Helping Adult Children Financially: Part 2 - Education Expenses

Education is an area in which parents often help their children by covering the costs of schooling, anywhere from preschool to undergraduate college studies and beyond. However, the amount parents are willing to pay for education depends not only on an individual parent’s ability to pay but also on their philosophy about how much the cost children should handle on their own at a given age. For example, expectations for a 25-year-old to shoulder more of the cost would likely be much higher than for an adolescent.

Nevertheless, the cost of education, particularly at the post-secondary level, has exploded in the past 60 years. As noted in 5 Reasons Your Adult Children May Need Help Financially, the average annual undergraduate college tuition cost more than tripled from 1963 to 2020. When parents attended school, the proportion of those able to say, “I worked my way through college” was much greater. Today, adult students may need parental help to make it through to graduation.

Some ways parents can assist their adult children with education costs are:

• Direct payments, including savings from 529 plans
• Cosigning or paying off student loans
• Paying for grandchildren’s education costs

Direct Payments

A parent can pay some or all of the student’s costs. Payments can be made to the student, who then pays the costs, or the parent can pay the educational institution directly or some combination of the two. Paying the institution directly has some definite benefits.

First, it provides certainty that the money pays bona fide education costs. Second, as will be covered in more detail below, money from a 529 plan must be paid directly to the institution by law. Third, tuition expenses paid directly to a qualified educational institution are classified as an exclusion from gift tax calculations. However, in the gift tax case, the instructions for IRS form #709 point out, “No educational exclusion is allowed for amounts paid for books, supplies, room and board, or other similar expenses that are not direct tuition costs.” Also, contributions to a 529 plan (see the next section) do not qualify for the educational gift tax exclusion.

The parent and student should agree on the amounts, timing, and payment methods beforehand. Efforts should be made to find the most accurate cost information so parents know what their contribution is covering and to reduce the student’s risk of needing more funds before the school year ends.

529 Plans

A smart way to accumulate money for education expenses is a 529 plan, an account that can be used to pay for education costs for kindergarten through graduate school students. At the end of 2022, Forbes magazine reported there were over 15.9 million 529 accounts in the U.S., with a total asset value exceeding $387 billion and an average account balance of $25,903.

Tuition, fees, room and board, and related costs qualify as allowable expenses payable from 529 funds. Also, thanks to the SECURE Act of 2019, money in a 529 plan can pay for registered apprenticeship program costs and student loan repayments of up to $10,000 for account beneficiaries and their siblings.

Although 529s were added to the federal tax code in 1996, the fifty states and the District of Columbia administer the plans. Consumers can open 529 plans directly with a state or via a broker or financial advisor. Each account has one specific beneficiary, so, for example, a family with multiple children would need to open a 529 for each. Generally, anybody can open a 529 plan for any beneficiary. However, the rules and fees of 529 plans differ by state, so it’s prudent to know all the details for the state administering your 529.

One of the premier attractions of 529 plans is that they are “tax-advantaged” since no taxes are paid on savings as they grow, and withdrawals are not taxed when used for qualified education expenses. Also, starting in 2024, as much as $35,000 in funds left over after paying for educational expenses can be rolled into a Roth IRA account, assuming the 529 account is at least 15 years old. Another advantage is changing the beneficiary on an account without paying taxes.

There is no yearly contribution limit for 529 plans. However, states place a cap on the total amount that can be put in during the life of the account, ranging from $235,000 to $550,000.

A 529 can be one of two plan types: prepaid tuition and savings.

A 529 prepaid plan allows in-state savers to “lock in” tuition at a specific post-secondary institution at the rates existing when the account was opened. Unlike 529 savings plans, prepaid tuition plans do not apply to K-12 schools.

Prepaid accounts are available from nine states, usually only for tuition and fees at public state schools. Some private colleges also offer prepaid tuition programs, but these operate outside the boundaries of state plans.

The significant advantage of prepaid plans is the assurance that enough money will be available when college costs are payable. The downsides of prepaid plans are that a specific institution must be chosen ahead of time, costs like room and board are not covered, and the federal government and some states do not guarantee funds in a prepaid plan.

Prepaid paid plans represent only a small percentage of all 529s, with savings plans comprising the vast majority of accounts. Money deposited in a savings plan is typically held in mutual funds, but other investments could include stocks, bonds, and guaranteed investment contracts. A saver selects the types of investments depending on their specific situation. For example, a popular type is an age-based portfolio in which high-risk/high-reward investments are used when the beneficiary (the student) is young. As the beneficiary ages, the investments become more conservative, making them less likely to lose value when the time to disburse the funds is near.

There are some disadvantages to 529 savings plans:

 Limited investment choices – depending on the state, the range of investment options may be limited in terms of variety or low-fee alternatives.

Lack of uniformity across states – The federal tax laws that created 529s allow a lot of flexibility in how states set up their programs. For example, some allow state tax deductibility for their plans, but other states don’t offer this feature. These differences force consumers to evaluate a daunting array of alternatives.

Strict plan rules – Funds from a 529 plan are limited to a specific list of educational expenses. Should funds be misused, investment gains on the funds are taxed at the regular capital gains rates plus a 10% penalty.

Federal student aid impact – When applying for financial aid, funds in 529 plans reduce a student’s eligibility to receive financial aid.

High fees – 529 plans differ in terms of fees, which reduce investment earnings. It pays to compare fees between different plans.

Perhaps because of these disadvantages, only 20% of U.S. parents use or plan to use 529 plans to fund education. For lower-income parents in 2023, a 529 might not make sense anyway. A couple filing jointly would pay no long-term investment capital gains taxes if their modified adjusted gross income comes in below $89,250. Therefore, they could save just as effectively with a non-529 account.

Helping With Student Loans

Student loans are a necessary evil for many who seek a higher education degree. As noted in 5 Reasons Your Adult Children May Need Help Financially, current student loan indebtedness stands at $1.77 trillion with an average monthly payment of $503, which the typical borrower will pay for 20 years.

Most recently, because of the COVID-19 pandemic, the federal government paused loan payments and set interest rates to 0% for eligible federal student loans from March 13, 2020, until September 1, 2023, with payments resuming October 1, 2023. As a result, many parents are inclined to help reduce the pain of student loans for their adult children in three ways:

• Cosigning
• Helping to pay off student loans
• Taking out a parent loan

First, it’s important to understand the types of student loans. The two basic loan categories are federal and private loans.

Federal loans are subdivided into four types:

Subsidized loans – Such loans are for undergraduate students demonstrating financial need, which is determined by comparing expected educational costs versus how much the student’s family can pay. These loans typically have the best terms compared to other student loan types. One significant advantage is that the federal government will pay interest payments while the student is in school and six months after graduation.

Unsubsidized loans – This loan type differs from a subsidized loan because it is available to undergrad, graduate, and professional students, and there is no requirement to demonstrate financial need. Undergrads pay about the same rates as subsidized loans but are responsible for all interest payments.

PLUS loans – PLUS loans can be taken out by graduate or professional students (Grad PLUS Loans) or by the parents of dependent undergrad students (Parent PLUS Loans.) The amount that can be borrowed depends on educational costs and how much financial aid the students receive. PLUS loans require a credit check, but a bad credit score may only result in a cosigner requirement.

Consolidation loans – These loans roll the indebtedness of multiple federal student loans into one fixed-interest rate loan. While there are no fees to consolidate, borrowers may pay higher interest and lose advantages like loan forgiveness or cancellation eligibility.

Private student loans are available through multiple sources, most commonly banks and credit unions. Private loans require credit checks and generally have higher rates and more fees than federal loans. Most private loans require a cosigner since students rarely have high enough credit scores.

Private loan lenders often have stricter rules than those for federal loans. For example, loan forgiveness or postponement are usually not available. Also, while such loans cannot be combined into a federal consolidation loan, refinancing in the private market may be an alternative.

As noted above, cosigning is a way parents can help with student loans. Even if a cosigner is not required, it may result in a lower interest rate due to a cosigner’s superior credit history. However, cosigning means the cosigner is on the hook if the student fails to pay the loan. The borrower and the cosigner must clearly understand this fact before agreeing to proceed.

Another route a parent can take is to help the student make loan payments. Here are some things to consider:

Can You Afford to Help? – At the outset, it’s important to honestly assess your ability to help with payments without jeopardizing your financial health. Sacrificing your retirement savings or putting off paying your own high-interest debt can be risky. The best strategy is to organize your finances to maintain fiscal stability and help with whatever funds are left over.

Be Smart About Making Payments – Make sure the way you pay is both efficient and effective. Consider setting up automatic payments from your bank account so none are missed. Also, biweekly payments might be more effective than monthly payments. For example, if a monthly $400 payment is instead paid $200 every two weeks, the loan will be retired sooner.

Make Payments Before Graduation – Many student loans do not require payments to start until after a six-month grace period post-graduation. However, loan interest accrues from day one of the loan, thereby adding to the total amount due for repayment. A parent making payments before the end of the grace period can reduce the total debt the student will face when post-grace period payments start.

Match Your Student’s Payments – A great way to share the payment burden is to match your adult child’s monthly payment. (You could even alternate biweekly payments to pay off the loan faster, as noted in #2 above.) This could motivate the student to pay more than the minimum each month.

Help With Non-Loan Expenses – Helping with other expenses like groceries or a cell phone can free up funds for the student to make loan payments

Loan Payments as Gifts – Consider making loan payments as holiday or birthday gifts. Also, if a parent receives a windfall like a work bonus or unexpectedly high tax refund, these funds could be directed to loan payoff without jeopardizing the parent’s regular financial obligations.

Refinancing/Consolidation – If the student has federal loans, a consolidation loan might help. If refinancing private loans is an option, a parent could cosign, thereby reducing the interest rate and helping to make payments.

Parent Loan – One of the most profound commitments a parent can make is to take out a parent student loan. According to Sallie Mae, a public corporation that handles private student loans, about one-fifth of parents borrow to pay education expenses. The federal loan option noted above is the Parent PLUS loan. There are also private parent student loans. Other alternatives are home equity loans and borrowing from a 401(k). To re-emphasize the point made in #1 above, parents need to carefully analyze their ability to help adult children. Taking on long-term debt cannot be made without careful forethought. It might be better to simply help the student make payments rather than shoulder the legal obligation of a loan contract.

As a final note for parents helping with loan payments, be aware of the gift tax rules mentioned in Helping Adult Children Financially: The Basics. Whereas payments made directly to an institution for tuition are excluded from gift tax calculations, student loan payments are not. The only exception is if the lender is the school itself. Consult a CPA or a tax professional to determine how your payments will be treated.

Paying for Grandchildren’s Education

One way parents can support their adult children on the education front is to provide funds for grandchildren’s education. The assumption is that adult children's finances are freed up by helping with grandkids’ education expenses.

Ideas for doing this are:

Set up a 529 for grandchildren – As noted above, there are no restrictions on who can set up a 529 plan for a given beneficiary.

Paying for Preschool – Funds for preschool tuition are excluded from gift tax calculations. This applies only to preschools qualifying as bona fide educational institutions, not typical daycare providers. On the other hand, if a grandparent’s annual contribution to preschool or daycare is under $17,000 for 2023, then no gift tax paperwork is required.

Helping with Student Loans – If grandkids are college-age, most of the ideas noted in the section above apply to grandparents who want to help pay or cosign for student loans.

Helping to pay for education is one of the most satisfying ways a parent can help their adult children get ahead in life. However, it needs to be done with eyes wide open to all the options available and the implications for the parents' finances to ensure the best decisions for both student and parent.