With the costs of college tuition increasing at a rate greater than inflation each year, many parents and grandparents want advice on the best way to prepare for future college expenses.
This two-part series will focus on four methods of paying for college and the tax efficiency of each method:
(1) direct payment of tuition expenses
(2) custodial accounts
(3) 529 accounts; and
(4) irrevocable trusts.
Method 1: Direct Payment of Tuition Expenses
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The simplest, most flexible method of paying for college is for parents and grandparents to pay tuition costs directly to the school.
There is an exemption to the federal gift tax for direct payments of tuition. However, the parent or grandparent must pay the school directly to be eligible for this exemption. Payments made to the student do not qualify, even if they are reimbursements for a legitimate tuition expense.
Payments of other related costs, such as room and board, books and school activity fees, are subject to the federal gift and/or generation-skipping transfer (GST) tax, except in cases where state law requires a parent to make these payments.
Before writing a check for college expenses, it is important that you make sure that the educational institution is the payee and the invoice is for tuition only. Planning to pay the school directly allows parents and grandparents to keep college funds in their names until the bills are due. Meanwhile, they retain complete control over investments and are free to change their minds and use the money for other purposes.
On the other hand, retaining assets in the parent’s or grandparent’s name means investment earnings are subject to income taxes at their rate and subject to claims by the parent’s or grandparent’s creditors, including ex-spouses. If the parent or grandparent dies before the child’s college years, assets in the parent’s or grandparent’s name will be subject to estate tax in his or her estate.
Method 2: UTMA/UGMA Custodial Accounts
The Uniform Transfers to Minors Act (UTMA) allows custodial accounts to be created for minor children. Every state has adopted it, except South Carolina, which follows the similar but older Uniform Gifts to Minors Act (UGMA). UTMA/UGMA accounts are simple to create and do not require a lawyer to draft a trust agreement.