5 Money Conversations to Have With Your Kids Before They Go to College

Many grandparents are willing to help with college costs. One thing to keep in mind is that grandparent-owned 529s have a downside related to FAFSA, though there are workarounds.

There are several ways grandparents can help pay for a grandchild’s education without giving money directly to the student. Grandparents, parents, and students must understand each of the options before deciding which one may be appropriate for them.

For instance, they need to know whether the method they’re using jeopardizes a student’s prospects for need-based financial aid, or if it meshes well with the grandparents’ overall estate plan.

Here is a look at three ways grandparents can help fund a grandchild’s education, and the pros and cons of each:

1. Invest in a ‘529’ plan

Financial advisers often recommend the state-sponsored education-savings plans known as 529s to grandparents who want to help with college costs because of the many advantages this type of plan offers.

These plans, which invest mainly in mutual funds, offer tax-deferred growth on every dollar invested, and distributions are tax-free when used for qualified educational purposes. Grandparents can pick any state’s 529 plan, and some states even offer residents a tax deduction on contributions. These plans also are flexible in that any unused funds can be transferred to another grandchild or blood relative.

Grandparents can put as much as $15,000 a year ($30,000 if they are married) per grandchild in a 529 plan without triggering gift-tax consequences. Even better, they can “bunch” five years of annual $15,000 gifts into a 529 in one year without triggering a taxable event, a potentially attractive benefit for those seeking to reduce the size of their estates.

“To me, the 529 is the turnkey solution for college planning,” says Jeff Motske, certified financial planner and president of Trilogy Financial, a financial planning firm in Huntington Beach, Calif.

Grandparents have the option of owning the 529 themselves or contributing to a 529 plan owned by the parent for the benefit of the child. One advantage of owning the account is that you “can control where the money goes right up until the time it’s used,” says Jody D’Agostini, a certified financial planner with AXA Advisors’ Falcon Financial Group in Morristown, N.J. Grandparents can even use the funds for themselves, albeit with tax consequences, should a financial need arise, she says.

INVESTING IN FUNDS

There is, however, a downside to grandparent-owned 529 plans for families seeking need-based financial aid: Distributions count as student income on the Free Application for Federal

Student Aid, or FAFSA, and student income is weighted much more heavily than parental income in the aid formula.

There are some potential workarounds, however. One option is to switch ownership of the 529 to the parent around the time the grandchild expects to start college. Not every state’s 529 allows for a change in ownership, however, so this is something to explore before choosing a plan, Ms. D’Agostini says.

Another option is to wait until after Jan. 1 of the beneficiary’s sophomore year in college to take a distribution, says Mark Kantrowitz, publisher and vice president of research at Savingforcollege.com. Since the FAFSA now asks for income and tax information from two years back, there would be no FAFSA on which to report the distribution if the student plans to graduate in four years. (If the student expects to graduate in five years, the family should wait until Jan. 1 of his or her junior year to take a distribution, Mr. Kantrowitz says.)

The grandparent also could roll over up to a year’s worth of college expenses to a parent’s 529 plan after the FAFSA has been filed. Provided all of the funds are spent on qualified educational expenses, it won’t have to be reported on the next year’s FAFSA, Mr. Kantrowitz says.

Some grandparents may not want the responsibility of owning the account, preferring instead to contribute a certain amount each year to a 529 plan owned by the parent for the child’s benefit. This may be appealing to those who want to give small amounts of money each year—around $1,000 or less.

In this scenario, “your grandchild gets all the benefits without you having to worry about maintaining the account,” says Joseph Conroy, a certified financial planner and financial consultant with Synergy Financial Group, a wealth-management firm in Towson, Md.

The downside, of course, is the grandparent cedes control of the money to the parent.

2. Direct payment to an educational institution

Grandparents can write a tuition check for any amount directly to a qualifying college or graduate school without triggering gift-tax implications, says Eric Brotman, chief executive of BFG Financial Advisors, a financial planning and wealth-management firm in Timonium, Md.

Some grandparents like this option because they can pay the university directly and still give the grandchild an additional $15,000 tax-free.

Grandparents, however, can’t claim a charitable distribution for tuition they pay on a grandchild’s behalf. Also, this exemption to the IRS’s gift-tax rules applies only to tuition expenses and not to other college-related expenses such as books and supplies. Another consideration is that the money isn’t refundable if the student decides to switch schools, so it isn’t advisable for grandparents to prepay tuition for all four years. Also, grandparents should be aware that this type of payment could have an impact on the student’s eligibility for need-based financial aid.

3. Fixed-indexed universal-life insurance policy

Another, less-talked-about option for paying for college—albeit a controversial one—is using cash-value permanent life insurance.

One type that some advisers like is fixed-indexed universal-life insurance. Mike Windle, a partner, and financial adviser at C. Curtis Financial Group, a financial-planning firm in Plymouth, Mich., recommends this option because of the flexible premiums and upside potential without the downside risk.

To make this strategy work, the policy should be owned by the grandparent, with the grandchild as the insured, making the cost of insurance inexpensive, says Mr. Windle, who owns these types of policies and offers them to clients.

Having such a policy allows grandparents to contribute after-tax money in a lump sum—monthly, quarterly or annually. When the funds are used, they are considered a loan against the cash value of the policy. They are tax-free at distribution, and they don’t count as income or assets on the student’s FAFSA, Mr. Windle says.

He generally recommends fixed-indexed universal-life insurance policies to clients whose grandchildren are 8 years old or younger. The policies he recommends have no cost to the grandparent to withdraw funds (and withdrawals aren’t counted against the grandparent’s yearly gift-tax limit) if the loans from the policy occur in the 10th year of the policy or later, Mr. Windle says. If grandparents take a withdrawal before the 10th anniversary, it could cost them about 2% of the loan, depending on the insurance company, he says.

Though premium rates aren’t guaranteed, Mr. Windle says the additional cost for a child would be minimal and is likely to be offset in part by growth in the policy’s cash value.

Another benefit is that the money can be used for multiple purposes—it isn’t limited to education. And the policies have a death benefit if something happens to the child.

There are downsides to using life insurance as a vehicle for college savings, however, and not everyone thinks it is a good idea. An insurance policy can be pricier and the investment selections more limited than with some other options grandparents have for funding college, financial experts say.

Before purchasing a life insurance policy for college-savings purposes, grandparents should consider the type of insurance and return on investment, as well as applicable costs, to ensure it’s the best option for their situation.

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Written by: Kathryn Flynn | 529 plans are investment products designed to help families save for future education costs. A direct-sold 529 plan is a lower-cost, DIY option that can be opened online. Advisor-sold 529 plans must be purchased through a licensed financial advisor.

There are many advantages to using an advisor-sold 529 plan. According to a study by Fidelity, 67 percent of families who work with a financial advisor feel they have a good understanding of the best way to save for college, compared to only 40 percent of families who do not work with an advisor.

But financial advice rarely comes free, and college planning is no exception. Families who purchase a 529 plan through a financial advisor often pay a sales charge in addition to the plan’s underlying mutual fund fees. The amount of commission an advisor earns depends on the mutual fund share class selected within the 529 plan.

Under the suitability standard, broker-dealers must have a reasonable basis to believe their share class recommendations are suitable based on the client’s needs and investment profile. The Financial Industry Regulatory Authority (FINRA) recently launched a 529 Plan Share Class Initiative to improve the supervisory practices and procedure of broker-dealers who sell 529 plans.

Two areas of concern were brokers who were recommending share classes to beef up their commissions, and the change in tax code that made K-12 tuition a qualified 529 plan expense.

A Sneaky Sales Practice

Advisor-sold 529 plans offered through brokerage firms (Merrill Lynch, Morgan Stanley, UBS, etc.) are typically sold as Class A shares or Class C shares. Class A shares have an upfront sales charge (as high as 5.75%) and low annual fees, and Class C shares have no upfront sales charge with higher annual fees.

Generally, Class A shares are recommended for 529 plan beneficiaries who have a longer investment time horizon, since there is more time to absorb the cost of the upfront sales charge and the investor will benefit from the lower annual fee.

But, some advisors intentionally placed clients with young children in Class C shares to collect the higher ongoing sales charges.

Shorter Investing Time Horizons for K-12

As a general rule of thumb, some broker-dealer firms recommended Class A shares for all beneficiaries younger than 12 years old. This was considered a suitable investment since the child had at least six years until college.

However, the Tax Cuts and Jobs Act of 2017 allows families to use up to $10,000 per year of 529 plan savings to pay for K-12 tuition expenses. Families paying for K-12 tuition typically have a much shorter time horizon than those saving for college, and therefore have less time to absorb the cost of an upfront sales commission.

How Broker-Dealer Firms are Responding to the Initiative

Many broker-dealer firms now use a suitability questionnaire and breakpoint calculator to see which share class is the best fit. FINRA supplied firms with a framework for the calculator, which provides a recommendation for Class C shares or Class A shares based on the investor’s time horizon.

Jeff Motske, President at Trilogy Financial Services in Orange County, CA, says that some broker-dealers are very strict about share class recommendations. Advisors are expected to understand the client’s investment goal and time horizon and keep documentation.

“With these new rules and regs, you’ve got to be examining pricing as part of your planning practice with your clients or you’re just not meeting the standard,” says Motske.

Russ Ryan, formerly FINRA’s Deputy Chief of Enforcement and a partner in King & Spalding’s Special Matters and Government Investigations team, says that although the deadline to self-report violations to FINRA has passed, taking a look at a firm’s supervision is a good business practice.

“The initiative may be prompting brokers to ask more questions of their customers before they make a recommendation to make sure they really do understand all the facts and circumstances of the customer’s situation and making sure that they are recommending the right type of 529 share class,” says Ryan.

How 529 Plan Fees Affect Your College Savings

With almost any 529 plan, the investor pays annual mutual fund fees. Direct-sold 529 plans typically invest in passively managed funds (such as index funds) with very low expenses. However, many advisor-sold 529 plans invest in actively managed funds with expenses as high as 1% and come with an additional sales charge to compensate the advisor. A 529 plan's expense ratio also varies by share class.

Even a small difference in 529 plan fees can add up over time. For example, if you invest $100,000 in a 529 plan with a 1% expense ratio you would pay $1000 in fees. If you instead invest in a 529 plan with a 0.10% expense ratio you would only pay $100 fees that year.

And remember, a 529 plan’s annual expense ratio is based on a percentage of assets in the account. So, as your account balance grows you end up paying more in fees. The more you pay in fees, the less money you are investing for your child’s college education.

Alternatives to Broker-Sold 529 Plans

Advisor-sold 529 plans are also sold by registered investment advisors (RIAs). RIAs have a fiduciary duty to put their clients’ best interests first. Instead of Class A shares or Class C shares, some RIAs place 529 plan clients in no-load share classes, such as Class I shares. The sales charge is waived, and the advisor typically charges an hourly rate, or an AUM advisory fee based on the assets in the 529 plan.

But, not all RIAs charge for 529 plan advice. Matthew Murawski, a financial planner with Goodstein Wealth Management, LLC in Encino, California offers pro-bono college planning advice to clients. His firm recommends 529 plans with low-cost index funds, no sales charge and no asset-based fee.

In Murawski’s experience, consumers are generally unaware of 529 plan share classes and that they can usually get the same investment at a lower cost. He recently helped two clients roll existing 529 plan assets from Class A and Class C shares to lower-cost Class I shares.

“Even if we were charging for it, let’s say we had an asset fee on there, we would still be saving you an incredible amount of money over the lifetime of the 529,” he says. “Fees really add up over the lifetime of a 529.”

Another RIA option is U-Nest, a college savings app that determines an optimal 529 plan investment portfolio based on your child’s age and time horizon. The funds are invested in Class I shares of the CollegeBound advisor-sold 529 plan managed by Invesco. Instead of charging an hourly rate, there is a $3 per month fee to use U-Nest.

According to Ksenia Yudia, Founder and CEO of U-Nest, the app is ideal for low- to middle-income families who may not be comfortable investing in a direct-sold 529 plan.

“Direct-sold plans come with certain complications, meaning the clients need to be comfortable opening their own investment account without the help of a financial advisor,” she says. “They need to have at least some basic knowledge of finance and investing.”

Final Thoughts

Families should regularly review their 529 plan to make sure the investments are still appropriate for their situation. It's perfectly reasonable to ask your advisor about which 529 plan share class you are invested in, especially if you have concerns.

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