I wish I’d started earlier taking advantage of 529 accounts. I’m running out of precious years of compounding. But what about the so-far untapped compounding for any future grandchildren? Using current assumptions, what would a plan to fund college-bound grandchildren look like?
Comfortably on the Couch
I can’t open 529s for grandkids that don’t yet exist. I’ll need to fast-forward into the future. I’ll set the time machine dial to thirty years into the future. Besides flying cars, imagine:
- I have $100,000 that I want to invest in my grandkids’ education
- I haven’t opened any accounts for them
- I have 24 grandkids, all of various ages. Not an unreasonable number given I have six kids of my own
- Some grandkids are already at college, some are toddlers, and the rest are in between
- I want to be as tax efficient as possible
- I want to be as fair as possible
- I want to stay in control so it isn’t blown on heroin
While I currently live in Virginia, for my examples I’m going to assume I live in Utah.
Given those parameters, what are some of my options?
Option 1: Write Checks
This is the “give the money to my kids, trusting them to do what is right” option. The easiest option by far. I simply divide $100,000 by 24, write checks to my kids and ask them to use it for my grandkids college. What could go wrong?
By abdicating control, I’ve given up the guarantee that the money will go towards educating the grandkids. I imagine I wouldn’t be happy if the money bought toys like boats, home remodels, or fed heroin addictions. At the same time, it also might be used to help one of my children who is going through a tough patch, so not necessarily the worst outcome.
This option is tax inefficient. I don’t save any on my state income tax. If I’m not careful in my check writing, I could also end up paying gift taxes.
Option 2: Give The Money To My Grandkids Through UTMA/UGMA Accounts
This option is not as easy as the first option. Now I have to open and manage 24 separate accounts. It does keep the money out of the hands of my greedy, grabby children, ensuring it goes to my grandkids.
UTMA/UGMA accounts are flexible and can be used for non-education expenses. Maybe a grandchild doesn’t want to go to college and instead wants to start a business with my gift. Or maybe it goes towards their budding heroin addiction. The UTMA/UGMA keeps options open, but I lose control when the grandchild hits adulthood.
Gains in UTMA/UGMA accounts are taxed. The first $1,100 is not taxed, the next $1,100 is taxed at the child’s rate, and any additional gains are taxed at my marginal rate. That’s probably not an issue when I’m dividing $100k twenty-four ways.
There’s generally no state income tax benefit for making my original contribution.
Option 3: Coverdell Education Savings Accounts
Similar to a 529, these accounts are used for education. Annual contributions are limited to $2,000/child and can be used in pretty much any kind of investment, the biggest reason why Dave Ramsey touts them so heavily. They must be used by age 30 or given to another family member. I also can’t contribute to them if I make more than $220k as a married couple. I also can’t contribute once a grandchild reaches age 18, a non-starter for several of my hypothetical grandchildren. ESA’s are custodial accounts, and control transfers to the beneficiary when they become an adult, meaning I’d lose control like I would with the UTMA/UGMA route.
Option 4: 529 Accounts
Invented in the later part of the last century, 529 accounts correct some of the problems from UTMA/UGMA and ESAs.
Unlike a UTMA/UGMA, the owner of the 529 account stays in control. If a grandchild choses to skip college, the money can be shifted by the account owner to another person, even including themselves.
Compared to an ESA, 529 contribution limits are sky-high. Unlike an ESA, there’s no income limit for contributing and there’s no beneficiary age limit for contributions or deadline when the money must be used up. Like an ESA, 529s can be used for more than just college. Unlike an ESA, 529 money stays in my control.
529s come with significant tax benefits. Any earnings, when used for qualified education expenses, are tax free on both the federal and state level. When my 2007 contribution of $3,500 grew to $13,000 by 2020, I didn’t have to pay a penny of tax on those earnings when I withdrew them to pay college expenses last fall.
While I don’t get any federal tax benefit when I contribute, I get a state tax deduction for my contributions. As an example, as a joint tax filer in Utah, I could deduct $4,140 per beneficiary in 2021. That means that my $100k will save me almost $5k in Utah state income taxes. 529s are also not considered part of the estate for estate tax purposes.
Not all 529 accounts are equal. Utah’s 529 is one of the best in the nation in options and low fees. Looking at one option, the Institutional Total Stock Market Index Fund (VSTSX), I can see it has a 0.010% expense fee. That’s incredibly low. And the other index fund options are similar. The Utah plan has no fees to open, no annual fee, and no minimum contribution.
If I choose, I can even give my kids read-only access to the accounts.
Additional links of interest from my529:
- How to contribute
- Information for Grandparents
- Information on important tax documents for 2017
- General FAQs
Choose My Own Adventure
With 24 grandchildren, there’s a good chance that one or two won’t go to college. Maybe they’d rather do beauty school or trade school. Great! A 529 can often cover that too, as long as the school qualifies for federal student aid.
There’s also no restriction that the student goes to college in Utah. As long as the school qualifies for federal student aid, my 529 funds can be used to pay for it.
But maybe it’s not school they want at all but to start their own business. I can always withdraw the money from the 529 at any time, with some caveats.
First, the amount I contributed was already taxed so there’s no additional tax. If I withdraw money for a non-qualified expense, I will have to pay federal and state tax on any gain, plus a 10% penalty. Additionally, if I got a state tax benefit (i.e. the tax credit, above), I’ll likely have to pay that back.
For example: I contribute $4,167 to the 529 of a grandson we’ll call Michael. I get a $208 (in 2021) tax credit. The money grows to $6,000 by the time Michael is ready to go off to college, but he has different plans. He wants to start a shaved ice stand because college is not for him. I decide to help him out by withdrawing everything from the 529:
- $208 (Utah state tax credit, clawback of previous income tax deduction)
- $183 (10% penalty for non-qualified expenses)
- $586 (federal tax on $1,833 of gain, assuming 32% marginal tax rate)
- $91 (Utah state tax on $1,833 of gain, 4.95% tax)
$4,932 remaining, of which $765 is net gain. By not using it for education, $1,068 went to taxes for an effective tax rate of more than 58%.
Instead of taking the tax hit, I could simply change the beneficiary to another grandchild. Or even keep the account active in the hopes that they change their mind about college, or decide to attend a trade school. Or maybe keep the account around to benefit a future great grandchild.
If I’m dead-set on my $100k cap but still want to help out my non-college bound grandchild, maybe I could arrange something with the other grandkids to buy out their non-college-bound peer for a discount. It complicates things, but could be an interesting economics lesson to all involved.
What if I fall on hard times and need the money myself? Luckily, the math above applies whether I take it out for myself or for a no-school grandchild.
The 529 has plenty of flexibility.
What Investment Option Would I Choose?
I prefer investing in stocks over bonds. Among the Utah 529 plan options, I would choose the Total US Stock Market option. I’m tempted by the Global Equity 90/10 or the Global Equity 70/30 with their mix of the global equity markets. If, say, I’m a big fan of growth stocks because Dave Ramsey likes them, then there’s always the Vanguard Growth Index Fund option.
I would not choose any of the Age-based because they are too conservative for my preference.
An alternative to choosing the investment options myself, I could instead invite my children to decide what investments they like. This both removes the burden from me and also could be a fun way to get them involved and “invested” in understanding the gift I’m giving to them and their children. Really, nearly all of the options in the Utah 529 are great options. Okay, so maybe not the FDIC insured for toddlers.
Either way, I would use the Utah 529 option to give read-only account access to my children so they could see the gift I’m giving and use it in their college funding plans.
Paying The Bills: Coordinating 529 Spending
- Withdrawals from 529s must happen in the same calendar year as expenses
- Withdrawals can’t exceed either the actual expenses for tuition, expenses and room and board, or the college’s estimated cost of attendance. For example, my daughter’s university expects undergraduates to have $20,156 of annual attendance.
- Keep good records for potential audits. I’ll need to coordinate my withdrawals with any other 529 accounts for that beneficiary. I should track the expenses that I pay for. One way to make this easier is for me to pay the tuition bill directly to the college on behalf of the student, letting other 529 account holders pick up any remaining expenses.
One thing to note is that grandparent 529s affect federal student aid eligibility. Unlike a 529 held by a parent, withdrawals count against the student as if it was untaxed income. For this reason, some experts suggest using grandparent 529s after January 1st of student’s sophomore year, bypassing FAFSA’s prior-prior year data.
Anyway I cut it, spending the 529 money will require coordination with my child and grandchild.
Contributing to 529 accounts for any future grandchildren is a great way to “pay it forward” while keeping control on how the money is spent. While this thought exercise has been useful, in actuality I have years until I need to think more about it.
Here’s are five steps to getting off that college funding couch:
- Decide how much money I want to contribute to each grandchild
- Get the full name and social security number for each one of my grandchildren
- Create an account at https://my529.org/
- Open a 529 account for each grandchild, investing the contribution in the the Total US Stock Market option
- Give my children read-only access to the account
Any questions or thoughts? Drop me a comment below!