With higher education costs increasing every year, many families find it difficult to imagine how they will help finance their children’s higher education. Even in cases where the price tag is less of an issue, the transaction can raise complicated questions about taxes and wealth transfers. Parents and grandparents should be mindful of how to approach the process so they can avoid incurring unnecessary taxes. The good news is that there are several methods at your disposal to help children and grandchildren pay for higher education.
Funding Education As A Business Owner
For people in the highest tax bracket, it’s a smart idea to transfer assets to your child through your closely held business. Because kids are typically in a lower tax bracket, the wealth you transfer to them will be taxed less, so your child will be able to maximize the assets.1 There are four main ways to approach this:
Paying For Education By Gifting Company Stock
If you have company stocks earmarked for higher education, it can be advantageous to transfer those stocks to your child for them to sell, rather than sell them yourself and then use that cash for education. This shifts the capital gains into a lower tax bracket.
There are some drawbacks to understand, however. While you may have minimized capital gains taxes, it’s possible that the transfer will trigger a gift tax. Kiddie taxes may also apply, by which a portion of your child’s unearned income will be taxed at the parent’s rate. Financial aid might also be affected since child assets are weighted more heavily than parent assets.
Finally, even if you manage to avoid all those pitfalls, you still might struggle to find a market for the stocks. There’s a chance the IRS will deem your pre-arranged sale to a family member a sham transaction. Be sure to consult a professional before committing to a gift of company stock.
Transferring A Partnership Or S Corporation Interest
Owners of a business registered as partnership or S-Corporation for tax purposes might be able to transfer an interest in the business to their children. This would allow them to receive distributions as unearned income that can then be used to finance higher education.
Be advised that there are rules in place with the IRS and with states dictating who is eligible to serve as a shareholder — so you’ll want to seek professional advice before pursuing this strategy. Kiddie taxes and risks to financial aid are also at play. You should also know that this is an intensive method, requiring costs and administration that, in some cases, might exceed the benefits.
Arranging A Gift-Leaseback Transaction
A gift-leaseback arrangement allows parents to give business assets (like land or buildings) to their child (either directly or through a trust) and then lease those assets from their child at fair market value. In this way, their child is receiving an income from the lease of the asset, and parents are able to fund college expenses — and even write off those lease payments as business expenses.
Depending on the value of the gift, potential drawbacks include gift taxes and effects to financial aid. The IRS also monitors gift-leaseback arrangements closely to ensure their legitimacy. It’s important to have everything properly appraised and to file all of the paperwork as if you were entering the arrangement with someone outside of your family.
Bringing On Your Child As An Employee
The most straightforward strategy for helping your child pay for college is to let them earn a paycheck. Obviously, child labor laws apply, and if the compensation exceeds a reasonable amount, the IRS might consider the excess to be a gift. But the method has several strengths.
If your child is working for the family business, they are making earned income — which exempts them from both gift taxes and kiddie taxes. Earned income also allows them to open an IRA that can be used for higher education expenses without incurring an early distribution penalty. Finally, in some cases, they will not have to pay Medicare and Social Security taxes until they turn 18.
Paying For Higher Education As A Parent Or Grandparent
Grandparents are also often eager to contribute to the higher education ambitions of their grandkids. Between their mature investments, savings, and Social Security income — to say nothing of the elders still active in the workforce — grandparents often have the resources to make intergenerational wealth transfers. Here are some effective methods for helping to cover education costs for kids or grandkids:
Paying For Education With Cash Gifts
Gifting grandkids with cash or securities is an attractive option because of its simplicity, so parents or grandparents who prefer not to tangle with different financial vehicles could consider doing this. But it does come with some downstream effects.
Any gift more than the annual gift tax exclusion amount ($15,000 for individuals and $30,000 for couples) may be subject to both a gift tax and a generation-skipping transfer. Also, as unearned income, cash gifts can impact financial aid eligibility.
Direct Payments To The Institution
Direct payments to an institution of higher learning are a great strategy for a grandparent. No matter the size, tuition payments are exempt from gift taxes. There are a few limitations, but in some ways, you might actually regard those as greater benefits.
Paying tuition directly ensures that the funds will be used exactly as intended, removes taxable value from your estate, and allows you to transfer cash gifts below the annual minimum without incurring the gift tax.
Using 529 Plans To Pay For Education
A 529 plan is an investment vehicle through which contributions grow tax deferred and qualified education expenses can be withdrawn tax-free. Non-qualified withdrawals are subject to a 10% penalty and are taxed as ordinary income, helping to ensure that funds are used as intended.
The lifetime contribution limit is typically over $350,000. Contributions can be made as recurring payments or as a lump sum (exempt from gift taxes under $75,000 for individuals and $150,000 for couples), and all contributions are considered removed from the grandparent’s estate. For financial aid purposes, grandparent-owned 529 plans do not need to be reported as assets, although there are implications for withdrawals.
Alternative Strategies Students Should Consider
Public Service Loan Forgiveness
This allows individuals in qualifying public service careers to wipe away their debt after they work in eligible public service positions for 120 months in a row. Some of the eligible public service positions include government organizations at any level and not-for-profit organizations that are tax exempt under the section 501(c) (3) IRS code. The Peace Corps and Americorps can also qualify. Two workarounds are to gift the cash to adult children instead of grandchildren, and to wait until after graduation and gift the cash to pay off student loans. As with the other strategies, financial aid can be affected — in this case by the amount of the grandparent’s direct payment — so it’s important to ask the college what to expect.
Work-Study Program
Work-study programs give students an opportunity to earn an income while they attend undergraduate or graduate courses. These programs are typically made available to students who can exhibit a need for financial assistance. To qualify for federal work-study programs, you must be pursuing a post-secondary educational degree or certificate.
Scholarships and Grants
According to the Department of Education, an estimated $8.8 billion is awarded each year to students. There are many different sources that provide scholarships and grants for high school and undergraduate students. These include companies and local community foundations, charitable nonprofits, corporations, federal or state agencies, and associations related to the student’s major.
The best place for students to start is to find out what academic or financial scholarships they might qualify for. Online sites such as scholarships.com will help students filter through the many scholarships available.
Higher education is an investment in the future. There are some key strategies to understand that can help you maximize that investment. Our expert advisers can guide you through all your options so that you can help put your kids and grandkids through college without stressing about how to do it.
1. Before taking steps that affect your taxes, always consult a tax professional.
