3 Critical Considerations For How To Save For Your Child’s (or Grandchild’s) College Education

If you have started to save for your child or grandchild’s college education, it’s worth considering whether to use a 529 plan, an education savings account, or an Irrevocable Trust. 

Here’s what we think you should consider as you decide: 

First, consider whether you want your kids to have broader options than just the traditional college experience. 

Since the start of the pandemic, college enrollments have declined by over one million students over the past two years, and with college tuition getting more and more expensive, many students are considering alternatives to the traditional higher education path.

Gap years, travel, trade programs, and online training are replacing the traditional college education path for many, and if you want that to be an option for your children or grandchildren, you should be aware that the traditional college savings plans may not be the right fit for your family.

Instead, consider whether it may make more sense to create an educational trust for your family, in which all of your children and grandchildren can benefit. More on that below in the section on education trusts.

Second, consider the financial aid consequences of how you are saving for college.

If you think your child or grandchild may need or want to qualify for financial aid, beyond student loans, the way you save for their education may significantly impact their ability to qualify. If your offspring will need financial assistance to pay for their education, it’s vital that the way in which you choose to save will not negatively impact their qualification for such assistance.

Third, consider the income tax consequences of how you are saving for college.

When you set aside money, unless you are saving for retirement in a qualified retirement plan, the income earned on that money is subject to income taxes. However, with various types of college savings plans, you can defer or avoid income taxes altogether. 

529 Plans & Education Savings Accounts (ESAs)

Since 1996, 529 plans, which are named for Section 529 of the Internal Revenue Code, have been one of the most popular options for covering college costs. Congress expanded these plans to cover K–12 education in 2017, and it also changed the program to pay up to $10,000 in student loan debt in 2019.

One reason 529 plans are so popular is due to their tax-saving advantages. The money you contribute to a 529 account grows on a tax-deferred basis, and withdrawals are tax-free, provided they are used for qualified education expenses, such as tuition, room and board, and other education-related fees. And many states also provide a tax deduction or credit for 529 contributions.

Another appealing feature of 529 plans is their relatively high contribution limits. There is no limit on how much you can contribute each year, although if you contribute more than $16,000 (the amount of the gift tax exemption limit  in 2022), you can trigger federal gift taxes and the requirement to file a gift tax return. If you plan to make a contribution close to or above $16,000, contact us for guidance.

Finally, with many 529 plans, you can set up an automatic transfer to add money directly from your bank account to your 529 account. Plus, many 529 plans allow automatic contributions as low as $25 per month.

Before you automatically save for your offspring’s future education using a 529 plan, keep in mind that to avoid paying taxes, plus a 10% penalty, the money must be used for eligible expenses only. Eligible expenses include tuition and fees, room and board, books, as well as  computers and other items if they are required for classwork.

If your child decides not to go to college, you will pay income taxes, plus the 10% penalty in order to withdraw the funds and use them for something else. The other downside to saving for your child’s education in a 529 plan is that your investment options may be significantly limited to only a small selection of mutual funds.  

Education Trusts

While 529 plans are quite popular, there is another way to save for your child or grandchild’s education through the use of an irrevocable trust. While there isn’t any income tax deferral on income earned by the assets held by these trusts, it is possible to structure a trust, so your beneficiaries could qualify for financial aid that they may otherwise be ineligible for with a 529 plan. If qualifying for financial aid would be even more valuable than savings on the income taxes owed on income earned by the trust, contact us to discuss setting up an educational trust for your family.
Next week, in part two, we’ll go into more detail about educational trusts. For now, take into consideration what matters most to you when it comes to saving for college: tax savings, financial aid considerations, or a variety of investment and education options. Then, contact us if you’d like to consider the educational trust option as part of your legal and financial decisions for the people you love.

The Benefits Of Education Trusts

In addition to the issue of qualifying for financial aid, another benefit of such trusts is that you can not only save for a single child’s or grandchild’s education, you can also structure your trust to provide a pool of funds for the education of all family members. Moreover, when creating the trust, “education” can be broadly defined to include any type of learning institution or organization, such as trade schools, educational workshops, community colleges, and private academies, to name just a few options. 

Furthermore, you can provide that the trust can pay for alternative education, such as travel, retreats, business building programs, and other nontraditional educational experiences, which may prove even more valuable than college. Bottom line: when you set aside money to educate your family with an education trust, you get to decide exactly how your beneficiaries can use the funds by what is most in alignment with your family values. And as part of creating your education trust, we will work with you to create a written set of guidelines for the trustee, who will be the person making decisions regarding distributions to the beneficiaries. 

Trust Creation Options

In terms of how the trust is set up, you can create an education trust that is built into your revocable living trust or will, and as such, it would not get registered and funded until your death. Or you can create an education trust that exists and is funded during and throughout your lifetime. In either case, the disbursements from the trust are designated for a beneficiary or a pool of beneficiaries’ education.

While you can stipulate how and when the funds are to be distributed inside the terms of the trust agreement itself, we would almost always provide the trustee with broad distribution authority and discretion (to maximize the asset protection benefits of the trust), and create a separate writing to provide guidelines on distributions, and then give a trusted person, or group of people, the right to remove and replace the trustee with someone else should your first choice not work out for any reason.

If a single trust is established for multiple beneficiaries, you can require the assets to be distributed in a number of ways. You can stipulate that the funds are divided equally among the beneficiaries, disburse the funds in a set amount, by percentage, or you can leave the decision as to how much each beneficiary receives to the trustee’s discretion.   

Tax Implications

Education trusts typically aren’t set up as tax-saving vehicles, as is the case with a traditional 529 plan, which does provide tax savings. That said, as we noted earlier, 529 plans have much more restrictive rules for how their funds can be used. Moreover, you could save on taxes with a trust if it is drafted in a way that allows the trust’s income to be taxed at your beneficiary’s tax rate, which could be significantly lower than your personal tax rate.  

If you establish an irrevocable trust for education purposes, make sure you consider all of the tax impacts on income earned by the trust. For example, the trust would be taxed on income not distributed by year’s end, but you can have the trust drafted to pay out all income to the beneficiary or include other provisions that cause the trust to be taxed to the beneficiary (even if income is retained).

That income would be taxed at trust tax rates, which could be higher than the beneficiary’s rate—and possibly even higher than your personal tax rate—so it’s important you are clear about whether income should be distributed before year’s end for each year the trust earns income. 

If the education trust is irrevocable, meaning that the gift cannot be taken back, and the amount contributed each year is less than the annual gift tax exemption ($16,000 in 2022), then no gift-tax return is required to be filed. Conversely, if the gift to the trust exceeds that amount, then you will need to file a gift-tax return, reporting the gift and using up part of your lifetime exemption of $12.06 million if single and $24.12 million if married filing jointly.

Since there are so many variables involved and different ways to set up an education trust, it’s vital to reach out to us at de Jesus Law Group, so we can walk you step-by-step through all of your options—and help you determine what’s best for your unique situation.

Potential Problems To Keep In Mind

One alternative to these plans (both 529 plans and education trusts) is to use money that has been saved for other purposes, such as funds you have saved for your retirement. However, it’s important to point out that using your retirement funds can affect your child’s eligibility for various need-based financial aid programs. To this end, retirement funds withdrawn to pay college expenses are reported on the Free Application for Federal Student Aid (FAFSA) as additional income.

Consequently, when using retirement funds, the expected family contribution used from FAFSA will be higher, which will therefore reduce your child’s chances of qualifying for financial assistance. Consult with us if you choose to tap into your retirement savings to fund college expenses, so we can ensure it’s done right and will have the maximum benefit for everyone involved.

Don’t Do-It-Yourself

To ensure you get the most benefit from your savings, don’t try to make these decisions on your own. As your life planning lawyers, we will work with you to determine the best way to set aside financial resources for the people you love, whether that’s using a 529 plan, an education trust, or some other option. Contact us today to learn more.

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