Tax-Advantaged Ways to Pay for Preschool

There are distinct benefits to grandparents paying for early education for their grandchildren. Most nanas and pop-pops have probably heard about the benefits of funding a 529 account, which helps pay off those formidable college costs by allowing their issue’s issue to draw from it tax free. But the bills for private preschools and elementary schools can be scary, too. It’s especially true in some of the nation’s larger cities, where fees can exceed those of in-state colleges. In New York City, for example, some of the more exclusive primary schools can cost more than $30,000 a year. 

Thankfully, the Internal Revenue Service (IRS) offers some nice incentives for grandparents who want to help with early education. Taking advantage of these provisions can stretch each dollar you spend, not to mention shield your assets from the taxman when your estate gets passed along to your heirs. 

Ordinarily, a taxpayer can only confer $14,000 a year to each grandchild (or anyone else, for that matter) without having to pay gift tax. This means, of course, that a couple could give $28,000 in total to each child. That limit, however, doesn’t apply if you pay your grandchild’s school directly to cover tuition fees. This "education exemption" is a great way for individuals to contribute toward those steep private-education costs.

For older adults with extensive assets, it’s an excellent estate-planning tool, as well. (For more, see What Are Gift Taxes?) Any money you give to your grandkids now helps reduce the size of your estate for tax purposes. That can make a huge difference, given that the government takes a 40% chunk of any estate larger than $5.49 million. Even though your heirs don’t pay the taxes directly, you’re doing them a huge favor by staying under that threshold.

In theory, grandparents can use the education exemption to cover preschool bills, too. But this is where things get a little dicey. If the preschool is more of a childcare facility than an educational institution, you’re out of luck. According to the IRS website: “A qualifying educational organization is one that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.” So if you plan to pay tuition in a high-cost part of the country, make sure to find a school that fits the criteria. It’s also important to keep in mind that the exemption only works for qualified tuition costs. It won’t apply for ancillary expenses, such as books and supplies. 

If the child enrolls in a school that requires a contract, experts caution that the person paying the bill – even if it’s a grandparent – should be the one who signs it. Otherwise, the IRS may argue that the grandparent is making a taxable gift to the parent, even if that’s not the case. 

Many savvy grandparents know about 529 college savings plans, but there’s another, more flexible option that sometimes flies under the radar. With a Coverdell Education Savings Account (ESA), you can help your grandkids save not just for college but also for elementary and secondary schools. As with a 529 plan, beneficiaries can withdraw the money tax free for qualified expenses. However, ESAs tend to offer more investment options and lower costs. (For more, see College Savings Plans: Funding a 529 or Coverdell?)

One stumbling block is the fairly low income limits for Coverdell plans. You can contribute up to $2,000 a year toward a grandkid’s account, but only if your modified adjusted gross income is under $95,000 a year – or $190,000 if you file a joint return. At that point the allowance starts to taper off. Those whose modified adjusted gross income exceeds $110,000 – $220,000, if filing jointly – are completely prohibited from making a contribution. 

However, there is a fairly easy work-around. Simply gift the money to your grandchildren and have them open an ESA on their own. By allowing them to save in advance for private school in a tax-advantaged way, you’re getting more out of each dollar you spend. What’s more, this is another way to shrink the size of your estate, which can help affluent families steer clear of the dreaded estate tax.

The IRS has a couple of provisions that benefit grandparents who want to help pay for private preschool and elementary school. Taking advantage of these carveouts can help shrink your tax bill, both now and in the future. If you're paying tuition directly, just be sure that the school qualifies for the gift-tax exemption.