Last week, in part one of this series, we discussed 529 plans and education savings accounts, which are both popular options for saving for college education. One of the main reasons for their popularity is their tax-saving advantages. The money you contribute to a 529 account grows on a tax-deferred basis, and withdrawals are tax-free, provided they are used for qualified education expenses, such as tuition, room and board, and other education-related fees.
That said, one of the downsides of 529 plans is that they come with strict limits on how you can use the funds (for education-related expenses only), and they also have a limited range of options for how you can invest your funds, primarily in various mutual funds. For these reasons, 529 plans and ESAs aren't always the best fit for some families looking to save for their loved ones' education.
As we noted in part one, one alternative way to save for your offspring's higher education is by using an irrevocable trust. Although there isn't any income tax deferral on income earned by the assets held by these trusts, it is possible to structure a trust, so your beneficiaries could qualify for financial aid that they may otherwise be ineligible for with a 529 plan. Depending on your situation, qualifying for financial aid may prove even more valuable than savings on the income taxes owed on income earned by the trust.
Here in part two, we'll further discuss how these trusts work and why they may be an attractive alternative to 529 plans, if you are looking to save for your loved ones' education—whether that education is college or some other form of learning.
The Benefits Of Education Trusts
In addition to the issue of qualifying for financial aid, another benefit of such trusts is that you can not only save for a single child's or grandchild's education, you can also structure your trust to provide a pool of funds for the education of all family members. Moreover, when creating the trust, “education” can be broadly defined to include any type of learning institution or organization, such as trade schools, educational workshops, community colleges, and private academies, to name just a few options.
Furthermore, you can provide that the trust can pay for alternative education, such as travel, retreats, business building programs, and other nontraditional educational experiences, which may prove even more valuable than college. Bottom line: when you set aside money to educate your family with an education trust, you get to decide exactly how your beneficiaries can use the funds by what is most in alignment with your family values. And as part of creating your education trust, we will work with you to create a written set of guidelines for the trustee, who will be the person making decisions regarding distributions to the beneficiaries.
Trust Creation Options
In terms of how the trust is set up, you can create an education trust that is built into your revocable living trust or will, and as such, it would not get registered and funded until your death. Or you can create an education trust that exists and is funded during and throughout your lifetime. In either case, the disbursements from the trust are designated for a beneficiary or a pool of beneficiaries' education.
While you can stipulate how and when the funds are to be distributed inside the terms of the trust agreement itself, we would almost always provide the trustee with broad distribution authority and discretion (to maximize the asset protection benefits of the trust), and create a separate writing to provide guidelines on distributions, and then give a trusted person, or group of people, the right to remove and replace the trustee with someone else should your first choice not work out for any reason.
If a single trust is established for multiple beneficiaries, you can require the assets to be distributed in a number of ways. You can stipulate that the funds are divided equally among the beneficiaries, disburse the funds in a set amount, by percentage, or you can leave the decision as to how much each beneficiary receives to the trustee's discretion.
Education trusts typically aren't set up as tax-saving vehicles, as is the case with a traditional 529 plan, which does provide tax savings. That said, as we noted earlier, 529 plans have much more restrictive rules for how their funds can be used. Moreover, you could save on taxes with a trust if it is drafted in a way that allows the trust's income to be taxed at your beneficiary's tax rate, which could be significantly lower than your personal tax rate.
If you establish an irrevocable trust for education purposes, make sure you consider all of the tax impacts on income earned by the trust. For example, the trust would be taxed on income not distributed by year's end, but you can have the trust drafted to pay out all income to the beneficiary or include other provisions that cause the trust to be taxed to the beneficiary (even if income is retained).
That income would be taxed at trust tax rates, which could be higher than the beneficiary's rate—and possibly even higher than your personal tax rate—so it's important you are clear about whether income should be distributed before year's end for each year the trust earns income.
If the education trust is irrevocable, meaning that the gift cannot be taken back, and the amount contributed each year is less than the annual gift tax exemption ($16,000 in 2022), then no gift-tax return is required to be filed. Conversely, if the gift to the trust exceeds that amount, then you will need to file a gift-tax return, reporting the gift and using up part of your lifetime exemption of $12.06 million if single and $24.12 million if married filing jointly.
Since there are so many variables involved and different ways to set up an education trust, it's vital to reach out to us, your Personal Family Lawyer®, so we can walk you step-by-step through all of your options—and help you determine what's best for your unique situation.
Potential Problems To Keep In Mind
One alternative to these plans (both 529 plans and education trusts) is to use money that has been saved for other purposes, such as funds you have saved for your retirement. However, it's important to point out that using your retirement funds can affect your child's eligibility for various need-based financial aid programs. To this end, retirement funds withdrawn to pay college expenses are reported on the Free Application for Federal Student Aid (FAFSA) as additional income.
Consequently, when using retirement funds, the expected family contribution used from FAFSA will be higher, which will therefore reduce your child's chances of qualifying for financial assistance. Consult with us if you choose to tap into your retirement savings to fund college expenses, so we can ensure it's done right and will have the maximum benefit for everyone involved.
To ensure you get the most benefit from your savings, don't try to make these decisions on your own. As your Personal Family Lawyer®, we will work with you to determine the best way to set aside financial resources for the people you love, whether that's using a 529 plan, an education trust, or some other option. Contact us today to learn more.
This article is a service of Eric D. Cotton, Personal Family Lawyer®. We do not just draft documents; we ensure you make informed and empowered decisions about life and death, for yourself and the people you love. That's why we offer a Family Wealth Planning Session™, during which you will get more financially organized than you've ever been before and make all the best choices for the people you love. You can begin by calling our office today to schedule a Family Wealth Planning Session and mention this article to find out how to get this $750 session at no charge.