when supporting education are rooted more in communication than savings strategies. Advisors not only need to suggest structures for supporting grandparents’ education funding goals, but also, they need to help provide guidance on what to communicate and when. The grandparents’ decision to pay for education should be an opportunity to encourage a family conversation. Families need to share with their children and grandchildren why supporting education is important to them. For many, it starts with a memory of the financial burden. Sharing this memory can help some families start the conversation about continuing to save for the future, regardless of the grandparents’ plans to pay for education. Perhaps the family feels it owes its financial success to great educational opportunities. Often, the private primary schools have a visitors’ day. Attending these days with the grandchildren is another opportunity for a family to show its commitment to education and perhaps share that paying for that private school is not just about giving financial support, but also about sharing a family value and bringing joy to grandparents.

The communication problems surrounding this issue can arise even if the desired financial values have been passed on. When the children have successfully saved and can afford to pay for college, it’s often still advantageous from an estate tax standpoint for the grandparents to pay. It’s only with open conversations that the adult children won’t be offended that their financial independence is diminished by their parents’ support. Advisors can help grandparents start a conversation to let the children know that this isn’t about who can afford it. Grandparents can share their pride in their children’s financial success, their parenting and the decisions they’ve made to educate the grandchildren. Offering to pay for education is a wise financial and estate-planning decision and doesn’t diminish the children’s personal success. Grandparents can share that they hope their children can pay it forward when the next generation is ready for education. Advisors can be most helpful when they share these and other conversation approaches, as well as financial structures for the goal of paying for education.


More Sensitive Counseling

Financial issues in families are never easy, and education funding is just one of many topics that can cause family strife. Years of reasonable tax and estate-planning advice have failed current families, and it’s better to advise them today to rethink what kind of promises they’re making to pay for education for the next generation of grandchildren. Today’s families are reporting that making promises has limited what they hoped their children learned in terms of the importance of their own savings. If there’s a commitment to pay for education, grandparents are exploring options to save or set aside funds that are more opaque and not so apparent to the grown children. The tax and estate incentives have remained relatively stable for years, but the experiences of today’s families inform advisors that it’s time for more sensitive counseling: first to family communication and second to successful financial structures.