Whether your grandkids are learning to walk or struggling through high school chemistry, now is the time to think about starting a college fund. U.S. News & World Report concludes that the cost of college is a major financial challenge for many households. That means your grandkids will probably need your help.
Thankfully, you have options. There are tax-advantaged accounts designed to house long-term college savings for grandchildren. There are also strategies that can generate cash right away. Read on for a review of what college really costs plus seven ways you can help your grandchildren pay for college.
How much does college cost?
So, how much are we talking about here? On average, college tuition and fees range from about $10,000 to $35,000 annually, or $40,000 to $140,000 over four years. Public, in-state schools are the most affordable, followed by public, out-of-state schools. Private schools are the most expensive, often costing over six figures for a four-year program.
If these numbers are shocking, you’ll want to sit down for this next part. Tuition and fees only represent part of your total expense. Students may also incur thousands more annually for housing, food, and books.
Plus, unless your grandchild is headed to college this fall, inflation is another factor working against you. Finaid reports that college tuition costs rise about 8% per year, which is well above the general inflation rate. At that inflation rate, tuition costs essentially double every nine years.
Ways to help grandchildren pay for college
The seven college funding methods below include long-term investing approaches plus ways to generate cash immediately. These aren’t mutually exclusive, either. You can combine some or all these strategies to raise the funds you need.
1. Life settlement
A life settlement is the legal sale of your life insurance for a lump sum of cash. Once the transaction closes and you receive your funds, someone else pays the premiums and controls the policy’s benefits. But here’s the good news: If you’re over 70, your life insurance could be worth 20% to 60% of the policy’s death benefit.
If your grandchild is already in high school, a life settlement could be a lifesaver. A marketable, high-value life insurance policy could deliver $100,000 or more to you — in cash, within a few months. There are few other financial strategies that can raise that much, that quickly.
If you go this route, you’ll need to know about gift tax laws. The IRS allows you a lifetime gift exclusion, which is $11.7 million in 2021. Assets you leave to loved ones in your will count against this amount. Gifts you give during your lifetime count also, but only if you gift more than $15,000 in a year to the same person. Once you exceed the $15,000 annual cap, you’ll have to submit a gift tax return with the IRS. You won’t owe any taxes though until you hit the $11.7 million lifetime cap, which makes this a great way for grandparents to create a college savings that is essentially tax free. The only exceptions would be if doing so would cause you the exceed the lifetime cap, and if you have to pay taxes from the life settlement (only applicable if you get a profit, which means you receive a payout greater than the premiums you’ve paid).
2. 529 plans
A 529 plan is an investment account and college fund that provides tax-deferred earnings growth and tax-free withdrawals for college-related expenses. The money gets invested in a mutual fund, usually one that gets more conservative as the college date approaches. If you have time on your side, this is a solid option since the tax-deferred earnings growth expedites wealth creation.
Your deposits to a 529 plan are after-tax and treated as gifts. There is a workaround, however, for preserving your $11.7 million lifetime gift exclusion. You can deposit five times the annual gift limit of $15,000, and then report it on your gift tax return over the next five years. That allows for a $75,000 contribution all at once.
You can fund a 529 plan with proceeds from a life settlement, too. If you did that, you’d take advantage of the five-year method to keep your lifetime gift exclusion intact.
529 plans do have state-mandated annual contribution limits, but they’re very high — over $235,000 per beneficiary.
3. Coverdell Education Savings Account (ESA)
From a tax perspective, the Coverdell ESA is like a 529. You contribute after-tax dollars, the investment earnings are tax-deferred, and your grandkids’ withdrawals for tuition and other college expenses are tax-free.
In other aspects, the Coverdell ESA is more limited than a 529. To start, the annual contribution limits are quite low and there are income restrictions. Specifically, if you file jointly and your modified adjusted gross income is $190,000 or less, you can contribute up to $2,000 per year to a Coverdell ESA.
You can contribute to a 529 plan and a Coverdell ESA benefiting the same child in the same year. If your income is too high for Coverdell ESA contributions, you can gift the money to your grandchild directly so he or she can deposit it to the account.
4. UGMA and UTMA Accounts
UGMA and UTMA accounts are custodial accounts that hold money for the benefit of a child until that child reaches legal age. You can invest the funds in exchange-traded securities like stocks, bonds, and funds. The IRS does tax the investment earnings over a certain amount, but at the child’s lower tax rate.
The money in a custodial account isn’t earmarked for college. The account custodian can withdraw funds for any legitimate expense benefitting the child, college or otherwise. Also, the child will gain full control of the account at 18 or 21. At that point, your grandkid could spend the money on anything.
5. Savings bonds
Bonds issued by the U.S. Treasury Department are another option. EE or I bonds offer tax-free earnings if the funds are used for qualified education expenses. You can also avoid taxation by liquidating the bonds and depositing the proceeds to a 529 plan or Coverdell ESA.
The big drawback to saving for college with savings bonds is the low returns. Your yield on these instruments will be well below college tuition inflation, which makes it hard to justify this approach.
6. Roth IRA
The money stashed in your Roth IRA is another potential funding source, no matter how old you are. At any age, you can withdraw the contributions from your Roth IRA without taxes or penalties.
There are more restrictions if you want to tap into the earnings in the account, however. Normally, if you’re younger than 59 and a half, you will pay a penalty plus income taxes on the earnings you withdraw. The penalty is waived, though, if you spend the money on qualified education expenses.
Once you are older than 59 and a half and your account has been open for five years, your Roth IRA withdrawals are tax- and penalty-free.
7. Reverse mortgage
A reverse mortgage is a home equity loan with no repayment requirements. You stay in the home, but the bank owns it when you die. To qualify for a reverse mortgage, you must be 62 years old and have sufficient home equity.
If you’d planned on bequeathing the home to your loved ones in your will, this strategy simply moves up the timeline. You cash out the home equity and give the funds to your grandchildren today, rather than passing the home to them once you’re gone.
The usual gift tax rules would apply. As with a life settlement, you can deposit the proceeds from your reverse mortgage to a 529 plan to use the five-year election.
Create a college fund for your grandchildren
If your grandkids are young, start saving and investing for their college expenses today. A 529 plan or Coverdell ESA keeps the funds strictly earmarked for tuition, while UGMA and UTMA accounts have more flexibility.
When the grandkids are older, you don’t have time to build a six-figure fund in an investment account. At that point, your options are a life settlement, a Roth IRA withdrawal, or a reverse mortgage. All can produce high cash proceeds quickly, but you may want to save your Roth IRA for your own living expenses. And you don’t want a reverse mortgage if you have plans to move or downsize your home in the future.
The decision may come down to how much cash is available from your life insurance, your Roth, or your home. Get a free quote on the market value of your life insurance to start comparing your options. The Harbor Life Settlements team can help you here and answer any questions you have about the process.