What to Do When Your Parents Want to Establish College Funds for Grandchildren

I’m in awe of the things my parents say to my kids: “Sure, you can do/have/play with/buy that! And here’s an ice cream cone. And $50. Oh, and a kitten.” 

Whaaaaa…?

I find myself wondering, “Where was that generosity when I was a kid?”

Then I remember: Oh, yeah, at my grandparents’ house.

Your parents (your kids’ grandparents) may want to help you save for college. 

Bravo for them! The only thing is, they may have very specific ideas on how they want to do it — which might not be the most advantageous to your child or the best option, tax-wise.

Let’s go through a few ways grandparents can help!

How Grandparents Can Help Save for College

Your parents may be in a perfect position to help for college — they may have plenty of money saved up and have plenty of ideas! But first… tamp down the excitement! College funds for grandchildren (and alternative options!) can go lots of directions.

1: Start a conversation.

The first step: Always start with a family conversation.

I remember working with this family in admission, the Larsons, who wanted their son to pitch in for some college costs. However, the grandparents wanted to pay the whole bill! (Tempers ran high, especially when the grandparents went behind the Larsons’ back and paid for a whole year of college up front.) 

Your parents can tap into a number of strategies. Throughout these conversations, consider how college savings might impact the whole family:

• Maybe you want your child to shoulder some of the cost so he takes college more seriously. 
• You want to cover the majority of the costs with your own money. (“My kid, my responsibility.”)
• You want to make sure your parents keep their own needs at the helm. Maybe they may live on a fixed income in retirement and shouldn’t pay for college. 
• Certain savings vehicles might affect the financial aid your child receives.

2: Discuss specific vehicles. 

Your parents may have it in their head exactly how they want to help your child pay for college. But is it the best option for your family? Here are some great topics to launch your conversations.

Talk About 529 Plans 

What’s a 529 plan? Many people herald them as the grandpappy of all college savings plans. Here’s why: Your parents won’t pay taxes on earnings and withdrawals as long as your child uses them for qualified education expenses. (Your parents can also save $10,000 of tuition expenses for elementary, middle, or high school education and to repay qualified student loans and expenses for apprenticeship programs.)

Your child can use 529 savings at accredited institutions for:

• Tuition
• Room
• Board
• Fees
• Other educational expenses

Appeal factor: 529 plans must be used for educational purposes and nothing else. For estate tax purposes: The money is no longer considered part of the parents’ or grandparents’ estate.

Your parents might wonder whether to use these options if your child is in high school. They sure can! For example, they can put in five years of annual gifts — up to $15,000 (up to $75,000 per person, per beneficiary) at once without messing with gift tax or scraping away at the lifetime gift tax exclusion. 

Consider UGMAs or UTMAs

Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts, also called custodial accounts, let the grandchild take control of assets in the account as soon as they reach a specified age. What age? That depends on your state laws. 

The custodian (who can be anyone — it doesn’t have to be your parents) controls the account until your child reaches (usually) 18 or 21. After that, he can spend the money on whatever he wants, even a brand-new Corvette. You may want to have a conversation with your parents about skipping this option if your kid’s liable to say, “I’m rich, I’m rich! Never mind going to college, let’s all go to the south of France!” And then he rents a house on the beach for his friend for a month and the money’s gone. 

Another issue: You can’t transfer UGMAs or UTMAs to another beneficiary. For example, let’s say it becomes super apparent that your child will goof off with the money. Your parents can’t switch and give money to a more studious sibling.

Also — talk to your parents about the possibility that your child will get less financial aid if your parents opt for a UGMA or UTMA because they count as student assets and factor in at 20 percent, more than the 2.6 percent to 5.6 percent for parent assets. (Yikes!)

Warn them that they won’t see as many tax benefits. The interest, dividends and earnings is the child’s income and taxed at the child’s tax rate once the child reaches age 18. The first $1,100 is untaxed if the child is under 18 and the next $1,100 is taxed at the child’s rate. Anything over $2,100 is taxed at the grandparent’s rate. Visit IRS.gov for more information.

Appeal factor: You can contribute virtually any type of asset toward both UGMAs and UTMAs. You can even contribute real estate to an UTMA. Your path is much less limited and your parents may like the larger number of investment options in a custodial account compared to a 529 plan.

Talk about Coverdell ESAs

A Coverdell education savings account (Coverdell ESA) is a trust or custodial account for paying qualified education expenses. You can pay qualified higher education expenses (and elementary and secondary education expenses) with a Coverdell ESA. Note: The designated beneficiary must be under the age of 18 or be a special needs beneficiary.

Your parents can contribute to a Coverdell ESA with cash but they’re not deductible. The downside is that the total contribution to all accounts on behalf of a beneficiary in any year can’t exceed $2,000 with a modified adjusted gross income (MAGI) up to $190,000. The amount reduces incrementally for MAGI between $190,000 and $220,000. If your parents’ incomes rise above $220,000, they’re ineligible to contribute to a Coverdell ESA.

Whew, that was kind of boring. Sorry! Let’s up the excitement in the appeal factor section.

Appeal factor: Tax-free withdrawals! More investment flexibility than 529s! No withdrawal cap like the 529’s $10,000 tax-free withdrawal cap for qualified expenses to an elementary or secondary public, private or religious school! Also, your parents can transfer money from one grandchild to another.

3: What if they prefer to pay the bill directly? Talk through it.

“We’re not interested in all that,” your parents may say, with a wave of a hand. “Taxes, shmaxes.” 

You may reply (with a hint of exasperation in your voice), “But a savings vehicle makes the most sense, tax-wise!” 

Paying directly is not considered a gift. Your parents could still use their annual gift exclusion to give up to $15,000 to one grandchild. However, direct tuition payments do affect financial aid. The other downside is that money doesn’t grow tax-free in an account — your child doesn’t have interest working in his favor.

4: Discuss a tuition payment plan.

The tuition payment plan is one of the secrets of breaking up college payments into tinier chunks. It simply means you pay for an item in fixed amounts at specified intervals — you make small payments over time. A tuition installment plan means you can reduce a remaining balance by splitting it up into a specified number of months. You’ll pay that amount over a typical nine- to 12-month period. 

Most colleges’ installment plans cover only the direct costs billed by and paid to the college, which includes: 

• Tuition
• Fees
• Room and board (only applicable if your child lives on campus)
• Books, supplies, equipment and transportation to and from school are not covered.

A tuition payment plan does not include things like transportation, school supplies and other outside expenses. 

Talk about a specific monthly amount they want to help with — and make sure you agree.

5: Discuss money they’ve already ferreted away. 

Do your parents have money ripe for plucking in traditional and/or Roth IRA accounts? Why not use it to pay for their grandchild’s college education — particularly if they’ll have plenty of money left in it for themselves?

As long as your parents are 59½ and older, they can withdraw money from a traditional IRA to pay for college without paying a 10 percent penalty on distributions. Traditional IRA owners do pay federal income tax on the amount withdrawn.

If your parents are under 59½, it’s better to take money from a Roth IRA. Your parents won’t suffer a 10 percent penalty on distributions used for qualified education expenses as long as the account as long as they’ve had the account for five years.

A Sweet Gesture

Even when you disagree on the vehicle to pay for it (or, like the Larsons’ parents, paid for the whole thing without permission) you’ve got to recognize the effort your parents are putting in.

The best thing you can do is talk as a family to discover which option fits your child best.