Editor’s note: This is the fifth article in a six-part series focused on paying for education using smart financial and estate planning. Part one is Direct Tuition Payments: A Tax-Efficient Way to Pay for School. Part two is 529 Plans: A Powerful Way to Tackle Rising Education Costs. Part three is Coverdell Education Savings Accounts: A Deep Dive. Part four is UTMA: A Flexible Alternative for Education Expenses and More. The final article will focus on family loans.
With the cost of education continuing to rise, it’s never too early to plan ahead and start setting aside funds for the education of your child, grandchild or other family members. Paying for education can be done through strategic financial and estate planning, but it is important to understand your options before deciding what makes the most sense for you.
As you explore smart saving strategies, setting up an irrevocable trust to fund education could be a valuable component of your estate plan. An education trust can be set up for a single beneficiary or multiple beneficiaries (i.e. all of the children, grandchildren, nieces, nephews, cousins, godchildren, etc.). When you set up a trust, the trust document specifies the intent, which can be as broad or narrow as desired. The grantor can decide to cover just tuition or include related expenses such as books, supplies, room and board, travel, etc. Likewise, the grantor can decide the age at which the assets may be used by the beneficiary for education or any other purpose.
The grantor may also include flexible terms to allow for the trust assets to be used for other purposes if the original beneficiary decides not to go to college or needs the money for a different purpose. Once the purpose of the trust is established, the trustee(s) have a fiduciary duty to uphold the terms even after the grantor passes away.
What to know about taxes
Assets placed in a trust are generally protected from creditors and lawsuits, providing a layer of security for the funds. They are also removed from the estate of the grantor, shielding them from estate tax. However, income earned in the trust is subject to income tax, and investment gains are subject to capital gains tax, making a trust less tax efficient than a 529 plan or a Coverdell. Depending on how the trust is drafted, income may be taxed at the trust’s tax rate or the grantor’s tax rate.
Contributions to a trust are subject to federal gift tax laws, although certain provisions can be added so the gifts, or portions of them, can qualify as an annual exclusion gift. If the beneficiary is granted certain withdrawal rights over contributions made to the trust (and specific notices are sent to the beneficiary when contributed), then the contributions will be viewed as a gift in the eyes of the IRS and can be counted toward the annual exclusion amount for the beneficiary in the year of the contribution. Even with such provisions, any amount over the annual exclusion amount will be taxable or count against your lifetime gift and estate tax exemption.
From an investment perspective, there are no restrictions (other than those specified in the trust documents) as to how the trust can be invested. The trustee(s) are responsible for investing the assets in a way that preserves them for the intended purpose, in this case paying for education. Depending on the time horizon, the assets may be invested in a range of asset classes and investment strategies.
As is the case with any trust, setting up and managing a trust can be more costly in terms of time and money. Appointing the proper person, or people, to serve as trustee is very important. This may make a trust seem less appealing for families who do not want the hassle of ongoing administration. (For more information on how to select the right trustee, please refer to our paper Who Do You Trust? Understanding Your Choices When Selecting a Trustee.)
Benefits of a trust to pay for education:
- Funds can be used however the grantor intends (and not just be limited to education)
- Trust assets are removed from the grantor’s estate
- Flexibility for the trust to be used for educational needs or other purposes, depending on trust terms
- Assets in a trust are protected from creditors and lawsuits
What to keep in mind when considering a trust to pay for education:
- Income earned in the trust is subject to taxes annually
- Contributions are subject to federal gift tax laws
- May reduce financial aid (trust is included in FAFSA calculation)
- Requires ongoing administration
- Cost of creating trust and tax preparation fees
Securing funds for education requires thoughtful planning, and an irrevocable trust can be a powerful tool in this strategy. By setting up a trust, you can tailor the terms to fit specific educational needs or broader financial goals, ensuring that the funds are used as intended. While there are tax considerations and administrative responsibilities, the benefits of asset protection and estate planning flexibility make it a compelling option. With careful management and the right strategy, a trust can create a lasting legacy for future generations.
My next article will be about using family loans to help pay for education.
