Grandparents have options for funding tuition

One of the best gifts grandparents can give their grandchildren is to help pay for their college education. A 2003 Survey by AIG SunAmerica Mutual Funds found that 54 percent of grandparents were already helping to pay college costs or planned to do so. Yet many grandparents don’t realize the most effective ways of going about it, according to financial planners.

Outright gifts

The AIG survey found that the vast majority of grandparents gave outright gifts of cash or securities. This is certainly the easiest option. Each grandparent can annually give away, free of estate- or gift-tax liability, up to $11,000 a grandchild, or $22,000 a year per grandchild if both grandparents contribute.

But this method has its drawbacks. Even $22,000 a year may not be enough money for the grandchild’s education. Private colleges can easily run well over $30,000, and some are around $40,000. Also, the gift could reduce the amount of available financial aid, particularly if the gift is made directly to the grandchild instead of to the parents. And the grandparent relinquishes control of the money, meaning that the grandchild could end up using the money for a new car or an exotic vacation.

Direct payment to schools

A major advantage of paying money directly to the school is that the giver can contribute as much as necessary without the gift counting as part of the annual $11,000 gift exemption. This method also ensures that the money is spent for college.

The major drawbacks to direct payment are that it applies only to tuition and it may reduce financial aid.

Coverdell accounts

Grandparents who have earned income can directly open Coverdell education savings accounts for a grandchild under the age of 18 and can contribute up to $2,000 a year. For those who don’t have earned income, the money can be gifted to the grandchild’s parents so that they can open the account. The grandparents can direct the investments as they choose, and the funds can be used for public and private elementary school as well as secondary education.

There are some major drawbacks: the limited size of the annual contribution; donors whose incomes are too high cannot contribute; and states don’t provide any income-tax deductions. Also, the contributions and earnings belong to the beneficiary, not the donor, and financial aid may be affected. Of course, as with any investment, there is the risk of losing money in the account.

529 plans

In the AIG survey, only 2 percent of grandparents polled had actually invested in 529 plans on behalf of their grandchildren. Yet, 529 plans can provide numerous benefits for both donors and recipients. A 529 plan is a state-sponsored college savings plan that invests money on behalf of participants, much like mutual funds invest shareholder money. Under current law, earnings grow tax-deferred from federal income tax, and often, state income tax. Withdrawals used for qualified education expenses will remain free of tax at least through 2010. The benefits for grandparents are numerous. They, not the grandchild, remain in control of the funds, yet the funds don’t count toward their estate for estate tax purposes.

Donors also can consolidate five years’ worth of tax-free gifting into a single year, for $55,000 per person or $110,000 as a couple, provided that they don’t contribute any more money during that five-year period. That means investing a lot of money up-front to grow for the grandchild. Most 529 plans allow total investments of at least $200,000, and some allow over $250,000. Unlike Coverdell accounts, they are free of donor income limitations.

Be aware that 529 plans are vulnerable to performance swings, just like mutual funds, and critics warn about potential high investment fees. Nonetheless, these remain a popular option for many parents, and they can be very beneficial for grandparents.

Prepayment

Prepaid tuition plans are operated by some states and by a consortium of private colleges. These plans allow investors to buy part or all of tomorrow’s tuition at today’s prices. Typically, an investor buys “units,” which might equal a semester, a year, or several years’ worth of today’s tuition, and the state or private consortium guarantees returns that will match the inflation rate for that system’s college costs.

The poor market returns in recent years and the high rate of tuition increases have prompted some states to drop these plans or to freeze enrollment.