What's the Best Way to Set Up an Education Fund for My Grandchild?

Dear Carrie,

I'd like to set up an educational fund for my new grandchild. I understand the tax benefits of a 529 account, but am also interested in gifting appreciated stock. What are your thoughts?

–A Reader

Dear Reader,

Congratulations on your new grandchild! I also applaud your generosity. What a fortunate child to have such a supportive family.

You're also wise to weigh your options. A gift of appreciated stock can be a great way to fund education. On the other hand, as you mention, a 529 account has several advantages, but a 529 only accepts cash, not stock or other assets.

As is so often the case, the devil is in the details. Regardless of whether it's you or your grandchild who ultimately sells the appreciated stock, that person may be hit with a tax bill that can include not only federal capital gains tax, but potentially also net investment income tax and state taxes.

New rules under the 2020 SECURE Act repealed the changes under the Tax Cuts and Jobs Act of 2017 that had made gifting appreciated stock to a minor problematic. (Under the 2017 law, assets owned or sold under a child or grandchild's name were often hit with tax rates faster and higher than assets sold by a parent or grandparent. This is no longer the case.)

1. You can gift the stock in-kind and have it sold under the grandchild's name. Under this strategy, the child may pay less in taxes than the grandparent, thus increasing the size of the gift.
2. You can sell the stock and gift the after-tax proceeds to your grandchild. This can make sense if you pay lower taxes on the sale than your grandchild would.
3. Alternatively, you can make a gift of the stock to your grandchild at your death. This takes advantage of a "step-up" in basis, which means paying no taxes on any previous appreciation on the stock. In this way you may be able to make an even larger gift, but the downside is you won't be around to see it.

A big part of your decision will be based on the difference in the total tax burden for you versus your grandchild in selling the stock. In addition, you'll want to weigh the pros and cons of placing college funds in a custodial account versus a 529. Let's take a closer look.

When anyone sells stock in a taxable account, they may have to pay capital gains taxes on any appreciation from the sale. Whoever owns the stock is also subject to income taxes from dividends paid out when holding the investment.

The capital gains tax rate is based on how long the stock has been held. Appreciation on stock held for one year or less is taxed at ordinary income tax rates where the highest federal tax rate is 37 percent. On the other hand, long term capital gains (LTCG) rates that vary from 0-20 percent apply if the investment is held for more than one year.

Fortunately, when you gift property, your grandchild assumes your holding period. So, your grandchild doesn't need to wait another 12 months to sell the stock to be eligible for LTCG rates.

Note that single individuals with a modified adjusted gross income (MAGI) more than $200,000 and married filers with MAGI more than $250,000 will also owe an additional Net Investment Income Tax (NIIT)—sometimes called the Medicare surtax—of 3.8 percent on top of LTCGs.

While the current (2021) federal top marginal tax rate on LTCGs is a combined 23.8 percent, taxpayers also have to pay state and local income taxes on their capital gains income. The state tax rate can vary from 0 percent in states like Florida and Nevada that don't levy an individual income tax to as high as 13.3 percent in California. So where you and your grandchild live may be another variable to consider.

Don't forget that gift taxes may apply if the amount you are gifting is over $15,000 (2021). It is unlikely that taxes would be due, but check with your tax preparer about whether you should file a gift tax return.

Lastly, ask your tax and financial advisor about other taxes that could come into the picture when selling stock; for example, increased taxes on Social Security or Medicare.

The Kiddie Tax is a special tax rule for minors who have unearned income, such as interest or dividends paid by an investment. One of the main goals of gifting appreciated stock to grandchild or child is to "shift" the taxable income of that asset from a higher tax rate (yours) to a lower tax rate (your grandchild's). You could pay less in taxes to Uncle Sam, and your child would get a bigger gift. A win-win.

Under the SECURE Act, the first $1,100 of a minor child's investment income (interest, dividends, and other unearned income) is not taxed. The second $1,100 is taxed at the child's tax rate. After that (a total of $2,200), additional income is taxed at the parent's marginal tax rate (this is the Kiddie Tax).

A child is generally considered a minor for Kiddie Tax purposes if he or she is under 18 or a full-time student under age 24 at the end of the tax year.

If you decide to gift your grandchild the stock (as opposed to cash), you'll likely place it in a custodial account. Using a Uniform Gift to Minor's Account (UGMA) or Uniform Trust to Minor's Account (UTMA) gives you control over the assets, but only until the age of majority (usually 18-21 depending on the state).

At that point, though, you have to understand that your grandchild has full rights to spend the money any way he or she wishes. In other words, your grandchild might decide to use the money for a car, not college, and you have to be comfortable with that possibility.

Also keep in mind that assets held under the child's name, including UGMAs/UTMAs, are looked at less favorably than 529 assets if applying for financial aid.

Now let's look at a 529 plan. I've written about 529 plans extensively in the past, and I believe they provide a great tax-advantaged way to fund an education. In fact, they are the most popular education savings plan for savvy families for good reason. But as I mentioned above, 529 plans can only accept cash.

Still, the proceeds of the stock sale could ultimately be used to fund a 529. A grandparent- or parent-owned 529 has lots of pros, including the following:

• Provides for more control over the gift to ensure that it's is used for education
• Can be more advantageous if applying for need-based financial aid in the future
• May be eligible for a state tax deduction
• Offers tax-free growth on qualified distributions

That said, remember that 529 accounts are specifically designed for education costs. Under the SECURE Act, up to $10,000 can now be used to repay qualified student loans (for the beneficiary or any siblings). Be aware that some states may consider this a non-qualified distribution and may reclaim state tax benefits you received. Check with your tax advisor.

If you want your grandchild to be able to use the funds for something other than an education, a 529 account may not be the best choice. Withdrawals from a 529 that are considered "non-qualified" are subject to ordinary income taxes and a 10 percent penalty.

Rather than an "either/or" decision, you could open both a 529 plan and a custodial account, possibly funding different accounts in different years. In the future, a UGMA/UTMA could be used to cover expenses for your grandchild (like clothes, a car, summer camp or flights home from school) not covered by the 529.

Taking a completely different tact, you should understand that a gift of appreciated stock at your death results in a "step-up" in the cost basis, potentially greatly reducing the tax liability. This can be a good option, especially for older grandparents closer to the end of their retirement who might be able to make a larger gift of the appreciated stock as part of their estate.

As you can see, finding the best way to fund a grandchild's education can be complicated business. There are lots of moving parts so it's important to consider all your options before making a decision. Most of us will do well to work out the specifics with a tax advisor and financial planner. These experts can help you refine strategies such as the timing of the gift and tactically combining a 529 plan with a custodial account. Who knows, you may be able to give more to your grandchild than you think!

Have a personal finance question? Email us at askcarrie@schwab.com. Carrie cannot respond to questions directly, but your topic may be considered for a future article. For Schwab account questions and general inquiries, contact Schwab.