As the cost of college education has skyrocketed, more and more grandparents are wondering how they can help their grandchildren pay for college. Below is an overview of five ways in which grandparents can contribute toward a grandchild’s education, as well as tips on pitfalls to avoid.

1. Pay tuition directly

Grandparents can pay some or all of the cost of tuition directly to the school, and the amount generally will not be subject to gift tax nor will it count toward the annual exclusion amount from gift tax. This allows grandparents to potentially contribute large amounts to a grandchild’s education without any gift tax consequences. It should be noted, however, that this only applies to tuition costs and not to the cost of books, supplies, or room and board.

In addition, caution should be exercised when considering this option, as this direct contribution can negatively impact a grandchild’s eligibility for financial aid. The tuition payment may be treated as untaxed student income on the Free Application for Federal Student Aid (FAFSA), which would reduce financial aid eligibility by 50 percent of the amount paid. For example, a $20,000 tuition payment would reduce financial aid eligibility by $10,000. So, unless the grandchild is not otherwise eligible for financial aid (or the grandparents can cover the entire cost of tuition), grandparents should ensure the grandchild has another way to cover any remaining education costs if they want to use this option to help pay for a grandchild’s college education.

2. Pay off student loans after grandchild graduates

Alternatively, grandparents can offer to pay off a grandchild’s student loans after they graduate from college. This will not jeopardize a grandchild’s eligibility for financial aid, and it provides the grandchild with an incentive to graduate. In addition, the grandchild may be able to deduct up to $2,500 of student loan interest on the grandchild’s income tax return each year.

Grandparents’ loan payments will be considered gifts, so any amount in excess of the annual exclusion amount ($15,000 per individual in 2019; $30,000 for married couples who split gifts) will use up a grandparent’s (and a grandparent’s spouse’s if split) remaining lifetime estate and gift tax exemption amount ($11.4 million per individual in 2019).

Given the current high cost of tuition, it is unlikely the annual exclusion amount would cover the cost of one year of tuition, fees, and room and board at a public university. As such, unless a grandparent is willing to use up some of his or her remaining lifetime estate and gift tax exemption amount, this option may take a number of years to complete. Lastly, unforeseen circumstances (such as a grandparent’s illness or death) before a grandchild graduates (or before the student loans are fully paid off) may prevent a grandparent from paying off the student loans.

3. Loan to grandchild

Another option is for the grandparent to loan the grandchild the funds to pay for education costs, which will not affect a grandchild’s financial aid eligibility and will ensure that the grandchild’s education is paid for even if circumstances change for the grandparent.

To avoid being considered a gift, the loan must be subject to an interest rate that is at least equal to a minimum rate set by the Internal Revenue Service (IRS), known as the Applicable Federal Rate (AFR). These rates are typically very low and are significantly lower than the federal student loan rates. For example, the AFR for long-term loans issued in October 2019 is 1.86 percent, whereas the interest rate for Direct Subsidized Loans and Direct Unsubsidized Loans for undergraduates disbursed on or after July 1, 2019, and before July 1, 2020, is 4.53 percent.

Other than the minimum interest rate requirement, the grandparent is able to set the terms of the loan. For example, the grandparent can set the term of the loan, allow interest to accrue until graduation, and/or require interest-only payments for a specified period of time. In addition, the grandparent has the option to forgive a portion or all of the loan balance. Such loan forgiveness is considered a gift, so any amount forgiven in excess of the annual exclusion amount each year ($15,000 per individual in 2019; $30,000 if split with a spouse) will use up the grandparent’s remaining lifetime estate and gift tax exemption amount ($11.4 million per individual in 2019).

It should be noted that interest on the loan will be taxable to the grandparent but will not be deductible by the grandchild. In addition, if the grandparent provides for the loan to be forgiven at his or her death in the grandparent’s estate planning documents, then the grandchild may end up owing income tax on the amount of the loan forgiveness. Lastly, if the loan is not forgiven and the grandchild refuses to repay the loan, this could cause family tension.

4. 529 plans

529 accounts offer tax-free earnings and tax-free withdrawals when the money is spent on qualified higher education expenses, including tuition, books, supplies, and some room and board costs. This means that the money deposited into the 529 plan by the grandparent can grow substantially over time without being taxed, and that the money is not taxed when the grandchild uses the funds to pay for qualified higher education expenses.

A grandparent can contribute up to the annual exclusion amount ($15,000 per individual in 2019; $30,000 if split with a spouse) to a 529 plan each year without using up any of the grandparent’s remaining lifetime estate and gift tax exemption amount ($11.4 million per individual in 2019). Alternatively, the grandparent could contribute up to $75,000 into the 529 plan in one year without using up any of his or her remaining lifetime estate and gift tax exemption amount if the grandparent elects to treat the contribution as if it were made over a five-year period. However, this means the grandparent would not be able to make any other gifts to the grandchild during that five-year period without using up some of the grandparent’s remaining lifetime estate and gift tax exemption amount unless the annual exclusion amount increased during such time period.

A grandparent may choose to contribute funds to a 529 plan in the grandparent’s name of which the grandchild is the beneficiary, or the grandparent may contribute funds to a 529 plan in the grandchild’s parent’s name of which the grandchild is the beneficiary.

If the 529 plan is in the grandparent’s name, the grandparent may receive a state tax credit or deduction for his or her contributions depending on where the grandparent lives and which plan the grandparent opens. The assets held in a 529 plan that is in a grandparent’s name will have no effect on the grandchild’s financial aid eligibility, but the amount withdrawn to pay for the grandchild’s qualified higher education expenses will be treated as untaxed student income on the FAFSA, which would reduce financial aid eligibility by 50 percent of the amount paid. It should be noted that if the grandparent’s circumstances change and he or she needs to qualify for Medicaid, in some states the money held in a 529 plan in the grandparent’s name will be considered an available asset to the grandparent that must be spent on medical and long-term care expenses before the grandparent will be eligible for Medicaid. Lastly, the grandparent will have control of the funds held in the 529 plan, as the account is in the grandparent’s name.

If the 529 plan is in the parent’s name, the grandparent may or may not be able to claim a state tax credit or deduction for his or her contributions. Unlike a 529 plan that is in a grandparent’s name, the assets held in a 529 plan in a parent’s name will be counted as a parental asset on the FAFSA and can reduce the grandchild’s financial aid eligibility by a maximum of 5.64 percent of the account value. However, there will be no effect on the grandchild’s financial aid eligibility when funds in a 529 plan in the parent’s name are withdrawn to pay for the grandchild’s qualified higher education expenses. Lastly, the grandparent will not have control of the funds held in the 529 plan, as the account is in the parent’s name.

5. Education trust

If a grandparent plans ahead, the grandparent can establish an irrevocable trust for the benefit of a grandchild that directs for the funds to be used for the grandchild’s education. The grandparent is able to specify his or her intent in the trust document, and the trustees have a fiduciary duty to administer the trust according to its terms even after the grandparent passes away. Once the grandchild is finished with his or her education, the funds in the trust may be used for other purposes as the grandparent directs in the trust. In addition, the trust may provide a level of creditor and divorce protection for the assets that remain in the trust.

For gifts to the trust to qualify for the annual exclusion amount, the grandchild will need to be given certain rights of withdrawal over contributions made to the trust. Gifts to the trust in excess of the annual exclusion amount ($15,000 per individual in 2019; $30,000 if split with a spouse) will use up the grandparent’s remaining lifetime estate and gift tax exemption amount ($11.4 million per individual in 2019). Lastly, depending on how the trust is drafted, any income earned in the trust may be taxed either to the grandparent or to the trust itself.

While this is not an exhaustive list of the options available for grandparents wanting to contribute to a grandchild’s education, the above options are certainly ones that should be considered. For more information about planning for a grandchild’s or other relative’s education expenses, please contact one of the attorneys in our Trusts & Estates Practice Group.