If you plan to help your grandchildren, here's what you need to know.
The cost of college gets higher every year. As a result, more grandparents are helping pay for tuition. Today, an estimated 53 percent of Americans are saving or plan to start saving to help their grandchildren pay for college in some way. If you are hoping to contribute to education costs, here's what you need to know about the tax benefits of putting that money away. Plus, how to make sure you don't damage their chances of getting financial aid because of your generosity.
Method: 529 Plan
This is what Jeremy Shipp, CLU, RICP, managing partner of O'Dell, Winkfield, Roseman & Shipp in Richmond, Va., calls "one of the most effective financial vehicles due to the tax benefits." Benefits: The contributions you make to a 529 (up to $14,000 per year if you file as single or $28,000 if you're married and file jointly) will grow tax-deferred. The money is withdrawn tax-free if it goes toward qualified post-secondary education purposes, like tuition, books, or room and board. And if the child doesn't go to college, you can transfer the money to another beneficiary or keep it for yourself. Some states even offer tax breaks for investing in 529 plans. Disadvantages: While the money in a grandparent-controlled 529 plan is not counted as an asset in the financial aid equation, any funds used for college must be reported on the financial aid forms used to calculate financial aid for the following year. If grandparents are paying part of the tuition, waiting until the student is a college senior can sidestep this complication (assuming they are graduating on time and aren't going on to graduate school). If the funds aren't used for qualified expenses, you'll pay income taxes and a 10 percent penalty on any earnings.
Method: Permanent Life Insurance Policy
The ideal way to set this up is for a grandparent to be the owner and beneficiary of the policy and a parent to be the insured, says Shipp. Benefits: There is no penalty for using the money for non-college-related expenses, so it could also be put toward something else, like a down payment on a car or travel costs for a gap year. Since the plan is in a parent's or grandparent's name, "the cash value of the policy will be invisible to financial means tests," says Shipp. Disadvantages: If funds are taken out as a loan against the policy, the money is kept away from financial aid formulas, but it would reduce your death benefit should something happen to you. And tax-wise, you'd miss out on any state deductions that a 529 plan would offer and would have to consider a loan as a taxable distribution if the policy lapses or is surrendered.
Method: Paying Back Loans After Graduation
This option is best for those who do not want to set up a 529 or life insurance policy, but do want to ensure their contributions don't limit financial aid opportunities. Benefits: Almost 71 percent of bachelor's degree recipients in 2015 graduated with a student loan. On average, those grads will have to pay back about $35,000. This approach allows you to alleviate some of that financial burden, while offering flexibility, because how you execute the arrangement is completely up to you.