How to Give a Gift of Educational Expenses: Tax Advantages and Pitfalls

How can you gift tuition and educational expenses to a child or grandchild? Should gift funds be direct payments to the educational institution? What funds should be gifted to the student? Are gifts for educational expenses tax-deductible?  If so, what educational expenses can be excluded from gift tax? How does a gift affect financial aid? What are the advantages of a 529 plan? How can 529 plans be used to establish education trusts? How can Roth IRAs be used to fund education? How can life insurance be used to fund education?

By James L. Cunningham Jr, Esq.

One of the best gifts you can give to people you love is the gift of education.

No one knew that better than my grandfather, who was born in 1909 and started college in 1928. He began his sophomore year in 1929, which of course is when the stock market crashed—and sure enough, he had to leave college to go back and work on the family farm.

Later, my grandfather became a factory worker for General Motors in Detroit, but he managed to put his three sons through school on his blue-collar wages. All three got advanced degrees—and it’s an understatement to say my family values education. We know that the educated live longer, happier, better lives. We know that educated citizens are better citizens. We know that education is the great equalizer in our society and the gateway to opportunity.

We also know, first hand, that higher education is super expensive and getting more expensive every year. Some people manage to get scholarships that help. Some take on crippling student loans. Most tap family-derived funds of one kind or another.

Here at CunninghamLegal, we work with families, parents, and grandparents as they make the financial, trust, and tax decisions that will permit the next generation to get the education they need and deserve. We know it’s some of the most important work we do, and we invite you to contact us.

The Endlessly Rising Costs of Education

Let’s start with a brief look at the daunting numbers.

As of this writing, four years at a good private college costs over $200,000 for tuition alone. The Ivy League runs more like $330,000. Costs were about half that much twenty years ago and will be over twice that in 2039. The hard estimates? Four years in a public college, in-state will jump from around $116,000 in 2022 to around $257,000 in 2039. A good private college will jump to nearly $500,000 for four years by 2039. Four years at a prestigious Ivy League college will leap to $766,000 in 2039!

These huge numbers aren’t guesses. Four-year university inflation has been running between 6 and 8 percent for the last couple of decades. This has considerably outpaced the overall rise in the cost of living, even now when overall inflation is again a concern.

Shocking, but real.

Educational Gifting Must Be Done Right

We all know that families need to diligently explore scholarships, student loans, financial aid, and related options, but in this article, I want to focus specifically on private family funding sources: be they parents, grandparents, generous aunts and uncles, or others. In other words, a gift for educational expenses.

Want to be generous with your kids or grandkids? Fabulous. But as with everything financial, there are right ways and wrong ways to go about it, especially from a tax exclusion perspective.

The Major Issues in Educational Gifting

The big issues in educational gifting, beyond the obvious one of how much you can afford, are:

  1. What kind of educational expenses paid by grandparents are free of gift tax? As of this writing, whenever you give a gift over $16,000, per donor per recipient per year, you must file a gift tax return. Sometimes, gift tax is due.
  2. How can you keep your gift from impacting any financial aid for which the student would otherwise qualify?
  3. How can you ensure that any leftover funds earmarked for a student’s education can still be used?
  4. How can you use a gift for educational expenses to maximize multi-generational wealth, while minimizing estate taxes?

How Should You Give Money to Students?

Given these factors, the most important ways of gifting money for educational purposes break into these five:

  1. Direct payments to an institution
  2. Gifting directly to the student
  3. 529 Plans
  4. Roth IRAs
  5. Life insurance

Before I go through each of these in some detail, I want to emphasize that you can mix, match, and combine any of the above—whatever makes the most sense for you individually. You aren’t restricted to just one approach. Aside from making sure you are doing things legally and with all the tax implications in mind, a professional advisor can help you strategize on the right mix of approaches.

Should I Establish a Trust for Educational Expenses?

You may be surprised that “trust funds” do not appear on the above list. That’s because, given the tax and financial aid impacts of trust funds, establishing a 529 plan is usually a better option. I say “usually,” because certain complex circumstances may require a trust, such as transferring stock or other types of non-cash assets into the trust fund.

The biggest problem is that if you establish a trust fund for your child or grandchild, they will have to report that as their own money when they fill out the FAFSA—the Free Application for Federal Student Aid, employed as the financial aid application for most colleges. That will likely reduce their aid eligibility. If you do a 529 right, it won’t impact financial aid, or won’t impact it significantly. More on that later.

Just as importantly, the asset growth in most trust funds is taxable—while the funds in a 529 plan are not.

Direct Payments to an Accredited Institution Avoid Gift Taxes

Can you gift education expenses for the grandkids to the university directly? Yes—in fact, that’s by far the best way.

As of 2022, the educational expense gift tax exclusion limit per year to any single individual, including a child, is just $16,000. However, if you’re making a payment directly to an accredited educational institution, you should have unlimited gift tax exclusion for educational expenses. Plus, if you’re a grandparent, such payments are not subject to generation-skipping tax (GST) limitations.

Always consider paying your child’s, grandchild’s, niece’s, or nephew’s tuition directly to their academic institution, rather than giving them the money to then pay the institution. It’s amazing how many people get this wrong when giving a gift for educational expenses.

If your student is living on campus, the same applies to room and board. If not on campus, you really should consider a 529 plan to pay room and board, rather than payments directly to students, which might be considered taxable gifts. Again, see below for more on 529s.

Direct Gifts to a Student Have an Annual Exclusion Limit

Giving gifts directly to the student is always an option for off-campus room and board, supplies, and so on. But the current GST and gift tax exemption for educational expenses is $16,000 per donor per student. Within these limits, even filing a gift tax return isn’t required.

There’s more to the “per donor per student” rule for gift tax exclusion. Educational expenses of up to $32,000 per college-age kid, for example, can be given by a married couple. Other donors such as grandparents can also give up to $16,000 annually per donor tax-free.

However, it’s not just the gift tax exclusion for educational expenses that you should consider here. Because the owner of the gift becomes the student, direct gifts from anyone, including grandparents, do impact financial aid qualifications.

Business Owners Can Put Students on Their Payroll

If you’re a business owner, you have another way to help your college-age kid financially. Many of our clients put their children on payroll and have them earn money for school. You could pay your high school or college-aged kid $30,000 a year just to use their likeness on marketing materials. Maybe they can help stuff envelopes. Often, they can do more significant work.

Aside from possibly deducting this cost as a business expense, one advantage of this approach is that it helps your kid build their credit and a track record that’s very useful once they graduate and are looking to rent an apartment, apply for a loan, or otherwise get on their feet.

Downsides? Putting them on the payroll will impact their financial aid eligibility. The child must also, of course, pay income tax on that money, though at their lower tax rate.

Again, consult a professional CPA on any such move.

Financial Aid Considerations

Here’s a chart that gives the basics of what’s taken into account when calculating the need upon which financial aid is based.

As you can see, 50 percent of a student’s income is expected to be paid to the institution before financial aid is granted. Direct gifts to the student and monies earned from employment in a family business both increase the student’s income and significantly raise the financial aid bar.

How to keep assets off the FAFSA balance sheet, or reduce their impact? Create a 529 plan.

What Is a 529 Plan for Educational Expenses?

A 529 is the most common tax-advantaged, education-focused savings plan. These “qualified tuition plans” are sponsored by each of the states and authorized under Section 529 of the  U.S. Internal Revenue Code (IRS). All the money invested in the plan is free from both federal and state taxes, including capital gains taxes on investments, for no matter how long the 529 exists. There are no income limits on the person putting money into a 529 plan—so it’s available to everyone. In a 529 plan, your investment vehicles are typically restricted to certain mutual funds—you can’t buy individual shares in a company—but you can still do some high-quality investing.

And if you do it right, a 529 will have little or no effect on financial aid calculations.

All these factors make a 529 an incredibly powerful tool for creating intergenerational wealth. Indeed, having a 529 plan for your college-bound child or grandchild can be the single most effective way of ensuring the money will be there, tax-free, when you need it.

It’s never too early to start—the earlier, the better.

Working Within 529 Contribution Limits

Contributions to 529s are limited per donor, per donee, per year. In 2022, that limit is $16,000 per donor, per donee – or recipient of the gift. So a married couple—whether parents or grandparents—can contribute up to $32,000 per year to a single student’s 529 plan.

However, you’re also allowed to front-load up to five years of contributions, also known as “superfunding.” That means a single donor can give up to $80,000 (per donor, per donee)—so a couple can contribute up to $160,000 per student when establishing a plan.

If both parents and grandparents want to contribute to a 529 plan, it’s almost always better for grandparents to have their own plan—because, as you will see, this can prevent counting the plan when determining financial aid. Also, your Living Trust (and every parent should have a Living Trust!) should authorize the trustee to deal with a 529.

For those with the means, front-loading a 529 is a great estate-planning tool, as any such contribution is immediately removed from the donor’s taxable estate. If a couple has multiple grandchildren, this tax-free amount can quickly add up to a substantial sum, as this graphic shows:

Multi-Generational 529 Fund: A Family Bank for Education

If you have three grandkids, and you have the means, you can front-load their three 529 plans at $160,000 each for a total of $480,000.

Now, you may think, “I don’t want to give up $480,000!” But let’s face it: if you’re thinking about funding a grandchild’s education, and you’re capable of putting together that kind of money, your best bet is to look at your full estate picture. Death Taxes (aka Estate Taxes) are very likely going to go up soon. If you have a large estate and you can gift $480,000 to three grandkids, that’s cutting your death tax bill by a couple hundred thousand dollars, because such a contribution does not erode your lifetime gifting exclusion provided that you live long enough.

If you do this for grandchildren starting when they’re age three, and assuming a decent rate of return, you will likely fund at least three out of their four years in a good college. Tax-free.

Legally, 529 Plans must be used for education—but say your 529 pays down your grandkids’ education and there’s still money left over. Rather than cashing in the 529 and paying taxes on it, you should consider keeping the plan intact to provide for other grandkids’ or even the next generation’s education—with no cap on how large that fund can grow! In essence, a 529 can be used to create what’s effectively a family bank for education, right through great-grandchildren and great-great-grandchildren!

A wide variety of financial institutions offer 529 plans. Definitely shop around.

Ownership and Timing of a 529 Is Crucial to Avoid Impacting Financial Aid

Does a 529 plan impact financial aid? The rules are complicated, and another good reason to consult a good CPA and lawyer. On the simplest level, if the 529 is in the name of the student it will be counted like any other asset, and greatly reduce eligibility. If it’s in the name of the parents’ it will impact eligibility, but at a reduced rate.

But here’s the huge reveal: If the 529 is in the name of a grandparent or other relative, it will not impact financial aid calculations at all, as long as you don’t use the money in the first two years at an institution. That’s because on FAFSA forms there’s only a two-year lookback on any money that was received by the student from a 529.

Bottom line, no matter where the money comes from, keep the 529 plan out of the ownership of the student, and ideally out of the ownership of the child’s parents as well.

Common Myths About 529 Educational Plans

There are several myths about 529 plans I’d like to dispel. We’ve already dealt with one of them: that a trust is the best tool for inter-generational education giving. No, a 529 is almost always better.

Another myth is that 529s can only be used for four-year schools. That’s simply not true. You can use them for accredited two-year junior and community colleges, and for graduate and professional schools. They can also be used for often-overlooked educational institutions like vocational and trade schools.

Funds from 529s can be used for more than tuition fees: they can be used for room and board, supplies, utilities—anything associated with education at an accredited institution.

And, to tackle yet another myth, it doesn’t matter how old the student is. If you’re an adult who’s raised children and wants to go back to school to get a first or additional degree, you can use a 529 to fund yourself! Indeed, unused money is easily transferred to another beneficiary within the family: if the kids are through college, any leftover funds can be used by mom or dad. You can use a 529 plan to get additional education at any stage of life.

We’ve already partly addressed a final myth: that 529s affect financial aid. Done properly, a 529 can have little or no impact on financial aid. See above.

Finally, if a student gets a scholarship, at graduation you can take out an equivalent amount from the 529 tax-free and without any penalty—again, assuming it’s done right, with the advice of a professional.

Paying Off Student Loans

Of course, another way to aid a student or former student financially is to help them pay off their student loans after the fact.

You should know, first off, that if there’s money left over in a 529 plan, up to $10,000 of it can be used to repay such a loan, tax-free: another good reason to pursue the 529 strategy. But let’s assume you have no such funds available, and simply want to help out with a gift while avoiding gift taxes.

Say your grandkid has run up $200,000 in student debt, which isn’t uncommon for professionals such as doctors, lawyers, dentists, and others with advanced degrees. You can pay off that $200,000 by structuring it as a loan or, more accurately, what’s called a self-canceling installment note. You make the loan, which you then forgive at the maximum gift rate of $16,000 a year until the entire note is canceled.

Presto! No gift tax. But again, make sure to execute this maneuver with the help of a pro.

Loan Repayment Instead of 401(k)

Here’s another little-known way to pay off student loans. Under the Tax Cuts and Jobs Act of 2017, a student’s later employer can match employee contributions as a loan repayment rather than as a matching contribution to a 401k. Indeed, in general, if you are less than thirty years old, having your employer pay down your student loan may be a better use of resources than building up a 401k that won’t be used for several decades.

In any case, you definitely want to consult a professional CPA or lawyer to do this correctly. And if you are a family member, never forget that paying an institution directly while a student in school is a much better road for everyone.

Using a Roth IRA to Fund Education

Roth IRAs are another way of funding higher education—though the IRA must be owned by the students themselves. One advantage to Roth IRAs over 529 plans is that there are no limitations on how the funds can be invested.

To have a Roth IRA, of course, you have to have earned income. Again, business owners may be able to hire their kids, giving them summer or other jobs, to establish such income and put it into a Roth IRA. Money can then come out of that Roth IRA for education without penalties or either federal or state taxes—as long as it’s been in the account for five years.

One limitation is that these funds count as a student’s assets, so they are used in making financial aid calculations. In short, be aware that Roth IRAs are a vehicle for funding education: they’re just not used as much as 529 plans.

Again, consult a professional before using a Roth for this purpose.

Life Insurance

One of the other often overlooked vehicles for funding education is life insurance, which can be used in conjunction with a 529 or another vehicle. Life insurance predates income tax in the United States—and perhaps for that reason, it has a very special place in the Internal Revenue Code and gets very favorable tax treatment.

We’re not talking term policies here. We’re talking “permanent life insurance” with a “cash value” that allows you to use the cash that accumulates from investing the funds in the policy. These policies can build cash in a manner that allows you to pull that cash out, tax-free, as a loan from the policy. If the loan interest is 4 percent and the policy is earning 7 percent, the loan is paying for itself. Of course, you need the time to invest these funds: likely a good six to ten years to marinate the cash accumulation if you’re using the policy for college planning.

I know it kind of sounds morbid, but you can get a life insurance policy on your kids. The reason why you would do that is because carrying a life insurance policy on a healthy young child is not expensive. We’ve done this for one-year-olds. The goal of such a life insurance policy is not a high death benefit, although there is a death-benefit component. It’s really for cash-value accumulation.

One advantage is that these funds can also be used for non-educational purposes, which means they don’t have to be used solely for education at an accredited institution.

Next Steps

What next? It’s never too early to start establishing a 529 or another vehicle for funding your children’s or grandchildren’s education. You’ve just gotten an overview of the main ways of doing this in the most tax-advantageous ways possible. However, the list isn’t exhaustive and there are many nuances that involve your specific, individual situations. Professional, expert advice can help you devise the best education-funding strategies for you and the next generations.

What Do We Do as California Estate Planning Attorney Specialists?

The lawyers and staff at CunninghamLegal help people plan for some of the most difficult times in their lives; then we guide them when those times come.

Make an appointment to meet with CunninghamLegal for California Estate Planning and Trust Administration. We have offices throughout California, and we offer in-person, phone, and Zoom appointments. Just call (866) 988-3956 or book an appointment online.

Please also consider joining one of our free online Estate Planning Webinars.

We look forward to working with you!

Best, Jim

James Cunningham Jr., Esq.

Founder, CunninghamLegal

At CunninghamLegal, we guide savvy, caring families in the protection and transfer of multi-generational wealth.

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Higher education is super expensive and gets more expensive every year. Some people manage to find scholarships that help. Some take on crippling student loans. Most tap family funds of one kind or another.