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Clients often ask us how to plan for educational expenses for their children or grandchildren.

According to the College Savings Plans Network, at an inflation rate of 6%, it will cost about $276,954.00 to send a child who is currently a toddler to an in-state, public college for four years, inclusive of tuition, fees, room, and board, and about $633,947.00 to a private college. Considering the staggering cost of education, it is crucial to plan ahead and explore strategies that can make funding education less burdensome. In this article, we will discuss three key strategies clients can use to fund education: section 529 education savings plans, direct payment of tuition, and trusts.

Section 529 Education Savings Plans

A section 529 education savings plan, commonly known as a “529 plan,” is a tax-advantaged tool that allows you to set aside money for educational expenses. It offers a combination of tax advantage, control, and flexibility.

Anyone can create a 529 plan by opening a 529 investment account for the benefit of a single beneficiary (the “donee”), usually a child or grandchild. Contributions to the 529 plan by a “donor” are post-tax, but earnings and qualified withdrawals are federal and in most cases state income tax-free when used for qualified education expenses. Qualified educational expenses include an annual tuition expense of $10,000 per donee for K-12 programs, specifically, elementary, middle, and high schools (which can be private, public, or religious). They also include unlimited tuition payments to college, university, vocational school, or other postsecondary educational institution eligible to participate in a student aid program administered by the US Department of Education. Additionally, qualified expenses include certain expenses for books, room, and board.

Here are some important points to consider:

  1. Control: With a 529 plan, the donor has complete control over the amount and frequency of contributions and can manage how the funds are invested.
  2. Flexibility: A 529 plan does not have to benefit only relatives; it can be opened for any individual. Additionally, the designated beneficiary can be changed at any time without tax consequences. This is important if for example, the initial donee/beneficiary qualifies for a scholarship and has no educational expenses.
  3. Front-loading: In 2023, the donor can front-load a 529 plan by giving up to five years’ worth of annual gifts, currently $17,000 per year, for a total of $85,000 per beneficiary without incurring gift tax or using part of the donor’s lifetime exclusion. However, this means the donor has used up his or her annual exclusion for that specific donee for the next five years.

However, it is important to note that a 529 plan can only have one beneficiary, and non-qualified withdrawals for purposes other than qualified educational expenses may incur penalties and state income tax.

Direct Payment of Tuition

Another strategy is making direct payments of tuition to the child’s or grandchild’s school. Here are some key benefits:

  1. Tax Exclusions: Under section 2503(e) of the Internal Revenue Code, tuition payments made directly to a qualified educational institution on behalf of an individual are not treated as taxable gifts and, under section 2642(c)(3)(B), these tuition payments are also exempt from the Generation Skipping Transfer (“GST”) tax. Thus, tuition payments made by you are not counted towards your annual gift tax exclusion amount ($17,000 in 2023) and will not use up any of your lifetime gift or GST tax exemption ($12.92 million in 2023). Therefore, a significant benefit of direct tuition payments is that it maximizes the benefit to your child or grandchild with limited tax consequence to you.
  2. Broad Applicability: You can pay anyone’s tuition, and it can be for any type of qualified educational institution, including primary schools.

Here it is important to remember that tuition payments must be made directly to the institution and cannot reimburse the student for a payment they made themselves. Additionally, payments for expenses such as room, board, and books do not qualify.

Trusts

Funding a trust for your child’s or grandchild’s education is another viable strategy. A trust is created by the “Grantor” who funds the trust for the benefit of one or more individual(s) or “Beneficiaries”. The Grantor also appoints the Trustee(s) who will be responsible for investing, administrating, and distributing the trust assets to the Beneficiary or directly to an institution on the Beneficiary’s behalf.   

Trusts offer unique benefits that are not provided by the other strategies. Below are some of these benefits:

  1. Broad Definition of Education Expenses. Unlike 529 plans or direct payment of tuition, a trust’s definition of a qualified education expense can be tailored to the Grantor’s preferences.

    Example of a Broad Definition: “Education” means primary, elementary, secondary, post-secondary, graduate, or professional schooling in an accredited institution, public or private, or attendance at other formal programs in furtherance of the beneficiary’s spiritual, athletic, or artistic education, including but not limited to payments for tuition, books, fees, assessments, equipment, tutoring, transportation, and reasonable living expenses.

    Example of a Restrictive Definition: “Education” shall include, without limitation, tuition, room and board, books and supplies, library and laboratory fees, special instruction, and other related expenses incurred during university and post-graduate education.
  2. Flexibility for Multiple Beneficiaries: Since a trust can have more than one beneficiary, a “Pot Trust” can be created to accommodate different levels of educational expenses. In a Pot Trust, funds are pooled together and distributed unequally among beneficiaries, and later, when all beneficiaries reach a certain age, funds can be distributed into separate trusts for each beneficiary.
  3. Creditor Protection: Trust funds are protected from creditors, offering an additional layer of security not available with 529 plans or direct payment of tuition.
  4. Incentives and Requirements: Through a trust, the Grantor can establish incentives or specific requirements for beneficiaries to receive distributions. For example, maintaining a specific GPA.  

Some commonly used trusts for education funding are 2503(c) Trusts, Crummey Trusts and Health Education Exclusion Trusts (“HEETs”). Review the following for a brief description of both:

2503(c) Trust

A “2503(c) Trust,” so called because it is governed under Section 2503(c) of the Internal Revenue Code, is a trust created for the benefit of a single minor beneficiary and is designed to be funded by the Grantor’s annual exclusion amount ($17,000 in 2023) gift-tax free. However, there are three requirements for a trust to qualify as a 2503(c) Trust:

  1. The trust principal and income must be made available for distribution to the minor Beneficiary or for his or her benefit;
  2. The Beneficiary must be given the power to withdraw all the trust assets when he or she turns 21 years of age; and
  3. If the Beneficiary passes away before reaching 21 years of age the trust assets become a part of the Beneficiary’s estate.

2503(c) Trusts are attractive options because their term can be extended if the Beneficiary is given a withdrawal power over all trust funds at age 21, but they do not exercise it in full. They also work well for grandchildren because they can provide GST tax advantages.

Crummey Trust

A Crummey Trust, like the 2503(c) Trust, is another type of trust which is funded by the Grantor’s annual gift tax exclusion amount ($17,000 in 2023). The Crummey Trust can be created for one (1) or more Beneficiaries and as long as the beneficiary is given a present interest in the trust, the gifts to the trust qualify for the annual gift tax exclusion. This present interest is created by providing the beneficiary with a right to withdraw the newly deposited funds, usually 30 days. This 30-day withdrawal window is provided by a written notice to the beneficiary or a “Crummey Notice,” after the 30 days lapse the funds become part of the trust and the beneficiary can no longer withdraw the contribution.

One of the primary benefits of the Crummey Trust is that it does not terminate when the beneficiary reaches 21 years of age and provides a longer lasting creditor protection.

Health Education Exclusion Trust

A Health Education Exclusion Trust (“HEET Trust”) is another trust governed by the Internal Revenue Code (Section 2503(e)), and its purpose is to directly pay medical and tuition expenses of a beneficiary who is two or more generations younger than the Grantor. Therefore, a HEET is a dynastic estate planning tool, where, usually, grandparents create the trust for the benefit of their grandchildren and the grandchildren’s descendants.

A HEET requires the distributions for the beneficiary’s benefit be made directly to his or her school via tuition payments or direct payments of medical care or medical insurance. By making direct distributions to educational institutions, such distributions are Generation Skipping Transfer Tax (“GSTT” or “GST tax”) free.

One caveat to a HEET is that at least one of the beneficiaries of the trust must be a charitable organization which receives an annual income distribution, but the amount of the distribution is up to the Grantor. With the addition of the charity, the trust gains a non-skip person (for GSTT purposes) which protects it from the GST tax.

Selecting the Best Strategy

When choosing the best strategy or the order in which to engage in these strategies, consider the following factors:

  1. Number of Beneficiaries: Your strategy may differ depending on whether you have one child/grandchild or multiple children/grandchildren.
  2. Age of Beneficiaries: Younger children/grandchildren may have different educational expenses compared to those heading to college soon.
  3. Timing of Funds: If the funds are needed in a couple of years but you want to start saving now, a 529 plan or trust may be the right choice.
  4. Tax and Estate Planning: Consider the importance of estate tax planning and income tax planning for your situation.
  5. Current Estate Plan: Assess your current estate plan to determine which strategy aligns best with your goals.

It is never too early to start on planning and funding your child’s or grandchild’s education. The cost of education is significant, but with careful consideration and the right strategies, you can make it a less taxing experience. If you have any questions or need guidance on funding education, please do not hesitate to contact a Wiggin and Dana attorney. We are here to help you navigate this important aspect of your financial and estate planning.