How Grandparents Can Save for Their Grandchildren

Grandparents often contribute to their grandchildren’s financial well-being for future education, significant life events, or a general head start. Various financial tools are available, each with specific features and considerations. Understanding these characteristics is important when planning financial support.

Savings Vehicles for Grandchildren’s Education

Saving for a grandchild’s education is a common objective, often involving 529 plans and Coverdell Education Savings Accounts (ESAs). These tax-advantaged vehicles offer distinct benefits for funding qualified educational expenses.

529 Plan

A 529 plan is a tax-advantaged savings plan for future education costs. Sponsored by states, these plans can be used for qualified education expenses at vocational schools, colleges, or graduate schools, including tuition, fees, books, and room and board. They also cover K-12 tuition, up to $10,000 per student per year.

Contributions to a 529 plan are made with after-tax dollars. Earnings grow tax-deferred, and qualified withdrawals are tax-free at the federal level. Many states offer income tax deductions or credits for contributions. While there are no federal annual contribution limits, contributions are considered gifts and are subject to federal gift tax exclusion rules. State-sponsored 529 plans have varying lifetime contribution limits, typically ranging from $350,000 to over $500,000 per beneficiary.

When a grandparent owns a 529 plan, they maintain control over assets, including investment decisions and beneficiary changes. Funds can be transferred to another eligible family member if the original beneficiary decides not to pursue higher education. Under current FAFSA rules, distributions from grandparent-owned 529 plans are not counted as untaxed student income for financial aid. To open a 529 plan, a grandparent needs the beneficiary’s name, date of birth, and Social Security Number, along with their own personal details.

Coverdell Education Savings Accounts (ESAs)

Coverdell Education Savings Accounts (ESAs) are another option for education savings, offering tax-deferred growth and tax-free withdrawals for qualified education expenses. Unlike 529 plans, Coverdell ESAs have a broader definition of qualified expenses, including elementary and secondary school costs such as tuition, books, supplies, and tutoring services. The annual contribution limit for a Coverdell ESA is $2,000 per beneficiary from all sources, making it a supplementary savings tool.

Contributions to a Coverdell ESA are made with after-tax dollars and are not federally tax-deductible. Earnings grow tax-free, and distributions are tax-free if used for qualified education expenses. Income limitations apply to contributors, with the ability to contribute phasing out for single filers with modified adjusted gross income (MAGI) between $95,000 and $110,000, and for joint filers between $190,000 and $220,000. Grandparents can open and contribute to a Coverdell ESA, maintaining control until the grandchild reaches the age of majority, typically 18 or 21, when the grandchild gains control of the funds.

For financial aid, a Coverdell ESA generally receives favorable treatment. If a grandparent owns the Coverdell ESA, the asset value is typically not reported on the FAFSA. To establish a Coverdell ESA, the grandparent needs the beneficiary’s name, date of birth, and Social Security Number, along with their own identifying information.

Savings Vehicles for Grandchildren’s General Use

Beyond education, grandparents may wish to provide financial support for a grandchild’s broader needs, such as a down payment on a home, starting a business, or general financial security. For these flexible goals, Uniform Gifts to Minors Act (UGMA) and Uniform Transfers to Minors Act (UTMA) accounts, as well as Custodial Roth IRAs, offer different approaches with varying degrees of control and tax implications.

UGMA and UTMA Accounts

UGMA and UTMA accounts are custodial accounts that allow adults to transfer financial assets to minors without establishing a formal trust. UTMA accounts are broader than UGMA accounts, permitting a wider range of assets like real estate, while UGMA accounts are typically limited to financial assets such as cash and securities. The adult opening the account acts as the custodian, managing the assets until the minor reaches the age of majority, which varies by state but is typically between 18 and 21. At this age, the assets automatically transfer to the grandchild, who then gains full control.

Contributions to UGMA/UTMA accounts are irrevocable gifts, meaning funds cannot be reclaimed by the grandparent. There are no specific annual contribution limits, but contributions are subject to federal gift tax rules. Earnings within these accounts are taxed to the minor, potentially at a lower rate. However, “kiddie tax” rules apply to unearned income above a certain threshold, taxing it at the parent’s marginal income tax rate.

UGMA/UTMA accounts can substantially impact financial aid. As student assets on the FAFSA, they can significantly reduce eligibility for need-based aid. Student assets are assessed at a higher rate than parental assets. To open an UGMA/UTMA account, the grandparent needs the grandchild’s Social Security Number and date of birth, along with their own identification.

Custodial Roth IRAs

A Custodial Roth IRA offers a distinct way to save for a grandchild’s future, primarily for retirement but with flexibility for other uses. To contribute, the grandchild must have earned income from employment. The annual contribution limit is the same as for a standard Roth IRA, or the total amount of the grandchild’s earned income for the year, whichever is less. Grandparents can contribute on behalf of the grandchild, provided there is sufficient earned income.

Contributions to a Custodial Roth IRA are made with after-tax dollars and are not tax-deductible. Earnings grow tax-free, and qualified withdrawals in retirement are also tax-free. Contributions can be withdrawn tax-free and penalty-free at any time. Earnings can also be used for qualified education expenses, though they would be taxed as income.

The grandparent acts as the custodian for the account, managing investments until the grandchild reaches the age of majority, at which point control transfers to the grandchild. For financial aid purposes, the value of a Roth IRA is generally not counted as an asset on the FAFSA. However, if withdrawals are made from the Roth IRA to pay for college expenses, these distributions will be considered untaxed income to the student on a future FAFSA, potentially impacting aid eligibility. Opening a Custodial Roth IRA requires the grandchild’s Social Security Number and proof of earned income, along with the grandparent’s identification.

Tax and Gifting Considerations for Grandparents

When grandparents provide financial gifts to their grandchildren, understanding associated tax and gifting rules is important. Federal gift tax rules apply to transfers of money or property for which the giver receives nothing, or less than full value, in return.

A primary consideration is the annual gift tax exclusion. This provision allows an individual to give a certain amount of money or property to any number of recipients each year without incurring gift tax or using their lifetime gift tax exemption. This annual exclusion amount is currently $18,000 per recipient. Married grandparents can combine their exclusions, effectively gifting up to $36,000 per grandchild annually without tax consequences.

Gifts within the annual exclusion do not need to be reported to the IRS on Form 709. If a gift exceeds the annual exclusion, the excess counts against the grandparent’s lifetime gift tax exemption, currently $13.61 million per individual. Federal gift tax becomes due only when cumulative taxable gifts exceed this exemption.

Another tax consideration is the Generation-Skipping Transfer (GST) tax, which applies to transfers of wealth to individuals two or more generations younger than the giver, such as grandchildren. This tax aims to prevent families from avoiding estate taxes by skipping a generation. For most gifts made within the annual gift tax exclusion, the GST tax is generally not an issue, as these gifts are typically excluded.

Making gifts to grandchildren can impact a grandparent’s estate. Gifting assets during their lifetime can reduce the size of a taxable estate, potentially leading to lower estate taxes upon the grandparent’s passing. The annual gift tax exclusion provides a mechanism to reduce estate value over time without immediate tax liabilities.