Personal finance decisions that involve multiple family members and generations are as much about communication as they are about dollars and cents. Since I began working at Heritage, one of the most popular questions our clients have asked during our review meetings has been “how can I help my grandchildren pay for college?” I recommend sitting down with your children to discuss your intent to help, to review the options, and to discuss potential pitfalls. The focus of this post is to create a bit of clarity in one of the murkier corners of our financial lives, and, as we often say here at Heritage, every detail matters.
COLLEGE EXPENSES AND STUDENT LOANS
Helping defray these expenses for your grandchildren (and their parents) may be one of the most impactful financial gifts grandparents can give to their grandchild. According to The College Board(1) published in 2016-2017, costs for a Private Nonprofit four-year institution have risen 3.5% since the 2006-2007 school year to an average of $35,020. In contrast, a college student in 1976-77 paid an average of $16,760 for these same costs. Oh, by the way, these increases are after accounting for inflation.
Student debt is also rising. From the same report, in 2014-15, the 61% of bachelor’s degree recipients from public and private nonprofit institutions who did borrow graduated with an average of $28,100 in debt. Student loans have now far surpassed outstanding credit card debt(2). This debt has been cited as a key contributor to young graduates delaying purchasing their first home, starting a small business, and even starting a family. I can personally attest to this: my wife, Lori, and I bought our first home at thirty-four and our son, Harry, was born when we were both thirty-six. Even still, the value of a college education is clear when it comes to future earning potential. Today, college graduates with a bachelor’s degree can expect to earn an income 67% higher than those with a high school diploma, and their unemployment rate is nearly half(3).
UNDERSTANDING FINANCIAL AID
Understanding the rules of the game is imperative. How do you know if your grandchild will even be eligible for financial aid? Get to know his parent’s Expected Family Contribution (EFC). A quick method for estimating the EFC is to take 20% of the parents’ gross income PLUS 5% of the parents’ non-retirement savings PLUS 20% of any savings owned by the student. The student’s financial need is simply the cost of attendance minus the family’s EFC. If the cost of attendance is higher than the EFC then the difference, the student’s Financial Need, is the gap that could be filled by needs-based aid via Federal financial aid programs. This is where the Free Application for Federal Student Aid (FAFSA) comes in and when you should sit down again with your family to review your options and plan of attack.
Although there are many options for saving for college expense let’s focus on the most popular: State-Sponsored 529 Education Savings Plans. The College Board reports total assets in 529 plans were $225.31B as of the end of 2014. This is up from $65.93B just a decade earlier. The main benefit is tax-free growth for withdrawals used for qualified secondary education expenses. You can sock away a very large amount of money in these plans, into the hundreds of thousands of dollars. Additionally, anyone can open a 529 for any beneficiary so even if the child’s parents fund a 529 you, as grandparent, can also open and fund a separate 529. Your state may also offer a state tax deduction for this contribution. 529 plans are considered assets of the custodian so only 5.64% is included in the EFC if they are parent-owned and nothing is included if grandparent-owned.
Financial aid is complicated and this is where we see clients’ good deeds can actually negatively impact their grandchild’s financial aid eligibility. Let’s focus on one cross-generation strategy. While assets held in grandparent-owned 529 plans are not included on the FAFSA, actually using those assets to pay qualified college expenses is. What’s the difference? Withdrawals made from a 529 owned by the student’s grandparent and used to pay these costs are counted as untaxed income to the student in subsequent school years thereby reducing financial aid eligibility. That reduction is potentially severe: untaxed income is included in the EFC to the tune of 50% of the amount in excess of the annual income allowance of $6,420.
In a September 2015 executive order(4) signed by then-President Obama aiming to simplify the FAFSA process one provision changed the income base year (the income year that is to be reported on the FAFSA) from the prior-year to the prior-prior-year. This change makes the filing process easier and, consequently, helps grandparents assist in paying for college. Because the base year is now two tax-years prior to filing the FAFSA, grandparents can essentially pay for all of the students Junior and Senior year costs without those payments added to any aid applications since the final income base year ends half-way through the student’s sophomore year (assuming he is graduating in four years and not attending graduate school right away).
THE WINNING STRATEGY
One strategy that takes advantage of these rules is to dedicate the parent’s savings to the first two years of college costs and the grandparent’s, in part or in whole, to the final two years. If, as is often the case, extra income when your grandchildren are very young and your children’s incomes are stretched is hard to come by, consider gifting annually to the parent-owned 529 and utilize your savings to fund 529s you own or to pay the school directly once it’s time to pay tuition. As they say: “it takes a village.” It also takes careful planning and uncommonly open communication.
Given the many options available and labyrinthine set of rules to follow, success in planning for a child’s education is about more than just money. We at Heritage routinely help our clients make prudent, effective financial decisions by aligning these decisions with their unique, personal values. Making decisions across generations requires an additional focus on the details. And while providing for the family’s education is a priority for many, be sure to coordinate that goal with your other goals of, say, not running out of money, reducing your estate tax liability, and, at the same time, enjoying your own hard-earned retirement.