Issue 27: 2014

Special Section — Education

Six Key Strategies for Funding Education

With tuition bills growing ever larger, tax-aware approaches to saving and paying for education can help to ease the burden.

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Education can be expensive, especially when you consider that the full length of an education could span 16 years — or longer if post-graduate and professional degrees are earned. The bottom line is that education can represent a substantial financial commitment, and the cost seems likely to continue rising faster than inflation for the foreseeable future. “Fortunately, numerous strategies are available to help pay the education costs for your children, grandchildren or future generations, and in ways that can help to minimize taxes, including gift taxes, estate taxes, generation-skipping transfer taxes (GST), and income taxes,” says Mitchell A. Drossman, national director of wealth planning strategies at U.S. Trust.

Six strategies in particular, he notes, are likely to be most appropriate for high-net-worth individuals:

 

1. Direct Payment of Tuition

The simplest and most straightforward approach is direct payment of tuition. “With this option, you receive an unlimited gift tax exclusion for any tuition you pay on behalf of anybody,” Drossman says. That means it does not reduce your $5.34 million lifetime gift tax exemption. Anyone — grandparents, parents, uncles and aunts, and friends — can pay for anyone’s education. “But it must be paid directly to the school to qualify,” he explains. “You can’t reimburse anyone or pay it to the parents and ask them to pay it to the school.” Also, it has to be tuition. The gift tax exclusion is not available for room, board, books or other education expenses, and it has to be a qualified educational organization. This includes primary, secondary, colleges and universities, as well as preparatory and vocational schools. Nursery schools could be included as well.

The bottom line is that education can represent a substantial financial commitment.

“The nice thing is that a transfer that qualifies for this gift tax exclusion also qualifies for a special exemption from the generation-skipping tax if a grandparent makes the payment,” says Steven Lavner, a member of the National Wealth Planning Strategies group at U.S. Trust. “So paying for a grandchild’s education could be a tax-effective method of wealth transfer.”

Key Features

  • No complicated setup procedures.
  • The beneficiary has no access to the funds.
  • Funding methods: cash only.
  • Any level of education can be funded.
  • No gift tax implications.
  • Assets are immediately removed from taxable estate.
  • Exempt from GST tax.

Click here to return to top.

2. The Custodial Account

Often parents are looking not merely to pay educational expenses for their children but also to transfer funds to them. A common way to do that in a tax-advantaged manner is to set up a custodial account. Sometimes this is referred to as a Uniform Transfer to Minors Account (UTMA).

If you make a transfer to one of these custodial accounts, it doesn’t qualify for the unlimited tuition exclusion from gifts, as with paying tuition directly, but it does qualify for the annual gift tax exclusion, which is currently $14,000 per recipient per calendar year. “So it is somewhat limited in that regard,” notes Lavner. “Also, it requires that the donor name a custodian who can use the property for the minor’s benefit, including educational expenses — and not exclusively for tuition.” It can’t be the same person making the transfer, he explains, and it probably shouldn’t be the minor’s parent for several reasons related to their own obligations to support the minor.

The time frame should also be considered. “Any property left in the account must be paid out to the minor at age 18 or 21, depending on state law. So these are not long-term arrangements,” he says.

Drossman adds: “Since it’s possible to add $14,000 to the account every year, and others can contribute as well, many parents worry about their children receiving huge payouts. The key is to ensure that the account isn’t overfunded, or perhaps arrange to have your child put the payout money, if there is any, immediately into a trust when the time comes.”

Key Features

  • Setup requires minimal paperwork.
  • Custodian has full control of assets. When beneficiaries reach age 18 or 21, they receive all remaining assets in the account.
  • Funding methods: cash, securities or other.
  • No limitations on usage: education or other.
  • For the benefit of a single beneficiary and cannot be redirected.
  • Qualifies for the $14,000 annual gift tax exclusion.
  • If you are the custodian of your child’s account, the account’s assets can be included in your estate, regardless of the contributor.
  • Contributions are generally exempt from GST.
  • Contributed funds are income taxed to the beneficiary. If the beneficiary is a minor under 18, investment income in excess of certain thresholds would be taxed at your rate under the so-called "kiddie tax." This will also apply to certain children aged 18 to 23.

Click here to return to top.


Justin Lewis/Getty Images

3. The Section 2503(c) Trust

A 2503(c) trust, which is named for the section of the tax law authorizing it, is similar to the custodial account. “Like the custodial account, contributions qualify for the $14,000 annual gift tax exclusion,” Drossman says. “Trustees can use the funds for the benefit of the minor, and that could include education expenses. It’s a short-term vehicle, like the custodial account; however, when the beneficiary reaches 21, payouts aren’t necessarily required.” The funds could be left in the trust, but the beneficiary must be given the right to withdraw them.

Key Features

  • Requires legal documentation. Attorney needed for setup.
  • Trustee has full control of assets until the beneficiary reaches age 21, at which point the beneficiary receives right of withdrawal.
  • No limitations on usage, whether education or other.
  • For the benefit of a single beneficiary and cannot be redirected.
  • Qualifies for the $14,000 annual gift tax exclusion.
  • Contributions are generally removed from the contributor’s taxable estate.
  • Contributions are generally exempt from GST.
  • Contributed funds would be taxed as income to the trust if the trust retains the income; distributions would carry out income to be taxed to the recipient.



Learning in America
From the schoolhouse to the online classroom.Read more

Click here to return to top.

4. The Crummey Trust

This oddly named trust has its benefits. “Crummey is the name of the taxpayer in the tax case that established the gift tax treatment of these trusts,” says Drossman. “Unlike other approaches, a Crummey trust allows the beneficiary the right to withdraw contributions for a limited period of time — typically 30 or 60 days from the date of the contribution.” Importantly, for a minor beneficiary, the parent would have the ability to exercise this power. This withdrawal right allows contributions to the trust to qualify for the $14,000 annual gift tax exclusion. Assuming the withdrawal right is not exercised, the funds would then stay in the trust on whatever terms the trust dictates and can be used for any purpose, including education. Unlike custodial accounts or 2503(c) trusts, they can continue after the beneficiary reaches 21.

Key Features

  • Requires legal documentation. Attorney needed for setup.
  • The beneficiary (or the parent) has a right to withdraw contributed funds for a limited period of time, typically 30 or 60 days. If the withdrawal power is not exercised, the trust's terms govern whether or not the beneficiary has any access thereafter.
  • No limitations on usage, whether education or other.
  • Funding methods: cash, securities or other.
  • The trustee has discretion to make distributions for the benefit of various beneficiaries, based on what’s set forth in the trust document.
  • Qualifies for the $14,000 annual gift tax exclusion.
  • Contributions are generally removed from your taxable estate.
  • Contributions with multiple beneficiaries will not be exempt from GST tax, even if your contributions qualify for the $14,000 annual gift tax exclusion. If the trust has a single beneficiary, then your contribution may be exempt from GST if additional requirements are satisfied (namely, during the single beneficiary’s lifetime there can be no distributions allowed to anyone else, and all undistributed assets have to be includable in the single beneficiary’s estate at death).
  • If withdrawal power is not exercised, the result could be that thereafter the income on that asset might be income-taxed 1) to the trust itself, or 2) to the non-withdrawing beneficiary as a grantor trust.

Click here to return to top.

5. The Section 529 Plan

Another strategy that is named for the section of the tax law authorizing it, the 529 plan is a special-educational account that allows funds to accumulate tax-free for a single beneficiary. Says Drossman: “Withdrawals are controlled by the owner (typically the parent or grandparent) and are income-tax-free if they are used to pay for post-secondary education. Payments are not limited solely to tuition expenses.”

Fortunately, numerous strategies are available to help pay the education costs for your children, grandchildren or future generations.

Each state sponsors at least one 529 plan. Contributions qualify for the $14,000 gift tax annual exclusion, but it also has a unique feature: It allows a contribution to be treated as if it was made over five years, so in year one, you could actually put five times the annual gift tax exclusion amount — currently $70,000 ($14,000 x 5) — and it would all qualify for the gift tax annual exclusion. “These plans also have some income tax benefits,” says Lavner. “On distribution, the account’s earnings are not subject to income tax if they are used for qualified education expenses. One thing to note here is that contribution amounts cannot be more than the amount necessary to provide for the beneficiary’s education expenses.”

Key Features

  • Minimal paperwork required for setup.
  • The owner of the account controls all distributions; the beneficiary has no control.
  • Funding methods: cash only.
  • Distributions can be used only for post-secondary education, for any “qualified educational expense,” which includes tuition, fees, books, supplies, some room and board, and more.
  • Qualifies for the $14,000 annual gift tax exclusion. You can also elect to treat contributions as if made over five years.
  • Contributions are immediately removed from your taxable estate, unless funded with five years' worth of annual gifts, in which case the assets won’t be fully removed from your taxable estate until five years later.
  • Contributions that qualify for the annual gift tax exclusion will also be exempt from GST tax.
  • Contributed funds will accumulate tax-free. You can withdraw earnings tax-free if the withdrawals are used for education expenses.
  • The owner can generally change the account beneficiary to another family member without tax consequence.

Please remember there’s always the potential of losing money when you invest in securities.

Click here to return to top.

6. The Health and Education Exclusion Trust (HEET)

The Health and Education Exclusion Trust, or HEET, is a trust established either during your lifetime or under your will to provide payments for medical expenses and tuition for your descendants. “It is designed to minimize the GST,” says Drossman. “This strategy is particularly appropriate for grandparents who are looking to make transfers to grandchildren. Everyone has a generation-skipping tax exemption that allows them to make transfers to their grandchildren, but a HEET allows funds to be paid for the benefit of grandchildren even if you’ve already used up your GST exemption.” To qualify, the money would come out of the trust to be paid as tuition directly to the school.

Key Features

  • Requires legal documentation. Attorney needed for setup.
  • You would establish the trust’s terms, which would govern whether or not the beneficiary has any access.
  • Funding methods: cash, securities or other
  • Applies to any level of education, but covers only tuition.
  • The trustee has discretion to make distributions for the benefit of various beneficiaries, based on what’s set forth in the trust document.
  • Contributions would not trigger GST tax, and subsequent distributions to pay a beneficiary's tuition would be exempt from GST tax.

 

Choosing the appropriate strategy for you

“There are many ways to fund education and many different considerations,” says Drossman, “so it might be appropriate to take advantage of more than one strategy.”

For instance, direct payment could make sense for the tuition portion of your child’s education expenses, but a custodial account could be used for other education expenses. And then, for grandparents who want to help with some education expenses, a HEET might be appropriate. So which approach or approaches are most appropriate for you? “The answer,” says Drossman, “as in all things related to the complexities of wealth planning, is that it depends. It depends upon your particular situation and goals, both short and long term, and the process should probably begin with a conversation between you and your advisor.”

IMPORTANT INFORMATION

Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

529 Plan
The beneficiary must be attending an accredited institution as least half time for room and board to be considered an eligible expense.

You are generally permitted to change the beneficiary to another qualified member of the family, as defined under the Internal Revenue Code, without triggering income and a 10% additional federal tax.

The gift-tax exclusion applies, provided you make no other gifts to the beneficiary during a five-year period. Contributions between $14,000 and $70,000 ($28,000 and $140,000 for married couples filing jointly) made in one year can be prorated over a five-year period without subjecting you to gift tax or reducing your federal unified estate and gift tax exemption. If you contribute less than the $70,000 ($140,000 for married couples filing jointly) maximum, additional contributions can be made without you being subject to federal gift tax, up to a prorated level of $14,000 ($28,000 for married couples filing jointly) per year. Gift taxation may result if a contribution exceeds the available annual gift tax exclusion amount remaining for a given beneficiary in the year of contribution. For contributions between $14,000 and $70,000 ($28,000 and $140,000 for married couples filing jointly) made in one year, if the account owner dies before the end of the five-year period, a prorated portion of the contribution may be included in his or her estate for federal estate tax purposes. Please consult your tax and/or legal advisor for such guidance.

Before you invest in a Section 529 plan, request the plan's official statement and read it carefully. The official statement contains more complete information, including investment objectives, charges, expenses and risks of investing in the 529 plan, which you should consider carefully before investing. You should also consider whether your home state or your beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's 529 plan.

Education can be expensive, especially when you consider that the full length of an education could span 16 years — or longer if post-graduate and professional degrees are earned. The bottom line is that education can represent a substantial financial commitment, and the cost seems likely to continue rising faster than inflation for the foreseeable future. “Fortunately, numerous strategies are available to help pay the education costs for your children, grandchildren or future generations, and in ways that can help to minimize taxes, including gift taxes, estate taxes, generation-skipping transfer taxes (GST), and income taxes,” says Mitchell A. Drossman, national director of wealth planning strategies at U.S. Trust.

Six strategies in particular, he notes, are likely to be most appropriate for high-net-worth individuals:

 

1. Direct Payment of Tuition

The simplest and most straightforward approach is direct payment of tuition. “With this option, you receive an unlimited gift tax exclusion for any tuition you pay on behalf of anybody,” Drossman says. That means it does not reduce your $5.34 million lifetime gift tax exemption. Anyone — grandparents, parents, uncles and aunts, and friends — can pay for anyone’s education. “But it must be paid directly to the school to qualify,” he explains. “You can’t reimburse anyone or pay it to the parents and ask them to pay it to the school.” Also, it has to be tuition. The gift tax exclusion is not available for room, board, books or other education expenses, and it has to be a qualified educational organization. This includes primary, secondary, colleges and universities, as well as preparatory and vocational schools. Nursery schools could be included as well.

The bottom line is that education can represent a substantial financial commitment.

“The nice thing is that a transfer that qualifies for this gift tax exclusion also qualifies for a special exemption from the generation-skipping tax if a grandparent makes the payment,” says Steven Lavner, a member of the National Wealth Planning Strategies group at U.S. Trust. “So paying for a grandchild’s education could be a tax-effective method of wealth transfer.”

Key Features

  • No complicated setup procedures.
  • The beneficiary has no access to the funds.
  • Funding methods: cash only.
  • Any level of education can be funded.
  • No gift tax implications.
  • Assets are immediately removed from taxable estate.
  • Exempt from GST tax.

Click here to return to top.

2. The Custodial Account

Often parents are looking not merely to pay educational expenses for their children but also to transfer funds to them. A common way to do that in a tax-advantaged manner is to set up a custodial account. Sometimes this is referred to as a Uniform Transfer to Minors Account (UTMA).

If you make a transfer to one of these custodial accounts, it doesn’t qualify for the unlimited tuition exclusion from gifts, as with paying tuition directly, but it does qualify for the annual gift tax exclusion, which is currently $14,000 per recipient per calendar year. “So it is somewhat limited in that regard,” notes Lavner. “Also, it requires that the donor name a custodian who can use the property for the minor’s benefit, including educational expenses — and not exclusively for tuition.” It can’t be the same person making the transfer, he explains, and it probably shouldn’t be the minor’s parent for several reasons related to their own obligations to support the minor.

The time frame should also be considered. “Any property left in the account must be paid out to the minor at age 18 or 21, depending on state law. So these are not long-term arrangements,” he says.

Drossman adds: “Since it’s possible to add $14,000 to the account every year, and others can contribute as well, many parents worry about their children receiving huge payouts. The key is to ensure that the account isn’t overfunded, or perhaps arrange to have your child put the payout money, if there is any, immediately into a trust when the time comes.”

Key Features

  • Setup requires minimal paperwork.
  • Custodian has full control of assets. When beneficiaries reach age 18 or 21, they receive all remaining assets in the account.
  • Funding methods: cash, securities or other.
  • No limitations on usage: education or other.
  • For the benefit of a single beneficiary and cannot be redirected.
  • Qualifies for the $14,000 annual gift tax exclusion.
  • If you are the custodian of your child’s account, the account’s assets can be included in your estate, regardless of the contributor.
  • Contributions are generally exempt from GST.
  • Contributed funds are income taxed to the beneficiary. If the beneficiary is a minor under 18, investment income in excess of certain thresholds would be taxed at your rate under the so-called "kiddie tax." This will also apply to certain children aged 18 to 23.

Click here to return to top.


Justin Lewis/Getty Images

3. The Section 2503(c) Trust

A 2503(c) trust, which is named for the section of the tax law authorizing it, is similar to the custodial account. “Like the custodial account, contributions qualify for the $14,000 annual gift tax exclusion,” Drossman says. “Trustees can use the funds for the benefit of the minor, and that could include education expenses. It’s a short-term vehicle, like the custodial account; however, when the beneficiary reaches 21, payouts aren’t necessarily required.” The funds could be left in the trust, but the beneficiary must be given the right to withdraw them.

Key Features

  • Requires legal documentation. Attorney needed for setup.
  • Trustee has full control of assets until the beneficiary reaches age 21, at which point the beneficiary receives right of withdrawal.
  • No limitations on usage, whether education or other.
  • For the benefit of a single beneficiary and cannot be redirected.
  • Qualifies for the $14,000 annual gift tax exclusion.
  • Contributions are generally removed from the contributor’s taxable estate.
  • Contributions are generally exempt from GST.
  • Contributed funds would be taxed as income to the trust if the trust retains the income; distributions would carry out income to be taxed to the recipient.



Learning in America
From the schoolhouse to the online classroom.Read more

Click here to return to top.

4. The Crummey Trust

This oddly named trust has its benefits. “Crummey is the name of the taxpayer in the tax case that established the gift tax treatment of these trusts,” says Drossman. “Unlike other approaches, a Crummey trust allows the beneficiary the right to withdraw contributions for a limited period of time — typically 30 or 60 days from the date of the contribution.” Importantly, for a minor beneficiary, the parent would have the ability to exercise this power. This withdrawal right allows contributions to the trust to qualify for the $14,000 annual gift tax exclusion. Assuming the withdrawal right is not exercised, the funds would then stay in the trust on whatever terms the trust dictates and can be used for any purpose, including education. Unlike custodial accounts or 2503(c) trusts, they can continue after the beneficiary reaches 21.

Key Features

  • Requires legal documentation. Attorney needed for setup.
  • The beneficiary (or the parent) has a right to withdraw contributed funds for a limited period of time, typically 30 or 60 days. If the withdrawal power is not exercised, the trust's terms govern whether or not the beneficiary has any access thereafter.
  • No limitations on usage, whether education or other.
  • Funding methods: cash, securities or other.
  • The trustee has discretion to make distributions for the benefit of various beneficiaries, based on what’s set forth in the trust document.
  • Qualifies for the $14,000 annual gift tax exclusion.
  • Contributions are generally removed from your taxable estate.
  • Contributions with multiple beneficiaries will not be exempt from GST tax, even if your contributions qualify for the $14,000 annual gift tax exclusion. If the trust has a single beneficiary, then your contribution may be exempt from GST if additional requirements are satisfied (namely, during the single beneficiary’s lifetime there can be no distributions allowed to anyone else, and all undistributed assets have to be includable in the single beneficiary’s estate at death).
  • If withdrawal power is not exercised, the result could be that thereafter the income on that asset might be income-taxed 1) to the trust itself, or 2) to the non-withdrawing beneficiary as a grantor trust.

Click here to return to top.

5. The Section 529 Plan

Another strategy that is named for the section of the tax law authorizing it, the 529 plan is a special-educational account that allows funds to accumulate tax-free for a single beneficiary. Says Drossman: “Withdrawals are controlled by the owner (typically the parent or grandparent) and are income-tax-free if they are used to pay for post-secondary education. Payments are not limited solely to tuition expenses.”

Fortunately, numerous strategies are available to help pay the education costs for your children, grandchildren or future generations.

Each state sponsors at least one 529 plan. Contributions qualify for the $14,000 gift tax annual exclusion, but it also has a unique feature: It allows a contribution to be treated as if it was made over five years, so in year one, you could actually put five times the annual gift tax exclusion amount — currently $70,000 ($14,000 x 5) — and it would all qualify for the gift tax annual exclusion. “These plans also have some income tax benefits,” says Lavner. “On distribution, the account’s earnings are not subject to income tax if they are used for qualified education expenses. One thing to note here is that contribution amounts cannot be more than the amount necessary to provide for the beneficiary’s education expenses.”

Key Features

  • Minimal paperwork required for setup.
  • The owner of the account controls all distributions; the beneficiary has no control.
  • Funding methods: cash only.
  • Distributions can be used only for post-secondary education, for any “qualified educational expense,” which includes tuition, fees, books, supplies, some room and board, and more.
  • Qualifies for the $14,000 annual gift tax exclusion. You can also elect to treat contributions as if made over five years.
  • Contributions are immediately removed from your taxable estate, unless funded with five years' worth of annual gifts, in which case the assets won’t be fully removed from your taxable estate until five years later.
  • Contributions that qualify for the annual gift tax exclusion will also be exempt from GST tax.
  • Contributed funds will accumulate tax-free. You can withdraw earnings tax-free if the withdrawals are used for education expenses.
  • The owner can generally change the account beneficiary to another family member without tax consequence.

Please remember there’s always the potential of losing money when you invest in securities.

Click here to return to top.

6. The Health and Education Exclusion Trust (HEET)

The Health and Education Exclusion Trust, or HEET, is a trust established either during your lifetime or under your will to provide payments for medical expenses and tuition for your descendants. “It is designed to minimize the GST,” says Drossman. “This strategy is particularly appropriate for grandparents who are looking to make transfers to grandchildren. Everyone has a generation-skipping tax exemption that allows them to make transfers to their grandchildren, but a HEET allows funds to be paid for the benefit of grandchildren even if you’ve already used up your GST exemption.” To qualify, the money would come out of the trust to be paid as tuition directly to the school.

Key Features

  • Requires legal documentation. Attorney needed for setup.
  • You would establish the trust’s terms, which would govern whether or not the beneficiary has any access.
  • Funding methods: cash, securities or other
  • Applies to any level of education, but covers only tuition.
  • The trustee has discretion to make distributions for the benefit of various beneficiaries, based on what’s set forth in the trust document.
  • Contributions would not trigger GST tax, and subsequent distributions to pay a beneficiary's tuition would be exempt from GST tax.

 

Choosing the appropriate strategy for you

“There are many ways to fund education and many different considerations,” says Drossman, “so it might be appropriate to take advantage of more than one strategy.”

For instance, direct payment could make sense for the tuition portion of your child’s education expenses, but a custodial account could be used for other education expenses. And then, for grandparents who want to help with some education expenses, a HEET might be appropriate. So which approach or approaches are most appropriate for you? “The answer,” says Drossman, “as in all things related to the complexities of wealth planning, is that it depends. It depends upon your particular situation and goals, both short and long term, and the process should probably begin with a conversation between you and your advisor.”

IMPORTANT INFORMATION

Neither U.S. Trust nor any of its affiliates or advisors provide legal, tax or accounting advice. You should consult your legal and/or tax advisors before making any financial decisions.

Always consult with your independent attorney, tax advisor, investment manager and insurance agent for final recommendations and before changing or implementing any financial, tax or estate planning strategy.

OTHER IMPORTANT INFORMATION

529 Plan
The beneficiary must be attending an accredited institution as least half time for room and board to be considered an eligible expense.

You are generally permitted to change the beneficiary to another qualified member of the family, as defined under the Internal Revenue Code, without triggering income and a 10% additional federal tax.

The gift-tax exclusion applies, provided you make no other gifts to the beneficiary during a five-year period. Contributions between $14,000 and $70,000 ($28,000 and $140,000 for married couples filing jointly) made in one year can be prorated over a five-year period without subjecting you to gift tax or reducing your federal unified estate and gift tax exemption. If you contribute less than the $70,000 ($140,000 for married couples filing jointly) maximum, additional contributions can be made without you being subject to federal gift tax, up to a prorated level of $14,000 ($28,000 for married couples filing jointly) per year. Gift taxation may result if a contribution exceeds the available annual gift tax exclusion amount remaining for a given beneficiary in the year of contribution. For contributions between $14,000 and $70,000 ($28,000 and $140,000 for married couples filing jointly) made in one year, if the account owner dies before the end of the five-year period, a prorated portion of the contribution may be included in his or her estate for federal estate tax purposes. Please consult your tax and/or legal advisor for such guidance.

Before you invest in a Section 529 plan, request the plan's official statement and read it carefully. The official statement contains more complete information, including investment objectives, charges, expenses and risks of investing in the 529 plan, which you should consider carefully before investing. You should also consider whether your home state or your beneficiary's home state offers any state tax or other benefits that are only available for investments in such state's 529 plan.