3 Tax-Friendly Ways to Pay Grandkids' Tuition

If you want to help with a grandchild’s college expenses, that’s awfully nice of you. Just make sure you do it in a tax-smart fashion. Here are three tips:

1. Contribute to Section 529 College Savings Account

The biggest advantage of Section 529 college savings plan accounts is they are allowed to accumulate earnings free of any federal income taxes. When the account beneficiary--your grandchild in this case--reaches college age, federal-income-tax-free withdrawals can be taken to cover higher education expenses. State income tax breaks are often available too.

Helpfully enough, contributions to a grandchild’s Section 529 account will also reduce your taxable estate because they are treated as gifts to the grandchild. Contributions in 2008 are eligible for the current $12,000 annual gift tax exclusion. In 2009, the exclusion will increase to $13,000. Annual contributions up to these amounts won’t diminish your $1 million federal gift tax exemption or your federal estate tax exemption ($2 million for 2008; $3.5 million for 2009). If you’re married, these annual gift tax exclusion amounts are effectively doubled.

If you’re feeling really generous, you can make a larger lump-sum contribution to your grandchild’s Section 529 account and elect to spread it over five years for gift tax purposes. This allows you to immediately benefit from five years’ worth of annual gift tax exclusions while jump starting your grandchild’s college fund. You make the five-year spread election by filing IRS Form 709 (the federal gift tax return form).

Here’s how it works. Say you’re unmarried. You can make a 2008 lump-sum contribution of up to $60,000 (5 x $12,000) to a Section 529 account set up for a grandchild. If you’re married, you and your spouse can together contribute up to $120,000 (2 x $60,000). Lump-sum contributions up to these amounts won’t diminish your federal gift or estate tax exemptions as long as you elect the five-year spread privilege. If you want to help several grandchildren, you can run the same drill for each one.

Important: If you want or need to get your money back from a Section 529 account, it’s allowed. You can take back all or part of the account balance. You’ll owe taxes on any withdrawn earnings plus a penalty equal to 10% of the withdrawn earnings. However, that’s a relatively small price to pay for the right to reverse a poor decision.

2. Contribute to Coverdell Education Savings Account

Some grandparents also have the option of contributing up to $2,000 annually to a Coverdell Education Savings Account (CESA) set up for a grandchild who has not reached age 18. A CESA is an account set up by a “responsible person,” which means you, to function exclusively as an education savings vehicle for the “designated account beneficiary,” which means your grandchild.

It works like a Roth IRA. CESA earnings are allowed to accumulate federal-income-tax-free. Then, tax-free withdrawals can be taken to pay for your grandchild’s college tuition, fees, books, supplies, and room and board. If you have several grandchildren, you can contribute up to $2,000 annually to separate CESAs set up for each one.

Here’s the big catch. Your right to make CESA contributions is phased out between modified adjusted gross income (MAGI) of $95,000 and $110,000 or between $190,000 and $220,000 if you’re a married joint filer. However, this restriction can often be circumvented by enlisting someone who is unaffected. For example, you can give the contribution dollars to your adult child (the parent of the grandchild in question), who can then open up the CESA as the “responsible person” and make a contribution on behalf of your grandchild. However, when the “responsible person” is someone other than yourself, your control over the account is lost. Keep that in mind.

3. Make Direct Payments to College for Tuition

Last but not least, you can use a pay-as-you-go strategy and still get tax-smart results. That’s because you’re allowed to make gifts of any amount to cover a grandchild’s college tuition without any negative federal tax consequences. However, you must pay the tuition money directly to the college to get this favorable treatment. Then the gift won’t reduce your $1 million federal gift tax exemption or your federal estate tax exemption ($2 million for 2008; $3.5 million for 2009) even though it will reduce your taxable estate (which is a good thing). If you wish, you can make additional gifts to your grandchild up to the annual gift tax exclusion amount ($12,000 for 2008; $13,000 for 2009) to help with other expenses like room and board and books. If you’re married, your annual gift tax exclusion is effectively doubled. Gifts up to the exclusion amount won’t reduce your federal gift or estate tax exemptions even though they will reduce your taxable estate.