1 By Sharon L. Klein Paying for the (Grand) Kids College Know all the options and combinations thereof Rising tuition for college education is a daunting reality for many parents and grandparents. Even the very wealthy would prefer to pay for higher education in the most tax-efficient manner. So help clients plan well. There are a number of educational funding options to explore and integrate into financial and estate plans. The attractive 529 college savings plan, as well as other educational funding tools and strategies, can offer substantial benefits. Often, it s a combination of techniques that yields the most advantageous results. Annual Exclusion Gifts Sometimes the simplest approach is best: One strategy is to leverage the use of annual exclusion gifts. As we know, every U.S. citizen and resident may make tax-free gifts in each calendar year of up to $12,000 to any number of recipients. So a married couple can gift a total of $24,000 to any recipient. Alternatively, if a donor s spouse elects to split gifts with the donor by making an election on the federal gift tax return, the donor s annual exclusion amount can be doubled to $24,000 per recipient. The annual exclusion gifts are free not only from gift taxes, but also from generation-skipping transfer (GST) taxes. A GST tax is imposed at the highest federal estate tax rate (currently 45 percent) on any gift that skips a generation (from a grandparent to a grandchild, for example) and is in addition to the estate and gift tax. Each individual has an exclusion from GST tax, which currently is $2 million. Sharon L. Klein is senior vice president, trust counsel and director of estate advisement at Fiduciary Trust Company International in New York But instead of outright gifts of annual exclusion amounts to children and grandchildren, consider other estate-planning techniques, some of which don t have any limitations on the amount of the donor s income. UGMA/UTMA For young children and grandchildren, a donor can establish a custodial account under the Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA), depending on the state. The provisions of these accounts are governed by state statute, not a trust instrument. To set up such an account, the donor appoints a custodian and transfers funds to the account. The funds belong to the minor, but are controlled by the custodian until the child reaches the termination age, which is 21 years old or 18 years old, depending on the jurisdiction. The big advantage to UGMA/UTMA accounts is that they are relatively inexpensive and simple to establish. But they have three potential downsides: (1) Upon attaining the termination age, the funds in the account are the child s absolutely, to be disposed of as the child determines. The funds are not earmarked for educational purposes. (2) Because UGMA/UTMA accounts are considered to be the child s asset for financial aid purposes, they may affect his eligibility for student financial aid. Typically, many colleges follow the rules for federal student aid eligibility in determining the college s own aid packages. Those rules require that a student make available a certain percentage of his assets for tuition. Parents are expected to contribute a lesser portion of their assets; a grandparent s assets are not considered. Most federal financial aid formulas
2 consider about 5 percent to 6 percent of parents assets to be available for their children s college tuition. Until July 1, 2007, 35 percent of a student s assets were considered available for his college tuition. Starting July 1, 2007, that percentage dropped to 20 percent a substantial decrease, but still markedly higher than what s taken into account for a parent s assets. (3) The biggest downside is the income tax treatment of UGMAs and UTMAs. The income is taxed to the child. And due to the kiddie tax, income above $1,700 is taxed at the parent s rates until the year in which the child turns 18 years old. If the child is over 18, the income is taxable at the child s rates, which might be as low as 10 percent to 15 percent. Starting in 2008, however, the kiddie tax also will apply to 18 year olds (until the year the child reaches 19 and to students under 24 who do not earn more than half their support.) The kiddie tax is intended to prevent a parent shifting income to a child to take advantage of the child s lower tax brackets. But it effectively penalizes fulltime college students with assets in UGMAs or UTMAs. It may be possible for funds held in an UGMA/UTMA account to be invested in a 529 plan, with the attendant tax advantages accorded to funds invested in such plans. However, only cash may be contributed to a 529 plan. If assets in a custodial account are liquidated for transfer to a 529 plan, the sale may have capital gains tax implications. Those considering UGMAs/UTMAs should appoint someone other than the parent as custodian, because if a parent acting as a custodian dies, there s a danger that the custodial funds will be taxable in the parent s estate. This is because a parent owes a support obligation to his or her children. That is to say, the power of the parent to use the custodial funds to discharge the support obligation creates a so-called general power of appointment, which makes the funds taxable in the parent s estate. Crummey Trusts A parent or grandparent can fund a trust for the benefit of a child or grandchild, and those funds can be used to pay for the beneficiary s educational expenses. For a gift to qualify for the annual gift tax exclusion, it must be of a present interest. A gift in trust, when the recipient will have use of the funds at a future time, does not normally qualify for the gift tax exclusion. But there s a way around this: a Crummey trust, which provides that, after a contribution is made to the trust, the beneficiary has the right to withdraw the contribution for a limited period of time, typically 30 days. A written notice of the right to withdraw trust contributions (a Crummey notice) must be sent to the beneficiary when a contribution is made to the trust. This present right to withdraw the funds converts the gift from a gift of a future interest to a gift of a present interest that qualifies for the annual gift tax exclusion. It s generally understood that the child will not exercise the withdrawal rights, although there can be no formal agreement to that effect. A Crummey trust has an advantage in that, unlike an UGMA or UTMA account, it continues for as long as the trust instrument specifies. The child has no right to receive the assets at any given age. And, a trust established by one donor can be used as a receptacle of gifts from multiple family members. But Crummey notices can be an administrative burden. If they re not sent, the gifts will not qualify for the annual gift tax exclusion and taxable gifts will be considered to have been made. If gift tax returns haven t been filed on an annual basis to report those gifts and pay the gift taxes, interest and penalties will be due. In terms of effect on financial aid, the trust is treated as the child s asset. In terms of income tax treatment, the trust can be structured as a separate taxpayer, which is required to file its own tax returns. Income will be taxed to the trust, unless it is currently distributed to the child. Income distributed to the child will be subject to the kiddie tax. Alternatively, the trust can be structured as a grantor trust during the grantor s lifetime. In that case, the grantor is considered the trust s owner for income tax purposes and is taxable on all of the income. Payment of the income taxes by the grantor is, in effect, a further tax-free gift to the trust beneficiaries, as the trust assets can grow without reduction for income tax payments. After the grantor s death, the trust will be treated as a separate taxpayer and will file its own annual return. The trust will pay income taxes on any income not distributed. With careful planning, it s possible to set up the trust in a jurisdiction, such as Delaware, where the trust will not be subject to any state income taxes. Any income distributed to the beneficiary will be taxable to the beneficiary at the beneficiary s rates, kiddie tax included. For maximum planning benefits, a grandparent can structure a Crummey trust with only one beneficiary per trust. Structuring the trust in this manner allows the annual $12,000 amounts transferred to the trust to be free from GST taxes. 2503(c) Trusts Those who don t want to deal with the hassle of annual notices to beneficiaries of Crummey trusts should consider a 2503(c) trust, named after the section of the Internal
3 Revenue Code upon which it s based. IRC Section 2503(c) carves out an exception to the present interest requirement for annual exclusion gifts. If the requirements of the section are met, a gift in trust for a minor will qualify for the gift tax exclusion. To qualify for the exception, the trust must provide: (1) the property and the income earned on the property may be paid to the minor or used exclusively for the benefit of the minor before age 21; (2) the property will pass to the minor upon his attaining age 21; and (3) if the minor dies before age 21, the trust property will be included in his estate. The 2503(c) trust often is extended by affording the child a limited window of opportunity to withdraw the funds at age 21, for example for 90 days after his 21st birthday. This limited opportunity to take the trust property satisfies the requirement that the trust property pass to the child at age 21. If the child doesn t exercise this right, the property can remain in trust until the child reaches a certain age or for the child s lifetime. After the child turns 21, the gifts to a 2503(c) trust will no longer qualify for the annual gift tax exclusion. That s why most 2503(c) trusts convert to Crummey trusts after the child has reached the age of 21. In that case, after the beneficiary reaches 21, Crummey notices must be sent out at least annually. By its nature, a 2503(c) trust is structured for the benefit of one beneficiary. The annual $12,000 amounts transferred to a 2503(c) trust will be free from GST taxes. And like a Crummey trust, a 2503(c) trust established by one donor can be used as the receptacle of gifts from multiple family members. The big disadvantage with a 2503(c) trust is that the beneficiary has the absolute right to withdraw the funds at age 21, even if only for a limited period of time. So, if the donor intends for the funds to stay in trust beyond age 21, the donor must feel comfortable that the beneficiary will not exercise the withdrawal right so that the trust can continue until the age specified in the trust document. In terms of financial aid, the trust is treated as the child s asset. For income tax purposes, the trust can be structured as a separate taxpayer, which is required to file its own tax returns. Income will be taxed to the trust, unless it s currently distributed to the child. Income distributed to the child will be subject to the kiddie tax. Alternatively, the trust can be structured as a grantor trust until the child turns 21. After 21, the beneficiary is considered the owner of the trust for income tax purposes and is taxed on all of the income. 529 Plans IRC Section 529 provides an option specifically for higher education funding (commonly known as a 529 plan. ) The funds invested not only accumulate and grow free of income tax, but also are totally exempt from federal income tax if used for tuition, room, board and other qualified higher educational expenses. Although 529 plans are created under federal law, each state sponsors a plan. An individual does not necessarily have to invest in his own state s plan, although there may be income tax incentives to do so. The relative merits of the different state plans should be considered before selecting a plan in which to invest. 529 plans are an extremely attractive way to provide for future education expenses, because of the combination of the tax-free accumulation feature and the tax-free distribution feature. Also, under some state programs, funds in a 529 account will not count towards eligibility for state financial aid under state-administered financial aid programs. However, federal or institution-based financial aid programs may take the plans into account. In that case, 529 plans established by a parent are treated as an asset of the parent. Moreover, some states allow residents to take an income tax deduction for contributions to the resident s state plan. In New York, for example, residents are entitled to an income tax deduction of up to $5,000. Some states allow earnings to be exempt from state income tax as well. Another interesting feature of the 529 plan is the accelerated gift option that allows a donor to pre-gift five years of annual exclusions. An individual can therefore contribute up to $60,000 ($12,000 multiplied by five) per beneficiary in any year (a couple can contribute up to $120,000) without generating any gift tax. There are also no income taxes or penalties if the donor decides to change the beneficiary of the plan to another family member. If a donor decides to withdraw the funds for reasons other than its intended use of funding higher educational expenses (other than for reasons due to death or permanent disability of, or qualified scholarship award to, the beneficiary), earnings from the funds are subject to federal income taxation and an additional federal penalty of 10 percent. The ability of the owner to withdraw the funds (subject to the payment of income taxes and a penalty) may prove useful if the donor later decides he needs the funds. There is no other estate-
4 planning tool that allows a donor to make an irrevocable gift yet retain the power to cancel the gift. 529 plans are attractive for grandparents who want to equalize the amounts they gave to older grandchildren, who may have been receiving annual exclusion gifts for many years, and to younger grandchildren who need to catch up. And funding a 529 plan currently removes the risk that tuition payments will not have been set aside before the grandparent s death. Moreover, if a grandparent or family member (other than a parent) establishes the plan, the plan may not be considered in determining the student s eligibility for financial aid. On the flip side, investment choices for 529 plans are limited to the ones provided by the state plan. Only cash contributions are permitted. And beware: If the donor/account owner changes the beneficiary to a new beneficiary who is in a younger generation than the original beneficiary, a gift tax may be due. If the new beneficiary is two or more generations below the original beneficiary, a GST tax may be payable. Those taxes will be payable by the original beneficiary, not the account owner, even though the original beneficiary had no control over the transfer. Coverdell Accounts Previously known as an education IRA, a Coverdell Education Savings Account is an account that can be opened for the benefit of a child under 18 for the exclusive purpose of funding that child s educational expenses. A donor can contribute to multiple Coverdell accounts, but the aggregate of the contributions for any one child cannot exceed $2,000 per calendar year. Contributions must be made in cash before the beneficiary turns 18. These types of accounts can be rolled over to another family member if the account document permits. If not rolled over, they automatically terminate and the funds are deemed distributed within 30 days of the beneficiary s 30th birthday. Like 529 plans, the assets in a Coverdell account grow tax-free and can be withdrawn free of federal income tax for qualified educational expenses, such as tuition, books, supplies and equipment. A donor can contribute to a Coverdell account as well as a 529 plan. For financial aid purposes, the account is considered an asset of the parent (or other account owner.) The big disadvantage is that contribution amounts are very limited. Unlike the other educational planning strategies we ve reviewed, donor eligibility is based on modified adjusted gross income. The maximum amount can be contributed only by single taxpayers with an adjusted gross income not exceeding $95,000 or $190,000 for married couples. There is a phase out of the contribution amount for single taxpayers with adjusted gross income between $95,000 to $110,000 and $190,000 to $220,000 for married couples. Contributions are not permitted at all if income exceeds the upper end of those ranges. Like 529 plans, amounts withdrawn for purposes other than qualified educational expenses will be subject to federal income taxation and an additional penalty of 10 percent. The nice thing about a Coverdell account is that a child may contribute to his own Coverdell account. If a family member wants to contribute to an account but runs afoul of the income limitations, that person can gift the funds directly to the intended beneficiary child, who can then transfer them to his own account. Tax-free Transfers In addition to annual exclusion gifts, there are a variety of tax-free transfers a client can make to pay for educational expenses. These include directly paying tuition, prepaying tuition, and using the $1 million gift tax exclusion. Direct payment of tuition expenses is not treated as a gift. Therefore, a donor may make unlimited payments for tuition to an educational institution and those payments will not be characterized as gifts for gift tax purposes. The payments must be made directly to the educational institution and only tuition is exempted. Incidental expenses such as room, board and books do not fall within the gift tax exclusion. Because these tuition payments on behalf of a beneficiary aren t considered gifts, the donor also is able to make $12,000 annual exclusion gifts to the same beneficiary. If a family member is in a position to pay the tuition expenses of a student directly, the family member could use one of the trust vehicles we ve discussed as the repository of the annual gifts. The beneficiary then would have the use of the trust funds for other purposes. In essence, this creates a double gift: The student s educational costs are paid and the student has the use of trust funds, which can accumulate handsomely over the years, for other purposes. As payments for room, board, books and related expenses are not excluded from the gift tax, it may be worthwhile to pay tuition expenses directly and establish a 529 plan for incidental educational expenses. Those expenses can add up very quickly. However, note that for financial aid purposes, paying tuition directly will likely be treated as a resource that reduces financial aid awards on a dollar-for-dollar basis.
5 Prepaying Planning Tip Prepayment of tuition bills may be another powerful way for family members to help. In a recent private letter ruling, PLR (released Jan. 13, 2006), the Internal Revenue Service authorized prepayments by a grandparent to an educational institution for the total annual tuition for six grandchildren through grade 12. Although this technique would work for any family member or friend, it s particularly effective for moving large amounts of money out of a grandparent s estate, thereby avoiding estate taxes on the funds used to prepay tuition and removing the risk that the grandparent might die before all the tuition payments are made, if paid on a yearly basis. In addition, the grandparent should be permitted to make annual $12,000 gifts to the grandchild. But caution: the prepayment technique is not without risk. In the PLR, the payments were nonrefundable. Although the students were enrolled in school, there was no guarantee of future enrollment, so payments would be forfeited if one of the grandchildren didn t attend the school. Moreover, if tuition increased over the years, additional funds would have to be paid. The effect of prepaying tuition on financial aid eligibility is that any prepaid amounts will likely be treated as a resource that reduces financial aid awards on a dollar-for-dollar basis. Like 529 plans, prepayment of tuition is a way for grandparents to equalize younger grandchildren and remove the risk of the grandparents dying before the tuition payments are due. Unlike 529 plans, where transfers count towards the $12,000 annual gift tax exclusion, a grandparent who prepays tuition can continue making $12,000 gifts to both younger and older grandchildren. Dynasty Trusts In addition to the $12,000 annual gift exclusion amount per recipient, each person also has a lifetime gift tax exclusion amount of $1 million. An individual can contribute up to $1 million to a dynasty trust that he creates for the benefit of family members, free of gift taxes. The trust could be sheltered from GST taxes by an allocation of that individual s GST exemption amount. After the assets are transferred to the trust, the appreciation in assets is removed from the individual s estate. The trust could be drafted flexibly enough to allow it to benefit children and grandchildren over multiple generations. Because the trust typically includes all descendants as beneficiaries, there is no concern about equalizing younger family members for any gifts made to older family members. The trust can be structured as a grantor trust during the grantor s lifetime. After the grantor s death, the trust is treated as a separate taxpayer and files its own annual return. While most states limit the amount of time assets can remain in trust, under Delaware law, trusts can continue indefinitely. By creating such a trust under Delaware law, most types of assets held in trust can benefit an individual s descendents forever without being subject to any estate, gift or GST tax. As long as there are no resident Delaware beneficiaries nor Delaware source income, the trust should not be subject to Delaware state income taxes. Any income distributed to the beneficiary will be taxable to the beneficiary at the beneficiary s rates, kiddie tax included. It s difficult to see how the existence of a dynasty trust could impact a student s financial aid eligibility. A dynasty trust typically includes multiple beneficiaries, with a trustee, in its sole discretion, determining which beneficiaries will receive a distribution and in what amount. Funding a dynasty trust shouldn t have an impact on the ability to make annual gifts. In addition to a taxfree gift of up to $1 million, a donor can continue to make $12,000 annual gifts to any number of recipients. This combined strategy is very effective in moving large amounts out of an individual s taxable estate. Plan of Attack When devising the optimal educational funding strategy, there is no one-size-fits-all solution. The best approach may be a combination of strategies. Be mindful, however, that if a donor utilizes multiple strategies, the totality of any one donor s transfers to any one recipient cannot exceed $12,000 without gift tax consequences. For maximum leverage, a donor should utilize his annual gift tax exclusion amount, a direct payment technique and the $1 million gift tax-free amount. Which and how many of these strategies are utilized will depend on the amount the donor is comfortable gifting and each donor s individual circumstances. Reprinted with permission from the January 2008 issue of Trusts & Estates (www.trustsandestates.com) Copyright 2008, Penton Business Media. All rights reserved. TE-253-HAD
6 This article includes views expressed by representatives of Fiduciary Trust Company International, as of date indicated, and is intended to provide general information only on the financial topics it addresses. It is not intended to provide specific advice or market predictions. You should consult your personal financial, legal and tax advisor(s) regarding your specific circumstances in determining whether the contents of, or opinions expressed in, this article are appropriate for you of relevant to any investment, tax or estate planning decisions that you make. U.S. Treasury Circular 230 Notice: Any U.S. federal tax advice included in this communication was not intended or written to be used, and cannot be used, for the purpose of (i) avoiding any penalties that may be imposed on such taxpayer by the Internal Revenue Service or (ii) promoting, marketing or recommending to another party any tax-related matter addressed herein.