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How Grandparents Can Help Pay for College Without Spoiling Their Retirement Savings

Many grandparents dream of helping their grandkids pay for their college education. Finding the money to send one or more grandchildren to an institute of higher learning can be an exciting prospect. And with the cost of college steadily rising each year, they’ll surely appreciate the help. 

Committing to paying for a grandchild’s college is an important financial decision that could have a major effect on your retirement planning. As CERTIFIED FINANCIAL PLANNERS™, we want you to know that with a bit of planning and smart spending, you can give the gift of education and keep your retirement planning goals on track. Here’s what you should consider.

Understand How Your Gift Affects Financial Aid

Roughly 66% of students apply for federal financial aid using the Federal Application for Student Financial Aid (FAFSA). If your grandchild plans to use financial aid, pay close attention to the rules so they can maximize it. 

In 2021, each grandparent can make a direct gift of up to $15,000 without incurring gift taxes. That means a couple can gift up to $30,000. You can also forego the gift tax by paying tuition directly to the college. However, either of these gifts will reduce the amount of financial aid your grandchild can receive, dollar-for-dollar. A cash gift is essentially treated as income for the student. 

Fortunately, there is a workaround for this. The application determines income based on the calendar year two years prior to the academic year (ie, the 2021-2022 FAFSA is based on 2019 income information). So, if you wait to gift the funds until the student is in their second year of studies (or junior for five-year students) and has already filed their last FAFSA, the gift won’t be counted against aid.

Consider a 529 Plan for Tax Savings

Instead of handing over a check, you can open a 529 plan to help save for the future. A 529 plan is a tax-advantaged savings account designed to pay for education. Both earnings and withdrawals are tax-free, as long as you spend on qualified educational expenses. But you’ll need to consider financial aid implications here, too.

A 529 college savings plan will affect your grandchild’s financial aid to varying degrees, depending on who owns the plan. If you (the grandparent) are the owner of the account, it will be reported as an asset on the FAFSA. Any distributions will count as untaxed income to the beneficiary, which could reduce their eligibility for financial aid money. If the account is owned by the student or the student’s parent, it counts as an asset on the FAFSA but ignores distributions. 

Most states, including Colorado, offer immediate income tax breaks upon deposit into a 529 plan. You can open a 529 plan in many states even if you aren’t a resident. Colorado offers three direct-sold 529 college savings plans and one advisor-sold 529 program.

Coverdell ESAs

Another tax-advantaged savings option is a Coverdell Education Savings Account or Coverdell ESA. Much like a 529 plan, they let you grow and withdraw your money tax-free if you use it for qualified educational expenses. Coverdell ESA contributions are not deductible, though. 

As with any financial investment, you should closely weigh the terms to make sure a Coverdell is a good fit for your goals:

  • Must be made before the beneficiary reaches age 18 (unless the child is a special needs beneficiary, as defined by the IRS) 
  • If you use the money for nonqualified expenses, you’ll owe tax, plus a 10% penalty on earnings
  • The maximum contribution per beneficiary per year is limited to $2,000 (you can set up more than one for a single beneficiary)

You can set up a Coverdell at your bank or with your financial advisor. 

Start When They’re Young

If possible, it’s wise to start saving while your grandkids are young. If you have little money but plenty of time, you can still help your grandchildren in a big way. In fact, the earlier you start, the better. If you begin saving $75 per month starting when the child is an infant (at 1% return) you would have almost $20,000 in 18 years. That’s the beauty of compounding interest.

Open a Guardian IRA

If you’ve thought about using your retirement funds to pay for your child or grandchild’s college tuition, you should know a few things: In general, you are taxed an extra 10% if you withdraw from your IRA before you are 59½ years old. But the IRS will waive the withdrawal penalty if you use it for qualified higher education expenses in the same year. 

Keep in mind, doing so takes money directly out of your retirement fund. And it could potentially be counted as income on the following year’s financial aid application.

If the grandchild is working and is still a minor, you can set up a custodial or guardian IRA in their name. Your contribution may not exceed the amount of their earnings, and you control the assets until the child is of age (18 or 21 depending on the state). This is a great way to avoid dipping into your own retirement IRA.

Find Creative Ways to Help 

There are other ways to help your grandkids pay for college. It’s possible to ease their financial stress while protecting your own retirement investment. Especially if you’re willing to help in non-financial ways:

  • Instead of paying upfront, help your grandkids repay their loan after graduation 
  • Pitch in with childcare to save their parents money on care costs, and agree to put the extra money into a college fund
  • Work together to find and apply for scholarships and grants (which they won’t have to pay back)

Put Your Retirement Savings First

You love your grandchildren and you want to give them the world—that’s totally understandable. But the first and most important question when it comes to helping them pay for college is: can you afford it? Are you financially able to help with costs without jeopardizing your retirement savings plan? 

Make sure your own retirement nest egg is secure before committing to helping your loved one. Know how much you’ll need to support the retirement lifestyle you desire. If contributing to your grandchild’s college means forgoing regular deposits to your retirement savings portfolio—don’t do it. 

At Wealth Legacy Institute, we are well-versed in the ways you can help your granddaughter or grandson pay for college. And as fiduciary financial advisors, you can rest assured that we will help you make the best decision for your future retirement goals. We’re happy to walk you through the process of budgeting for college expenses (and plenty of other financial decisions too).

Thinking about college expenses can be overwhelming. But despite the stress, you’re always better off with a plan. Make sure you have these 7 things handled before you decide on a college savings strategy: Get the 2021 Essential Retirement Guide

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