Back to School: The New Parameters of Funding a Grandchild's College Education

Abstract

This article examines several different mechanisms for funding college expenses from the perspective of a grandparent. The mechanisms considered include direct gifts to the grandchild or the educational institution, college savings bonds (both state and federal), prepaid tuition contracts, college savings plans created under tax code section 529, and Coverdell Education Savings Accounts.

Although these college funding mechanisms are not new, legislation enacted within the past two years has radically altered many of the rules of thumb that have applied in the past. Specifically, the Tax Increase Prevention and Reconciliation Act of 2005 (actually enacted in May 2006) and the Small Business and Work Opportunity Tax Act of 2007 that accompanied that year's increase in the federal minimum wage have basically eliminated any tax advantage of custodial accounts as college funding vehicles. On the other hand, the Pension Protection Act of 2006 has enhanced the tax appeal of 529 plans at the same time that the Deficit Reduction Act of 2005 (actually enacted in February 2006) improved the financial aid status of such plans. Finally, that Deficit Reduction Act also created significant hurdles for grandparents who anticipate accessing the Medicaid program to pay their long-term care costs.

To determine the approach that best serves all family members, this article begins by considering several factors that are relevant to the financing of a grandchild's college expenses. These factors include: (1) the grandparents' and the grandchildren's income tax situation, (2) the grandparents' possible exposure to gift taxes, (3) the grandparents' desire to ensure that the funds they provide are actually used to pay for college costs, (4) the Medicaid implications for the grandparents, and (5) the impact on a grandchild's eligibility for needs-based financial aid. The article then examines the various mechanisms that are available to fund a grandchild's college costs and analyzes each mechanism in terms of these factors.