Funding Education in Your Estate Planning: Giving Your Children Roots and Wings

Parents worry about education. Not only about paying for education, but about fostering curiosity so kids want to learn.  It is why we limit screen time but send them to coding classes. With an education we have more options in life, which means more freedom, independence, and (hopefully) happiness. Let’s explore how to efficiently fund your child’s education with estate planning tools.  I am a big proponent of family meetings and I hope this article can be a jumping off point for you and yours.

529 Plans & Secure Act 2.0

Many of my clients and parents everywhere are eyeing a certain provision of the Secure Act 2.0 that mitigates one major drawback of 529 plans: What if the kid doesn’t use all the money? But first let’s do a quick overview of a 529 plan.

529 plans are tax-advantaged tuition savings plans sponsored by the states. Much like a retirement plan, the money deposited grows tax free. They are great for new parents, who can set them up and then anyone can contribute. In New York State, the most that can be contributed to such an account is $520,000. Gifts to a 529 plan are tax free up to the annual exclusion amount ($17,000 in 2023) but donors can make a five year lump sum payment ($85,000). This of course uses up the annual exclusion amount to that beneficiary for 5 years. Those who contribute can receive a New York State income tax deduction of up to $5,000 per year ($10,000 for married couples filing jointly).

Any money put into a 529 savings plan can be withdrawn tax free to pay for “qualified educational expenses.” Traditionally this meant only college and vocational related expenses, including tuition, room, board, textbooks, computers, software and the like. The 2017 Tax Act expanded the definition somewhat to include distributions of up to $10,000 per year toward K-12 tuition.

We all know the big drawbacks – withdrawing funds for non qualified expenses incurs both income tax on the earnings and a 10% penalty. If a child does not go to college, the account can be rolled over to eligible family member or deal with the tax and penalties.

The Secure Act 2 passed into law on December 29, 2022 and now some of that money can be recouped. The 2019 Setting Every Community Up for Retirement Enhancement (SECURE) Act changed retirement planning by eliminating the lifetime stretch for all but a few qualified beneficiaries.  It did allow 529 account holders to use funds in their plan to repay up to $10,000 per year in student loan debt. Section 126 of SECURE Act 2.0 would allow rollover of the 529 plan to a Roth IRA for the beneficiary. There are certain caveats:

• the account must have been in existence for at least 15 years; contributions to the 529 plan within the last 5 years (and the earnings on those contributions) are ineligible;
• the annual limit for how much can be moved to a Roth IRA is the IRA contribution limit for the year, less any ‘regular’ traditional IRA or Roth IRA contributions made for the year; and
• the maximum amount that can be moved from a 529 plan to a Roth IRA during an individual’s lifetime is $35,000.

There is also the question of how a 529 plan impacts financial aid. When filling out the Free Application for Federal Student Aid, income and assets of the parent and student are all reported. If the 529 Plan is owned by the parent, it is counted as an asset. If owned by someone else, like a grandparent, it is not an asset but considered income to the student. That’s not ideal because income reduces financial aid more than assets. Income verification is usually requested two years before the school year. Therefore, if the grandparent owns the 529 Plan, the student should hold off distributions until the second half of their sophomore year to reduce the negative impact.

Tax Free Gifts from Family & Friends

Many grandparents want to help pay for education. Same with many of my clients who never had children but have beloved nieces and nephews. What most people don’t realize is that each year they can gift an annual exclusion amount that is free of any gift taxes to anyone ever. In 2023, this is $17,000 per individual. You could give more of course, but then it is counted against your ridiculously high $12.93 million exemption.

Right now, the federal estate and gift tax is high – in 2023 you can leave anyone $12.93 million without incurring the 40% gift & estate tax. But it wasn’t always like this – in 2017 it was $4.9 million. Moreover, this federal exemption is slated to sunset in 2026 back to 2017 levels adjusted for inflation. So for now until 2026 – use that exemption and gift away to grandkids and nieces and nephews.

Not only can you gift $17,000 per year tax free, any direct payments you make to an education institution, K through 12 or college, is also tax free. This is only for tuition, not room and board, but it’s still efficient. As an aside, payments made directly to a provider for medical expenses are tax free too. Tuition can even be prepaid to the school if a family member or friend is concerned they won’t live long enough to help with tuition.  It would be silly to make a nonrefundable payment to Harvard for your 7 year old granddaughter. But when kids are already attending the school it is smart. It’s also incentive for them not to drop out.

This direct gifting also avoids generation skipping transfer tax (GSTT).  GSTT applies to gifts made to grandchildren or a non-relative at least 37½ years younger (spouses do not count). Again, maybe not as important with the current lifetime exclusion of $12.93 million, but estate tax schemes change.

What about Trusts?

I rarely recommend living trusts for children these days for one practical reason. People usually don’t want to give away big chunks of money while they are still alive to a trust they have no control over. Someone –either a parent or the donor—has to pay income tax on the trust earnings (think money in brokerage account). It always makes sense for our doctor clients because by moving money out of their estate it is protected from lawsuits.

However, right now with that ridiculously high federal estate tax exemption set to go away forever in 2026 – now is the time to gift assets to a trust. I am not choosing $6 million arbitrarily and the number is actually $6.58 million. This is the 2023 New York State estate tax exemption. Anyone who passes away with assets over 105% of the New York estate tax exemption will have to pay up to 16% on the entire amount – not just the overage. We call this the “cliff.”

NYS does not have gift tax. The federal gift tax is combined with the federal estate tax, often called the unified tax credit for this reason. The gifting sweet spot is between the NYS exemption and the federal. Any New Yorkers with over $6.58 million can avoid state estate taxes by gifting assets over that amount but below $12.93. Be sure to discuss any capital gains issues with your attorney and accountant – you do not want to trading one tax for another.

Testamentary Trusts

Maybe you’re thinking, okay okay yeah we don’t have that much money and want to hold onto what we do have until we die. That’s why we do testamentary trusts – trusts that are only triggered upon your death. We put all the details of how the trusts will be administered and distributed in your own Will or trust. On your death that provision serves as the child’s trust.

A testamentary trust doesn’t save on estate taxes. But it gets assets to minors because even if you could give assets over $10,000 to a minor (you can’t), you likely shouldn’t. Eighteen or 21 is too young. Name a trustee, set some parameters, choose an age the child can inherit. Maybe even put in a provision only allowing distributions for education – which allows you to incentivize from the beyond.

As you can see, there is no one perfect solution to funding education. The best approach is multi-faceted, which is why I love working with financial planners and holding family meetings. Educating our young’uns should be easier and cheaper, but until we revamp our educational system we need to use the tools at our disposal. As my aunt says about her experience raising children: they need roots and wings.