MMM Newsletter and Website Header 10.2.15

By Carrie Schwab-Pomerantz, Charles Schwab & Co., Inc.

Key points

  • Investing for your grandkids’ education is generous, but first make sure your own retirement needs are covered.

  • There are essentially four account options to choose from for education investing.

  • Choose the account that offers the best combination of tax advantages and investment control for your purpose.

Investing in a child’s education is a wonderful gift. To do it thoughtfully, there are essentially four options to consider: a 529 plan, a custodial account, a trust account, or simply using your own account with the plan to make gifts to your grandchildren later. Here are the basics of each.

A 529 plan is the most popular tax-deferred vehicle

In a 529 account, earnings grow federally tax deferred and withdrawals aren’t taxed as long as the money is used for “qualified” higher education expenses — things like tuition and fees, room and board, books and school supplies. (Make sure to keep the receipts!)

The federal tax advantages of a 529 are a big plus, but there are also additional benefits:

  • An individual can contribute $70,000 ($140,000 for a married couple) in a single year without triggering gift taxes (provided no additional gifts are made over the next five years).

  • You control the assets. The child is the beneficiary but can’t access the money directly.

  • You can transfer unused assets to other family members. Say one grandchild was college bound, but the other wasn’t. The 529 assets could be shifted to the one headed for college without penalty.

  • Some states offer tax deductions and even tax credits for 529 contributions.

What’s not to like? Well, 529 plans may offer fewer investment choices than some custodial accounts or trusts, and trading and exchanges are often limited. Plus, the funds can only be used for higher education; if you withdraw them for some other reason, you’ll pay federal and state taxes on any investment income, plus a 10 percent penalty.

For the record, a Coverdell Education Savings Account (ESA) also has tax benefits and can be used for elementary and secondary education as well as college. The drawback is that annual contributions are limited to $2,000, and then only if you qualify based on your adjusted gross income.

A custodial account allows more investment flexibility

If you’re sure your grandkids will go to college, a 529 plan makes sense. But if your goal is simply to give them some financial assistance later in life, you might consider a custodial account. It’s generally more flexible than a 529 in terms of what you can invest in, and how your grandkids can use the money.

That second point can be a double-edged sword. While you control the investments now, the assets become the beneficiaries at 18, 21, or 25 (depending on your state and your wishes). Theoretically, your grandchild could reach the legal age and cash out the account to buy a Ferrari, and there’d be nothing you could do about it. That’s something to think about.

Earnings don’t grow tax-deferred and there are no qualifying tax-free withdrawals, as in a 529 plan, but a custodial account may offer a tax benefit: Under the 2016 tax code, the first $1,050 of investment earnings are tax-free and the next $1,050 is taxed at the child’s (usually lower) rate; after that the marginal tax rate goes up to the parents’ rate.

You also need to be aware of the gift tax exclusion. While there are no limits on the amount you can contribute to a custodial account, currently an individual can only contribute a maximum of $14,000 per year ($28,000 per couple) without triggering the gift tax.

A trust account gives you more control

If you want more control over the money, look at a trust account, either a Crummey Trust (the odd name comes from the first person who successfully set one up) or a 2503(c) Minor’s Trust. These are more complex and more expensive than your other options. If they sound appealing, consult a trust expert. With a trust account, you’re also limited to the annual gift tax exclusion.

A final option: Keep it in your own account

One final option is simply to earmark that money for your grandchildren and keep it in an account in your own name. Of course, you’d need to stipulate your intentions in your will (or set up a trust), and think about estate taxes. But the pluses are that you’ll have complete control over how the money is invested and how and when it’s disbursed. And if you should happen to need the money yourself, it’ll be available.

You have a lot of options, although given the amount of money you plan to invest, the 529 plan may make the most sense. Pick one with low expenses and a wide range of investment choices, and then choose investments that match the time horizon you need and offer plenty of diversification. Target funds, which rebalance automatically as the date of matriculation grows nearer, offer a simple solution, so check them out.

Whatever you choose, I’m sure your generosity will be remembered for years to come.


About LRPC’s Monday Morning Minute

Lawton Retirement Plan Consultants, LLC (LRPC’s) Monday Morning Minute is crafted to provide decision-maker’s with important information about the economy, investments and corporate retirement plans in a format that allows a reader to consume the information in less than 60 seconds. As an independent, objective investment adviser, LRPC has access to many sources of research and shares the best and most relevant information with its readers each week.

About Lawton Retirement Plan Consultants, LLC

Lawton Retirement Plan Consultants, LLC is a Milwaukee, Wisconsin-based independent, objective Registered Investment Advisory (RIA) firm providing investment advisory, fiduciary compliance, employee education, vendor management and plan design services to retirement plan sponsors. The firm currently has contracts in place to provide consulting services on more than $400 million in plan assets. For more information, please contact Robert C. Lawton at (414) 828-4015 or or visit the firm’s website at Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser.

Important Disclosures

This information was developed as a general guide to educate plan sponsors and is not intended as authoritative guidance, tax, legal or investment advice. Each plan has unique requirements and you should consult your attorney or tax adviser for guidance on your specific situation. In no way does Lawton Retirement Plan Consultants, LLC assure that, by using the information provided, plan sponsor will be in compliance with ERISA regulations. Investors should carefully consider investment objectives, risks, charges and expenses. The statements in this publication are the opinions and beliefs of the commentator expressed when the commentary was made and are not intended to represent that person’s opinions and beliefs at any other time. The commentary does not necessarily reflect the opinion of Lawton Retirement Plan Consultants, LLC and should not be construed as recommendations or investment advice. Lawton Retirement Plan Consultants, LLC offers no tax, legal or accounting advice and any advice contained herein is not specific to any individual, entity or retirement plan, but rather general in nature and, therefore, should not be relied upon for specific investment situations. Lawton Retirement Plan Consultants, LLC is a Wisconsin Registered Investment Adviser and accepts clients outside of Wisconsin based upon applicable state registration regulations and the “de minimus” exception.

Additional Important Disclosures

The information provided here is for general informational purposes only and is not intended to be a substitute for specific individualized tax, legal or investment planning advice. Where specific advice is necessary or appropriate, consult with a qualified tax advisor, CPA, financial planner or investment manager.