Planning for College Expenses

Recently I celebrated my birthday with my family on a great Saturday evening. It was one of those rare evenings that we were all together, including my wife, our oldest son who is a sophomore at the University of Michigan and our twin 17 year old sons who are juniors in high school.During our dinner and in between me feeling the brunt of bold and old age jokes, it struck me like a ton of bricks, in a little over a year we will have not just one, but three college students in the family.While we have done our best to plan financially for this event, I don't think any of us feel totally confident that we have enough to fully pay the way.

According to the College Board, the average cost of attending an in-state four-year public college in 2011-2012 is more than $19,000 per year; for a four-year private college it is nearly $40,000 per year. Over the last decade, published tuition and fees for in-state students at public four-year colleges and universities increased at an average rate of 5.6% per year beyond the rate of general inflation.

As a result, saving for college is the most significant savings goal of many families facing future college costs for their children, especially considering the recent wide-spread depletion of portfolio and home values starting in 2008. Advisors who understand the various education savings tools will bring significant value not only to their clients, but also to the advisory team.

In this edition of News + Views, I will examine several of these educational savings tools as well as the impact they can have on financial aid.This edition is a bit lengthy, but it represents my best effort to summarize an extensive amount of information.

Uniform Gifts to Minors Accounts (UGMA)
Uniform Transfers to Minors Accounts (UTMA)

The simplest form of education savings vehicles, and therefore quite common, is an account created under the Uniform Gift to Minors Act (UGMA) or its successor, the Uniform Transfer to Minors Act (UTMA) in the child's state. While easy and inexpensive to establish, there are considerable disadvantages to these including:

  • The beneficiary has the absolute right to the account upon reaching the age of majority (18 or 21, as defined by state law) and can spend this money however he or she pleases. For a beneficiary receiving needs-based government benefits, the required outright distribution may cause the loss of these benefits until the UGMA/UTMA funds are gone. For an immature beneficiary, the distribution and subsequent spending can cause other problems.
  • Neither the custodian nor the donor can change the beneficiary after the account has been established. Until the beneficiary reaches the age of majority, the custodian has a fiduciary duty to spend the income or principal for the benefit of the minor.
  • If the custodian uses income derived from UGMA/UTMA property to discharge or satisfy, in whole or in part, a parent's or guardian's legal obligation to support or maintain the minor, the income is taxable to the parent or guardian.
  • The "kiddie tax" may also come into play. If the child is under age 18 (under 24 if a dependent, full-time student) all of the child's unearned income above $1,900 (for tax year 2011), including UGMA or UTMA income, is taxed at the parent's income rate, whether or not the parent is the custodian of the account. For children 18 years and older (24 and older if a dependent, full-time student), the child's unearned income is generally taxed at the child's income tax rate.
  • There is limited investment flexibility with these accounts; UGMA accounts are very restrictive in terms of the types of assets they may hold.
  • While a transfer to a minor under UGMA or UTMA constitutes a completed gift for federal gift tax purposes at the time of the transfer, if the donor names himself or herself as custodian of the account and that person dies before the child reaches majority, the UGMA or UTMA account assets will be includable in the donor/custodian's gross estate for estate tax purposes.

What To Do With Existing UGMA/UTMA Accounts

On realizing that the now-teenager beneficiary will soon have an absolute right to the account assets, many parents and grandparents who have made significant gifts to an UGMA or UTMA will want to restrict somehow the beneficiary's access to the account or eliminate the danger. There are at least three ways to accomplish this:

  1. The custodian can spend the account funds for the benefit of the beneficiary (ideally other than in satisfaction of the guardian's legal support obligation to avoid income tax on the gain) before the beneficiary reaches the age at which he can withdraw the funds.
  2. The custodian may be able to give the child an unqualified withdrawal right when the beneficiary attains the age of majority and, upon lapse of the demand right period, invest the funds (on behalf of the child) in an illiquid manner (e.g., in a Family Limited Partnership or Family Limited Liability Company) or (on behalf of the child) transfer the funds to a self-settled trust for the beneficiary that limits the beneficiary's access. Giving the child an absolute right to withdraw principal should suffice for purposes of vesting. To be on the safe side, the custodian should get the child's consent to the investment AFTER the child has attained age 18.
  3. The custodian could liquidate the UGMA/UTMA account and invest the proceeds in a Qualified Tuition Program (QTP) under Section 529 or another investment. Some of these QTP savings plans grant the beneficiary unrestricted access to the funds upon attainment of the age of majority; however, if the child uses the funds for something other than qualified higher education expenses, they will be subject to tax on the income.

Qualified Tuition Programs (529 Plans)
Under Section 529, states can set up two types of plans:

  1. Prepaid tuition plans, through which the state guarantees tuition rates, will remain at current levels; and
  2. Savings plans, which are essentially state-sponsored mutual funds.

Only cash contributions (checks, money orders, credit cards and similar methods) can be made to a QTP. Contributions are not tax-deductible, but earnings grow tax-free and distributions are tax-exempt if used for "qualified higher education expenses" (QHEEs), which include tuition, fees, books, supplies, equipment, and room and board expenses.

Coverdell Education Savings Accounts (ESAs)
Education Savings Accounts, formerly Education IRAs, were of little significance until passage of the Economic Growth and Tax Relief Reconciliation Act of 2001 (EGTRRA). EGTRRA made four major changes that made ESAs more attractive and useful:

  1. Increased the maximum annual contribution limit from $500 to $2,000 per beneficiary;
  2. Increased the AGI limits for maximum contributions to these accounts, currently to $220,000 for a married couple filing jointly and $110,000 for single taxpayers;
  3. Allowed a donor to make contributions to an ESA and a 529 plan for the same beneficiary in the same year; and
  4. Allowed ESAs to be used to fund primary and secondary school.

ESA funds are to be used for qualified education expenses. Contributions must be made in cash and cannot be made after the beneficiary reaches age 18. The beneficiary's parent or legal guardian controls the account (regardless of who makes the contributions) until the beneficiary attains the age of majority. A change of beneficiary is tax-free if the new beneficiary is a member of the prior beneficiary's immediate family or a first cousin.

Contributions constitute a completed gift for gift tax purposes. For estate tax purposes, funds in an ESA are "owned" by the beneficiary and are includable in the beneficiary's gross estate, not the donor's.

Life Insurance
A cash value whole life or universal life insurance policy generally gives its owner the option of borrowing against the policy's cash value. Flexible premium universal life and variable universal life policies typically include the option to take partial withdrawals of cash value without triggering loan interest charges.

Withdrawals from a cash value life insurance policy (other than a modified endowment contract) are not subject to income tax until the cumulative withdrawals exceed the cost basis (i.e., the aggregate premium payments on the policy). Policy loans from cash value life insurance policies may be used to avoid current income tax on cash distributions in excess of cost basis. Policy owners may therefore take tax-free withdrawals and tax-deferred loans to pay educational expenses (or for any other use), while the cash value build-up continues to grow tax-free. If the policy continues until death, the income tax-free death benefit will repay any policy loans and the policy's beneficiaries will receive the remaining net death benefit.

In the event of premature death, the life insurance benefit can complete the planned education funding. The interest rate on policy loans is typically no more than 8%, although the insurance company will credit 6% or more back to the policy's cash value. If the owner chooses not to pay the interest when due, automatic policy loans to pay the interest charge will further reduce the policy's cash value and may ultimately cause the policy to lapse.

2503(c) Minor's Trust
Absent Crummey demand rights, a gift in trust is generally not a gift of a present interest. However, a minor's trust under Internal Revenue Code Section 2503(c) is a statutory exception to this general rule. To qualify for the annual exclusion, a 2503(c) minor's trust must meet three requirements:

  1. The trust must give the trustee discretion to expend trust principal and income for the benefit of the beneficiary before he or she reaches age 21, without substantial restrictions;
  2. The trust principal and undistributed income must pass to the beneficiary when he or she reaches age 21; and
  3. If the beneficiary dies before reaching age 21, any remaining trust principal and undistributed income must be paid to the beneficiary's estate or be subject to a power of appointment.

If the trust meets these requirements, contributions of up to $13,000 per beneficiary per year are not subject to gift tax (unless the donor's annual gift tax exclusion for the beneficiary is applied to other gifts by the donor to the beneficiary).

For the 2503(c) trust to continue after the beneficiary reaches age 21, the beneficiary must have a reasonable period of time after attaining age 21 to withdraw all of the trust principal and undistributed income. The trust should also grant the minor a testamentary general power of appointment to avoid inclusion in the parent trust maker's estate if the beneficiary were to die before reaching age 21.

Demand (Crummey) Trust
Demand rights convert what would otherwise be a gift of a future interest to a gift of a present interest, thereby qualifying the gift for the $13,000 gift tax annual exclusion. To qualify, the trustee must adhere to the strict procedure requirements for Crummey trusts: the trustee must notify the minor beneficiary (through the child's legal guardian) that the donor has made a gift to the trust and give the beneficiary the trust-specified period of time (typically 30 days) to demand a distribution from the trust up to the amount of the gift. If the demand right lapses, the gift will stay inside the trust and continue to be governed by the trust terms.

This demand right allows the trust maker to make contributions of up to $13,000 per year, free of gift tax and possibly Generation Skipping Tax (GST) tax, in the latter case only for the beneficiary's generation.

Demand trusts remove the trust assets from the trust maker's estate, even if the trust maker acts as trustee, as long as the trust instrument limits the trustee's discretion to make distributions to "ascertainable standards," i.e., the health, education, maintenance and support of the beneficiary (and provided the trust instrument does not give the trust maker too much control over the trust). If a demand right beneficiary dies during the time that a demand right is outstanding, the amount of the outstanding demand right is includable in the beneficiary's gross estate for estate tax purposes.

Health and Education Exclusion Trust (HEET)
Health and Education Exclusion Trusts are designed specifically to take advantage of the gift tax-free and GST tax-free nature of direct payments to providers for a beneficiary's health and education expenses. With this type of trust, the donor transfers property to a trust carefully drafted to be exempt from GST tax. Oftentimes the donor establishes the trust in a jurisdiction that permits perpetual trusts because, once exempt from GST tax, the trust can pay direct health and education expenses for grandchildren and their descendants without anyone ever having to pay the onerous GST tax (a tax at the highest federal estate tax rate, currently 35%).

To prevent imposition of GST tax, a HEET must have a charitable beneficiary with a significant interest that is not separate from the non-charitable beneficiaries' interest.

Direct Payments
Another educational funding option is for the donor to make transfers directly to an educational institution. Under the Internal Revenue Code, these transfers are not subject to gift, estate, or GST tax. Therefore, prepaid tuition payments by a donor can achieve a significant estate tax reduction. Direct payments are not deductible as a charitable contribution for income tax purposes, however, because they are made for a particular student.

Since only direct payments to the educational institution qualify, it is highly recommended that the donor make contributions to the school while the child is presently enrolled. If the donor wishes to make advance payments for numerous years' tuition, the donor (and the parent(s) if the donor is the student's grandparent) should enter into a written agreement with the educational institution providing that the prepayments are non-refundable. In a 1999 Technical Advice Memorandum, the IRS used as an example a situation where the beneficiary's parent also agreed to pay any tuition and fee increases.

Impact on Financial Aid

For many clients, the availability of financial aid plays a role in the planning process, because assets placed in the student's name may reduce (or even eliminate) the amount of otherwise available financial aid. According to FAFSA's 2011-2012 Application and Verification Guide, the need-based financial aid rules state that 12% of the parent's assets (special rules determine this amount for financial aid purposes) and 20% of the child's assets are available for education. Therefore, shifting assets from the parent to the student through the use of UGMA/UTMAs, ESAs and 529 plan distributions may reduce the student's need-based financial aid. Alternatively, life insurance should not impact need-based aid, whereas a demand trust may, depending upon the child's access through the trust terms.

Numerous options exist for funding educational expenses. As with most planning, no one option is best for all individuals in every circumstance and often a combination of options will best meet the individual's needs and objectives.

Dan A. Penning