Educational gifts that make for wise investment strategies

The pros and cons to consider when giving educational gifts

As you think about the year to come — and make adjustments to your financial plan and goals you want to accomplish — you may want to plan with your wealth advisor about how to set funds aside for educational gifts.

If you have a child or grandchild, niece or nephew, or perhaps another special young person in your life who you'd like to leave funds to for private school, boarding school or college expenses, planning for these gifts long before they need the funds is key.

Here are three strategies to consider when giving gifts of this kind.

1. 529 plans

A 529 plan is a tax-advantaged account that can be used to pay for qualified education costs. Contributions made for the benefit of a beneficiary count towards your annual gift exclusion amount, so you can contribute up to $15,000 in 2021, or $30,000 if you are married and your spouse also contributes. If you'd prefer to make a lump sum deposit, you can front-load up to five years' worth of annual gifts all at once, as long as you don't make any additional gifts to that beneficiary during the next five years. That means you could front-load up to $75,000, or up to $150,000 if your spouse also makes a contribution.

While there is no Federal income tax benefit from making contributions, some states do offer a state income tax credit. However, funds in the 529 account grow tax-deferred, and withdrawals are tax-free as long as they are used for qualified education expenses. That includes costs for undergraduate or graduate studies, or as much as $10,000 per year towards K-12 education expenses. Additionally, in 2019 the SECURE Act expanded the use of 529 plans so that funds can also now be used to cover registered apprenticeship program expenses and up to $10,000 in student loan debt repayment for beneficiaries.

When considering a 529 plan, there are two options:

  1. Education savings: In this case, funds may be used at any college or university of the beneficiary's choice.
  2. Prepaid tuition plan: If your beneficiary has their heart set on a particular college or university, a prepaid tuition plan may enable you to lock in the current tuition rate, adjusted for inflation, regardless of how many years are left until they enroll at the school. If the student decides to attend a different school, they can still use the 529 funds; however, they will have to pay tuition at whatever the rate is at the time of enrollment.

In the event that the beneficiary opts out of college, or doesn't use the full amount in their 529 plan, you can name one of their siblings (or another relative) to the account and that person can then use the funds without penalty.

One of the challenges to consider with 529 plans is that they don't offer much flexibility in how the funds can be used. If funds are withdrawn for anything other than education-related expenses, income taxes and a 10% penalty will be placed on the earnings. Your investment options are also limited to whatever the plan's sponsor offers; however, most provide several low-cost index options.

2. Trusts

Trusts provide more flexibility than 529 plans as the funds can be used for expenses outside of educational needs. As the trustee, you can define how and when the funds can be withdrawn and how the beneficiary may use them. Therefore, if you would like to specify that the funds can be used to purchase a car for school, but that they cannot be used to fund a vacation with friends, you can include that in the terms of the trust. You can also set age limits for distributions so that they receive portions of the money at set intervals rather than all at once.

Putting educational gifts into a trust may be advantageous as you won't be restricted in the types of investments you make and there are no contribution limits. Depending on the terms of the trust and how much you contribute, your gifts may count towards your annual gift exclusion amount but may also use up part of your lifetime gift exemption amount. While you likely won't owe any gift tax on the gift, you may need to file a gift tax return.

Although trusts can provide more flexibility than 529 plans, one of the challenges with trusts are the additional costs that are involved. First you will need to pay an attorney to draft the trust. Depending on who is named as trustee, there may be ongoing trustee fees involved. You may also want to hire a professional tax preparer to file the tax return for the trust. And lastly, trust tax rates are more onerous than personal income tax rates. In 2021, the top Federal income tax rate of 37% kicks in after only $13,050 of taxable income. Therefore, it's critical to work with your wealth advisor as well as your attorney when evaluating the terms, costs, pros and cons of using a trust to accomplish your gifting goals.

3. Custodial accounts

Custodial accounts are also more flexible than 529 plans. Similar to trusts, funds from a custodial account can be used for non-education expenses, and there are no contribution or investment limits. Custodial accounts are often chosen because they're easier and less costly to establish and administer than a trust, offering the best of both worlds.

If you're considering a custodial account, keep in mind that the custodian may only control the account until the child reaches the age of majority. From that point on, the child owns the account and may use the funds however they wish. If your intention is for the funds to be used for tuition but, they purchase a luxury car instead, there's not much that can be done aside from appealing to their long-term interests.

Earnings on a custodial account are also taxable. The beneficiary may owe on the income under the "Kiddie Tax," rules, so it's important to consult with your tax preparer on the implications of this route as well.

4. Outright gifts

Each of the strategies outlined above come with gift tax implications. Since each person is limited to giving away $15,000 to another each year, gifts over and above this amount count towards your lifetime gift exemption amount (currently $11.7 million per person). There are, however, a few exceptions to this rule. One of those exceptions is for payments of tuition directly to an educational institution. These do not count towards your annual or lifetime gift exemption amount. So, for example, you could write a $10,000 check made payable directly to your grandchild's college for her tuition, which does not count towards the annual exclusion, but then also give her an additional $15,000 that does.

Next steps

When considering the different options for educational gifts, you may find yourself leaning toward one of these strategies over the others. Whichever you choose, partnering with your wealth advisor, attorney and tax professional and gathering their insights through the process will be critical. Because your wealth advisor has a holistic understanding of your personal financial situation, your goals, and your "Why of Wealth, " they can help guide you in the right direction and provide additional context on these different options — helping to ensure that you make the best choice for you and your loved ones.

Each of these savings vehicles will allow you to make significant gifts to your loved ones and to support them in their pursuit of any educational needs. The right choice for your family will depend on the goals of you and the beneficiary, as well as your unique financial circumstances.

The views expressed in the article are those of the author and/or person interviewed and do not necessarily reflect the views of Silicon Valley Bank, a division of First-Citizens Bank and First Citizens BancShares, Inc. The materials on this website are for informational purposes only, are subject to change and do not take into account your particular investment objective, financial situation or need. Since each client’s situation is unique, you should consult your financial advisor and/or tax planning professional before acting on any information provided herein.