Q&A: Here’s something you might not know about how colleges hand out financial aid

Dear Liz: After the pandemic started, we received money from the federal government and decided to put it in a custodial account for our son, starting when he was 14. We invested the money in a Standard & Poor’s index fund. I now think I made a mistake and should have simply added the money to the 529 college savings plan we have for him. Can I close the custodial account and transfer the money to the 529? If so, what is the process? Another benefit I see to doing so may be that the funds might not be considered in financial aid calculations. He will not qualify for aid based on need as we are financially well-off but he may qualify for aid based on merit.

Answer: You can transfer the funds from a custodial account, but contributions to 529 college savings plans have to be made in cash. That means you’d have to sell the index fund, which likely means paying a tax bill on the gains.

If your primary concern is financial aid and your family won’t qualify for need-based help, then there may be little reason to incur that tax bill right now. The merit aid you’re hoping to get won’t be affected by where you save. Merit aid isn’t based on your financial situation but is instead an incentive to attend the school and reflects how much the college wants your kid.

Need-based aid, by contrast, can be profoundly affected by custodial accounts, which are considered the student’s asset. Because 529 plans are treated much more favorably by need-based formulas, a transfer could make more sense. If there are a lot of gains in the custodial account, though, parents would be smart to get a tax pro’s advice before making this move.

With college expenses looming, consider picking up a copy of “The Price You Pay for College: An Entirely New Road Map for the Biggest Financial Decision Your Family Will Ever Make,” by New York Times personal finance columnist Ron Lieber. The book offers a comprehensive but readable guide to a fraught, potentially expensive process.

Q&A: College expenses and 529 plans

Dear Liz: You’ve been writing about what to do with leftover money in 529 college savings plans. Our grandchild went to a great state university with low tuition. To manage this ahead of time, we have carefully withdrawn some “excess” funds every year. This must be payable to the beneficiary student. The tax on non-qualified distributions applies only to earnings, not contributions, and will be negligible while the student is in college and has no or very low income. We paid for our CPA to prepare the tax filings. We have used this to pay for “non-eligible” living, travel and other expenses. I also recommend that parents start a college savings account in addition to a 529, because the strict definition of eligible costs leaves out a lot of expenses.

Answer: Previous columns have mentioned that withdrawals from 529 plans can be tax free when used to pay qualified expenses, which include tuition, fees, books and certain living costs, such as on-campus room and board or off-campus living expenditures up to the college’s “cost of attendance” limits, which are listed on its site.

Other common expenses, such as transportation and health insurance, typically aren’t considered qualified. Withdrawals that aren’t qualified will incur not just taxes on the earnings portion of the withdrawal but also penalties. The federal penalty is 10%, said Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting.

Your approach could be a good way to use up excess 529 funds, as long as you’re reasonably sure your grandchild won’t need the money for graduate school and you’re not interested in other options, such as naming another family member as beneficiary or rolling up to $35,000, subject to annual contribution limits, into a Roth IRA for your grandchild. (The Roth rollover option is new this year and applies only to accounts that are at least 15 years old. In 2024, up to $7,000 can be transferred for someone under 50, assuming they have at least that much earned income.)

As you noted, it’s important to ensure the non-qualified withdrawals are paid to the student if the idea is to minimize the tax bite. Otherwise the taxes would be calculated based on the account owner’s tax rate.

“If the grandparents kept the excess earnings, it would be taxed to the grandparents plus a 10% penalty, so it would almost always be the case that it would be better to have the excess funds paid to and taxed to the beneficiary,” Luscombe said.

Q&A: There’s a new option for leftover funds from a 529 college savings plan — your kid’s retirement

Dear Liz: We put four kids through college using 529 college savings. All four are out of college with good jobs and we have about $50,000 left over. Would you suggest just letting it build for the grandkids’ college in 20 to 30 years? The amount should grow considerably in that time and may pay for all the grandkids’ college expenses as well.

Answer: You have a number of options with leftover 529 funds, including eventually changing the beneficiaries to your future grandkids. Since none have been born yet, and may not be for a while, you can just leave the accounts alone to grow for now.

In addition to paying qualified college education expenses, up to $10,000 per year of 529 funds can be used for private school tuition for kindergarten through 12th grade. In addition, up to $10,000 per beneficiary can be used to repay student loans.

If you do decide to earmark funds for the grandkids, you may want to think about the best way to divide the money. You may not know for a while how many grandkids you’ll have. It’s entirely possible for the first grandchild to reach college age before the last one even comes along.

Another option that’s new this year is to use the leftover 529 money to fund Roth IRAs for your children, the original beneficiaries. If the account has been open at least 15 years, each year you can roll over an amount equal to the contribution limit, which for 2024 is $7,000. (The lifetime rollover limit for each beneficiary is $35,000.) This assumes the beneficiary has earned income at least equal to the rollover amount.

Q&A: Using 529 accounts on groceries

Dear Liz: You said 529 accounts could not be used for groceries. I searched on the internet and found that students can use 529 money to purchase meals off campus and buy groceries. Which is correct?

Answer: The original letter writer’s child lived on campus, so the amount the family can withdraw tax free from the 529 account is limited to what they spent on a campus meal plan. Grocery runs and restaurant meals aren’t covered.

Once the child moves off campus, the family can use the college’s official “cost of attendance” figures to determine the maximum they can withdraw tax free to pay for food. The child should keep all receipts as proof to back up the withdrawal.

Please be careful about assuming that the results of any internet search are reliable, especially if artificial intelligence is involved in creating — or inventing — the answer. Tax law can be particularly tricky to interpret, which is why I rely on tax experts such as Mark Luscombe, principal analyst for Wolters Kluwer Tax & Accounting, who helped with the original answer.

Q&A: A capital gains surprise

Dear Liz: My son has decided to settle abroad and wants to purchase a home. I made a gift of stock valued at $17,000, which had significant gains. My broker indicated that giving him the stock would avoid capital gains on my part, and he could cash the stock in at that value, also without accruing capital gains. Our CPA is now telling him that he will, indeed, have to pay the capital gains. What’s the real scoop?

Answer: It shouldn’t be a scoop that the person who does taxes for a living gave you the correct answer.

When you gave your son the stock, you also gave him your tax basis — essentially, what you paid for the stock. Once the stock was sold, your son owed taxes on those gains.

Q&A: Trusts and taxes

Dear Liz: My parents set up a family trust, which my brother and I have now inherited but not fully distributed. Included in that trust was the understanding that $130,000 would go to my daughter who is now 23. She has not received any of the money yet but would like to receive it within the next year for a down payment on a house. Would it be better to give her half the money this calendar year and half next year, or give her everything at once? I’m thinking there may be tax breaks for first-time home buyers that would offset the tax burden that a sudden increase in income from the inheritance would cause. She has been living on her own for several years and has a full-time job earning about $52,000 per year. She is already taking advantage of her company’s 401(k) match.

Answer: The inheritance won’t be considered income and isn’t taxable as such. Of course, any money the inheritance earns would be taxable. So if your daughter parks the money in a high-yield savings account while she looks for a home, she would pay income tax on any interest earned.

There also isn’t currently a first-time home buyer federal tax credit, although many states have various programs to help people buy homes. These typically do have income limits, although, again, the inheritance itself wouldn’t be considered part of her income.

Before you distribute the money, however, get clear on what exactly the “understanding” is about this money. If the trust clearly states this amount goes to your daughter, that’s one thing. If this money has been allocated to you, however, and you’re complying with your parents’ unwritten wish, you may have to file a gift tax return when the money is distributed. (Gift taxes won’t be due unless you give away millions in your lifetime.) An estate planning attorney can advise you.

Q&A: Social Security survivor benefits

Dear Liz: My husband died 10 years ago. He had a good salary for many years. I just turned 60 and have been told that I may now claim Social Security benefits as his widow. He has a minor child from another relationship. If I claim survivor benefits now, will it diminish the benefits his child now receives?

Answer: No. If you’re still working, however, your benefit will be reduced by $1 for every $2 you earn over a certain limit, which in 2023 is $21,240. The earnings test disappears once you reach full retirement age, which is 67 for people born in 1960 and later.

Also, you’re allowed to switch from a survivor benefit to your own and vice versa. That flexibility is unusual, and could allow you to let your own benefit grow until it maxes out at age 70. You may want to consult a fee-only financial planner or a Social Security claiming strategy site for advice.

Q&A: Paying a grandchild’s student loans

Dear Liz: Regarding the grandparent who would like to pay off a grandchild’s student loans.

You wrote that paying off the loans would be considered a gift. However, if the grandparent paid the funds to the institution that originated the student loan, would it then not be a gift? This would exempt the grandparent from filing the gift tax return.

Answer: You may be thinking of the unlimited exception for a family member’s medical expenses or education. Unfortunately, payments made to a student lender aren’t included in this exception.

Normally, any gift that’s larger than the annual gift exclusion limit — which is currently $17,000 per recipient — would require filing a gift tax return. Gift taxes aren’t due, however, until the amount given away over the annual limits exceeds the lifetime gift and estate exemption limit (which is currently $12.92 million). Clearly, someone has to be quite wealthy, and quite generous, before gift taxes are a concern.

But even the necessity to file a gift tax return can be avoided for larger gifts if you’re paying someone else’s education or medical expenses. The unlimited exception for these expenses, however, applies only to tuition payments made directly to the educational institution and payments for medical care made directly to a healthcare provider. Payments to other parties, such as lenders or insurance companies, aren’t included in this exception.

Q&A: What’s the best way to save for education? A 529 plan or I bonds?

Dear Liz: Please write a comparison of 529 college savings plans versus using I bonds for education. I had given baby gifts of 529 funds to grandkids before they had their first birthdays. But due to market volatility, this year I matched those with I bond funding for the kids. The oldest is now 6, so there is time to get past penalty issues for withdrawals should they use these for education, as I hope they will.

Answer: As mentioned in previous columns, 529 college savings plans are a flexible, tax-advantaged way to save for education costs.

Money can be used tax free for private kindergarten through 12th grade tuition as well as qualifying college expenses. Plus, up to $35,000 of leftover funds can be rolled over into a Roth IRA.

Accounts owned by parents have minimal impact on financial aid, and accounts owned by grandparents aren’t included in federal financial aid calculations at all.

College savings plans typically offer an array of investment options, including age-weighted funds that get more conservative over time. The ability to invest the money means you have a good shot at generating inflation-beating returns over time, but you also have to deal with some ups and downs in the markets.

I bonds — technically, I Series Savings Bonds — have advantages as well.

These are government-issued bonds, so you can’t lose your principal, and they are designed to help investors keep up with inflation. I bonds earn a fixed rate for the 30-year life of the bond, which is currently 0.4%, plus a semiannual variable rate pegged to inflation (currently 3.24%).

The composite rate formula for I bonds issued from November 2022 through April 2023 is 6.89%. In the previous 6 month period, bonds paid 9.62%.

The interest is added every six months to the bond’s value, rather than paid out, so bond owners can defer federal taxes until the bond is cashed in. (I bonds are exempt from state and local taxation.) And the interest can be tax free if the bond proceeds are used to pay for certain higher education costs.

Getting that tax-free treatment is somewhat complicated, however.

First, the bonds would need to be owned by the parents rather than you or the grandkids. Qualifying college expenses must have been incurred by the bond’s owner, the owner’s spouse or a dependent listed on the owner’s federal tax return.

There’s an age restriction too: The bond owner must have been at least 24 before the bonds were issued. The ability to get the exclusion ends if modified adjusted gross income is above certain limits (in 2022, it was $100,800 for singles or $158,650 for married couples filing jointly).

I bonds have other restrictions. No withdrawals are allowed in the first year of ownership. Any withdrawals made within the first five years trigger a loss of three months’ worth of interest income.

People can buy $10,000 of electronic I bonds each year, plus they can use their tax refunds to purchase an additional $5,000 of paper I bonds.

I bonds are certainly a reasonable alternative for college savings, but the various restrictions on their purchase and use may make 529 college savings plans a better option for many families.

Q&A: Why you need to pay attention to your credit utilization

Dear Liz: Recently my granddaughter gave birth to twins. I’d like to put $500 into a trust for each of them to mature when they are 18. I’m hesitant to set up an education fund in case they decide not to go on to college. I would like something that includes growth and safety, the least amount of cost and minimal tax consequences. Is there something you could recommend?

Answer: A trust would be overkill, given the relatively modest amount you have to contribute. Consider instead setting up 529 college savings plans, which provide the benefits you’re seeking, including some flexibility in how the money is spent.

The money you contribute can be invested to grow tax-deferred. Withdrawals are tax-free when used for qualified education expenses, which include costs at vocational and technical schools as well as colleges and universities. In addition, up to $10,000 per year can be used for private school tuition for kindergarten through 12th grade. If a beneficiary doesn’t use the money in their account, the balance can be transferred to another close relative. The account owner (you) also can withdraw the money at any time. You would pay taxes on any earnings plus a relatively modest 10% penalty.

Legislation passed at the end of last year offers another option: Money that’s not needed for education can be transferred to a Roth IRA, starting in 2024. After an account has been open at least 15 years, the beneficiary can start rolling money into a Roth. The amount rolled over can’t exceed the annual contribution limit (which in 2023 is $6,500), and the lifetime limit for rollovers is $35,000.

These plans are offered by the states and operated by various investment companies. You can learn more at the College Savings Plan Network.