Helping Fund Your Grandchild’s Education

By Rick Shaffer

New Investment Tools Provide Options. Here’s What You Should Know.

Hoping to save enough to help pay for your grandchild’s college education while also saving enough for your retirement – whenever that may come or whatever it might look like? Good goals, but for many of today’s grandparents, probably not feasible.

The reason? Simple: cost.

Over the past 20 years, the cost of a college education has skyrocketed. Today, the average total cost for a four-year education at a public university is more than $40,000; at a private university, it’s more than $100,000. (What it will be 10 to 20 years from now is anyone’s guess.)
At the same time, as the overall cost of living continues to rise, and as people live longer and longer, the cost of retirement – or, more specifically, the amount one needs to save in order to live comfortably once no longer fully working – continues to rise precipitously.

Indeed, “experts” urge you to enter your retirement years debt free (especially on your home). In addition, they urge you to save 20 percent of your gross income each year toward retirement – a goal that many, if not most, people simply can’t reach.
As a result, most grandparents today have to face this stark reality: if you’re going to save enough for retirement, then the amount you can afford to save for your grandchild’s education is most likely going to be very small.

So, how do you pay for college education? For most families, the answer includes a lot of financial aid – mostly in the form of loans taken by the student once he or she gets to college – in addition to whatever amount can be saved before college. This makes it that much more important to get the best possible return on the amount you save.

Here, at least, there is some good news, in the form of Coverdell Education Savings Accounts and the 529 College Savings programs.

Coverdell ESAs

Originally introduced as “Education IRAs,” Coverdell Education Savings Accounts (ESAs) offer a number of benefits to parents and grandparents looking to save for higher education. The biggest benefit: although money invested is not tax deductible, it does grow tax free and is withdrawn tax free, as long as the amount withdrawn in a given year is used for qualified educational expenses and does not exceed the beneficiary’s qualified education expenses for that year. (Money invested in a Coverdell ESA that is not used for qualified education expenses is taxable and subject to a 10 percent penalty.) ESAs provide additional benefits including:

• Up to $2,000 can be invested per beneficiary annually (up from the original $500 limit on Education IRAs).

• Money can be used for expenses at virtually all college, university, vocational and other post-secondary educational institutions anywhere in the country.

• Money can also be used to pay for qualified educational expenses at private elementary and secondary schools.

• Money can be invested in virtually any investment vehicle, and the investment vehicle can be changed.

• Qualified educational expenses generally include tuition and fees, books, supplies and other necessary equipment and, in many cases, room and board.

Moreover, money invested in Coverdell ESAs is transferable to other immediate family members. So, for example, if one of your grandchildren decides not to go to college, the money can be transferred to another child (or even to yourself, if you’re going back to college).

Are there any drawbacks to Coverdell ESAs?

A few. Money invested in an ESA is considered an asset of the beneficiary (your child or grandchild), so it counts against them to a greater degree when applying for financial aid. (However, given that most financial aid comes in the form of loans, this drawback should not stop you from investing in an ESA.)

Next, under the legislation setting up Coverdell ESAs, ESAs can be set up at any bank or other qualified financial institution. However, because of the relatively small amount one can invest in an ESA each year, some financial institutions have been reluctant to set up and manage these accounts.

Finally, there are income limitations on who can contribute to an ESA. Generally, individuals with a modified adjusted gross yearly income over $110,000 (for married couples filing jointly, $220,000) cannot contribute to an ESA.

529 Plans

Most states today offer some form of 529 plan – so named after section 529 of the 1997 tax law. These plans are managed by a private investment, mutual fund or other large financial investment/management firm. While the specific investment choices will vary with each 529 plan, most offer a choice between various aggressive, conservative and middle-of-the-road portfolios of mutual funds, bonds and fixed investment vehicles. All 529 plans include most of the advantages of Coverdell ESAs, including tax-free growth and withdrawal for qualified expenses at almost any post-secondary educational institution in the United States.

529s also offer a number of advantages that Coverdell ESAs do not. These include:

• Much higher contribution limits. Limits vary with each 529 plan, but they are much higher than the $2,000 yearly ESA limit.

• No income limits on those who contribute.

• A large choice of plans. Virtually every state offers a 529 plan, and residents of one state are allowed to contribute to their own state’s and/or any other state’s 529 plan.

• State tax benefits, in some states.

• Flexibility of investment choices. Although this was not originally the case, most 529 plans now allow you to switch your portfolio distribution each year. This allows you to more actively manage 529 accounts by taking an aggressively invested 529 portfolio, which the portfolio should be when your grandchild is 10 to 15 years away from entering college, and progressively making it more conservatively invested, which it should be when your grandchild is less than five years away from entering college. (Some 529 plans will automatically reallocate portfolios in this manner.)

529s and Estate Planning

Finally, due to a relatively new change in legislation, 529 plans now offer more affluent grandparents an advantageous estate tax planning tool. Here’s how it works: Currently, estate tax law allows an estate tax exemption of $1 million on an individual’s total estate. Each year, every individual is allowed to gift up to $11,000 apiece to one or more people without lowering this overall estate tax exemption. (Gifts over $11,000 do lower the $1 million exemption.)

In a 529 plan, however, individuals can contribute up to $55,000 in a single tax year toward each grandchild’s (or nephew’s, niece’s, etc.) college savings without running afoul of the yearly estate tax $11,000 gift limit. (The $55,000 is allowed to be “spread out” into $11,000 “gifts” over a five-year period.)

What’s more, if you set up a 529 plan for a beneficiary, you retain control over the account and can take back the contribution at any time. Yet, so long as the “gift” is not revoked, the money is considered to be out of your estate and, therefore, not subject to estate taxes.

Moreover, so long as you designate yourself (rather than your grandchild) as owner of the 529 account, the money invested will not be considered part of the child’s assets and will not count against them when applying for financial aid.

Final Thoughts

Here are a few points to remember:

• Don’t save toward your grandchild’s education if that savings cuts into the amount you should be saving toward retirement. After college, children have many years of earning potential to pay back college loans. However, if you reach retirement without enough savings or income to live on, you will likely be faced with some very stark and difficult choices.

• If you can afford to save toward your grandchild’s education, and you’re fairly certain the child will attend private elementary or secondary school, fund a Coverdell ESA first.

• Recognize that there are many exceptions to the rules that apply to both Coverdell ESAs and 529 plans. So, before investing in either, read available literature on each program or plan you are considering, and seek the advice of your accountant or tax lawyer on the tax rules governing your investment.


For more information on both Coverdell ESAs and 529 plans, check the following Web sites:

• Internal Revenue Service –, the IRS guide to the “Tax Benefits for Higher Education” (Publication 970). – The Internet guide to 529 plans provides information, research and advice on how to best take advantage of this savings option.

Rick Shaffer is an attorney, writer and host of “The Money Show,” a call-in radio show.