How to Pay for College: Creating a Family Trust

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The concept of putting away money in a “family trust” may conjure up images of yachts and country clubs, but it can be a useful tool for some students and their families when it comes to saving for college.

A trust involves three people: the grantor, who creates and puts assets into the trust; the trustee, who manages the trust; and the beneficiary, the recipient of the funds.

Like a custodial account, a trust can transfer assets from the parent’s tax bracket to a child’s tax rate, says Kathryn Murphy, co-author of Estate and Trust Administration for Dummies.

“Income on assets in the trust is taxed to children if distributed to children, at presumably lower income tax rates than parents,” she says. “If [the assets are] not distributed to children, the income is taxed to trust at a higher trust income tax rate and capital gains taxed to the trust are [taxed at] 15%.”

Family trusts can offer flexibility with advantages like unlimited investment options, the ability to change the beneficiary of the trust, and the fact that the trustee can control when the beneficiary receives the trust’s assets. Murphy explains that the trust can pay out all of the income for a child’s benefit, or there can be income payments made out in the discretion of the trustee.

“Payments of principal can be made totally discretionary, but examples of types of discretionary payments can be given; for college education, purchase of a home, and medical expenses,” says Murphy. “The trust can be set up for children's lifetimes or to distribute all [of the assets] when a child attains a certain age [as determined by the trust].”

Advantages of a Family Trust

For families who want some wiggle room in how the beneficiary (usually the child) is able to use the money, a family trust could be a good way to keep your options open, according to Daniel Nigito, vice president of Merion Wealth Partners and author of The Power of Leveraging the Charitable Remainder Trust: Your Secret Weapon Against the War on Wealth.

“The trustee can use the money for the child’s education, health, or maintenance, and that gives the trustee the freedom to absolutely have to give the money for education if the child wants it, but they could also use those funds to do other things,” he says. “What if the child doesn’t want to go to college and wants to go to a different type of school or go into a trade or wants that money to use to start a business?”

A properly designed trust can be used to accumulate family wealth and make use of a trustee’s expert investment services, who can use their discretion to create the terms of the trust, says Connie Fontaine, chartered financial consultant and professor at the American College.

“Family trusts can be quite useful estate planning devices for many reasons, probably the greatest of which is to reduce the size of the grantor’s estate,” she says. “They are popular because assets can be given to the beneficiaries without giving the beneficiaries outright control.”

If parents want to make a gift to their children in the form of a trust that still qualifies for the annual gift tax exclusion ($13,000 per person or $26,000 if filing jointly), parents must structure it so that the gift includes enough of a present interest to take advantage of the exclusion, says Murphy, which can be done with what is called a “Crummey trust”.

“[It] is structured to create a brief window of time (30 days) during which the beneficiary has the right to withdraw the gift, after which time the right to withdraw lapses,” says Murphy. “When the gift is made to the trust, the beneficiary must be notified of this right of withdrawal (it is assumed the child will not withdraw the gift). Once the right of withdrawal lapses, the parent is left with all of the benefits of having transferred the gift to a trust, rather than outright to a child, but is able to use the annual gift tax exemption.”

For families who want to protect the money in a trust from creditors looking to go after a child’s debts, a spend thrift provision can be enacted.

“The beneficiary of that trust cannot use that money and assign it for debt or anything else, no one else can attach it,” Nigito says.

Disadvantages of a Family Trust

For families who have the financial capabilities to set up a trust for their children, the experts say that more than likely the financial aid eligibility for that child will be affected.

“The income and principal of a trust for the benefit of a child will be counted as assets of the child for FAFSA purposes,” says Murphy.

Another aspect to consider is that once the family trust is established, it is irrevocable—the grantor cannot take back the assets.

“In some cases, the grantor’s estate could have a future liquidity problem,” says Fontaine. “In addition there are income tax and gift tax consequences that may result from these trust arrangements—with the qualified personal residence trust, if the grantor does not survive the selected term, no estate tax benefits will be realized.”

Murphy explains that only families with substantial assets to incur estate tax on assets over $5 million are in a position to invest in a family trust and that those families should seek the advice of tax and estate planning professionals, as the laws can be complicated.

Although a family trust can be a useful estate planning tool, families in lower tax brackets may want to seek out other avenues to save for their children’s education.

“I think it really becomes an issue of a person’s current net worth and cash flow because the family trust is going to be done for the higher end clientele, whereas the 529 plans and gifting strategies can be applied to any income,” says Nigito.