College financing: An integral part of your estate plan
The staggering cost of college makes it critical for families to plan carefully for this major expense, and in many cases grandparents want to play a role. As you examine the many financing options for your grandchildren, be sure to consider their impact on your estate plan.
A simple but effective technique is to make tuition payments on behalf of your grandchild. So long as you make the payments directly to the college, they avoid gift and generation-skipping transfer (GST) tax without using up any of your gift or GST tax exclusions or exemptions.
But this technique is available only for tuition, not for other expenses, such as room and board, fees, books, and equipment. So it may be desirable to combine it with other techniques.
A disadvantage of direct payments is that, if you wait until the student has tuition bills to pay, there is a risk that you will die before the funds are removed from your estate. Other techniques allow you to set aside funds for future college expenses, shielding those funds from estate taxes. A tool that is particularly attractive for grandparents is the health and education exclusion trust. (See the sidebar "To reduce pain of college tuition, apply HEET.")
If your grandchild is planning to apply for financial aid, also be aware that most schools treat direct tuition payments as a "resource" that reduces financial aid awards on a dollar-for-dollar basis.
Grantor and Crummey trusts
Trusts offer several important benefits. For example, they can be established for one grandchild or for multiple beneficiaries, and assets contributed to the trust, together with future appreciation, are removed from your taxable estate. In addition, the funds can be used for college expenses or for other purposes. Also, if the trust is structured as a "grantor trust" for income tax purposes, its income will be taxable to you, allowing the assets to grow tax-free for the benefit of the beneficiaries.
On the downside, for financial aid purposes a trust is considered the child's asset, potentially reducing or eliminating the amount of aid available to him or her. So keep this in mind if your grandchild is hoping to qualify for financial aid.
Another potential downside is that trust contributions are considered taxable gifts. But you can reduce or eliminate gift taxes by using your annual exclusion (for 2013, $14,000 per recipient; $28,000 per recipient for gifts by married couples) or your lifetime exemption ($5.25 million in 2013) to fund the trust. To qualify for the annual exclusion, the beneficiary must receive a present interest. Gifts in trust are generally considered future interests, but you can convert these gifts to present interests by structuring the trust as a Crummey trust.
With a Crummey trust, each time you contribute assets, you must give the beneficiaries a brief window (typically 30 to 60 days) during which they may withdraw the contribution. You also must notify beneficiaries of their withdrawal rights.
If a Crummey trust is established for a single beneficiary, annual exclusion gifts to the trust are also GST-tax-free. If there are multiple beneficiaries, however, contributions may be subject to GST. The impact of the GST tax can be mitigated, or even eliminated, if you allocate some of your GST exemption to the trust.
Sec. 2503(c) minor's trust
One alternative to a Crummey trust is a Section 2503(c) minor's trust. Contributions qualify as annual exclusion gifts, even though they are gifts of future interests, provided the trust meets these requirements:
- Assets and income may be paid to or on behalf of the minor before age 21,
- Undistributed assets and income will be paid to the minor at age 21, and
- If the minor dies before reaching age 21, the trust assets will be included in his or her estate.
A Sec. 2503(c) trust qualifies for the annual exclusion without the need to offer Crummey withdrawal rights. Once the beneficiary turns 21, however, it is possible to extend the trust by giving the minor the opportunity to withdraw the funds for a limited time (30 days, for example). After that, contributions to the trust no longer qualify for the annual exclusion, unless you have designed it to convert to a Crummey trust. Then, so long as you comply with the applicable rules, gifts to the trust will qualify for the annual exclusion.
An integrated approach
Other college financing options include Sec. 529 college savings and prepaid tuition plans, savings bonds, retirement plan loans, Coverdell Education Savings Accounts, and various other tax-advantaged accounts. The best approach is to integrate college financing into your estate planning efforts and to select options that help you optimize your family's overall financial situation.
Sidebar: To reduce pain of college tuition, apply HEET
If you want to finance college expenses for your grandchildren and other future generations at a minimal tax cost, while also giving to a charity, consider a health and education exclusion trust (HEET). A HEET is a "dynasty" trust designed to make direct payments of tuition (and, if you desire, medical expenses) on behalf of its beneficiaries.
You can use your annual exclusions and lifetime exemption to make gift-tax-free contributions. Contributed assets are removed from your estate.
Most significant, a properly designed HEET allows you to avoid generation-skipping transfer (GST) tax without using up any of your GST tax exemption. A trust can trigger GST taxes in two ways: 1) a taxable distribution to your grandchild or another "skip person" (that is, a person more than one generation below you), or 2) a taxable termination, in which all nonskip trust interests terminate and only skip interests remain.
A HEET avoids taxable distributions by making direct payments to educational or health care organizations. And it avoids taxable terminations by granting a significant interest (usually 10% or more) to a charity, which ensures that there is always at least one nonskip interest.