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How Grandparents Can Save For College

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Grandparent Saving For College | Source: The College Investor

For grandparents looking to help fund a grandchild’s college education, there are several ways to save and invest. Choosing the right account depends on tax benefits, financial aid implications, and estate planning goals.

While 529 plans are the most popular, alternatives like UGMA/UTMA accounts, Coverdell ESAs, and direct tuition payments each offer unique advantages and drawbacks.

Let's break down the pros and cons of each option for grandparents with a focus on both gifting and estate planning.

Table of Contents
529 Plans: Tax Benefits And Financial Aid Considerations
UGMA/UTMA Accounts: More Flexibility But Taxable
Coverdell ESA: Tax Benefits with Limits
Paying Tuition Directly: The Simplest Option
Which Option Is Best?

529 Plans: Tax Benefits And Financial Aid Considerations

A 529 plan is one of the most effective ways for grandparents to save for a grandchild’s education. These state-sponsored accounts allow investments to grow tax-free, and withdrawals for qualified education expenses are also tax-free.

Pros

  • Tax-Free Growth: Contributions grow tax-free when used for eligible education expenses.
  • Estate Planning Benefits: Contributions up to $19,000 per year ($38,000 for couples) qualify for the annual gift tax exclusion. Grandparents can also front-load up to five years’ worth of contributions ($95,000 per individual, $190,000 per couple) without affecting their lifetime gift tax exemption.
  • Control Over Funds: Grandparents maintain control over the account and can change the beneficiary if needed.
  • Financial Aid Impact: Previously, distributions from a grandparent-owned 529 were considered student income for FAFSA purposes, reducing aid eligibility. However, grandparent-owned 529 plans no longer impact FAFSA.

Cons

  • State-Specific Rules: Some states offer tax deductions or credits for contributions, but eligibility often depends on residency.

UGMA/UTMA Accounts: More Flexibility But Taxable

A Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) account allows grandparents to contribute funds that become the child’s asset when they reach adulthood. Unlike a 529 plan, these accounts are not limited to education expenses, but they are considered taxable investment accounts.

Pros

  • No Restrictions on Use: Funds can be used for anything, not just education.
  • Easy to Set Up: No state-specific rules or restrictions on contributions. Every major brokerage firm allows custodial accounts.
  • Potential Tax Benefits: Earnings are taxed at the child’s tax rate, which may be lower than the grandparent’s.

Cons

  • Financial Aid Impact: UGMA/UTMA funds are considered student assets and may significantly reduce financial aid eligibility.
  • Loss of Control: Once the grandchild reaches adulthood (typically 18 or 21, depending on the state), they gain full control of the funds.
  • Tax Implications: Unearned income above a certain threshold is subject to the “kiddie tax,” which applies the parents’ tax rate.

Coverdell ESA: Tax Benefits with Limits

A Coverdell Education Savings Account (ESA) offers tax-free growth and withdrawals for educational expenses, but contributions are limited. There are also age restrictions and income restrictions which make these accounts much less flexible than other options.

Pros

  • Tax-Free Growth: Similar to a 529 plan, funds grow tax-free if used for qualified expenses.
  • Flexible Use: Unlike 529s, Coverdell ESAs can be used for K-12 expenses in addition to college.
  • Investment Options: Offers a wider range of investment choices compared to most 529 plans.

Cons

  • Low Contribution Limit: Contributions are capped at $2,000 per year per beneficiary (though you may be able to bypass them).
  • Income Restrictions: Higher-income families may not be eligible to contribute.
  • Must Be Used by Age 30: Any remaining funds must be distributed by the time the beneficiary turns 30.

Paying Tuition Directly: The Simplest Option

Another option is for grandparents to pay tuition directly to the school or college. This method has estate planning benefits, as tuition payments made directly to an institution are not subject to the gift tax.

Pros

  • No Gift Tax Limits: Payments do not count toward the annual gift tax exclusion.
  • Doesn’t Affect FAFSA: Since the payment is made directly to the school, it does not impact financial aid calculations.
  • Simple and Immediate: No need to open or manage an investment account.

Cons

  • No Investment Growth: Unlike a 529 or other savings account, there’s no opportunity for tax-free investment growth.
  • Limited to Tuition: Payments must be made directly to the institution and cannot cover other college costs, such as room and board or books.
  • Requires A Child To Have Tuition Payments: Some grandchildren may not attend private school or college and not have any tuition payments that need to be made on their behalf.

Which Option Is Best?

Of course, it depends. Each savings method has unique benefits depending on a grandparent’s goals:

  • For tax benefits and investment growth: A 529 plan is usually the best choice.

  • For flexibility in how the money is used: A UGMA/UTMA account allows broader spending options.

  • For a smaller, tax-advantaged savings option: A Coverdell ESA is worth considering.

  • For estate planning without tax concerns: Direct tuition payments ensure funds go to education without gift tax limits.

Before choosing a plan, grandparents should consult with a financial advisor to understand how their savings approach impacts financial aid, taxes, and estate planning.

Editor: Colin Graves

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