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COLLEGE SAVINGS 101

Plans help fund grandchildren's college

12/10/2007

QUESTION:
Dear Joe,

I would like to set up an account to which I could contribute money on birthdays and holidays for my grandchildren's future education. Would you recommend a savings account, money market, stocks or bonds? Thank you.

-- Diane

ANSWER:
Dear Diane,

You have several options for funding a child's future education, but I think the 529 plan works best for most grandparents. A 529 plan is a state-sponsored investment program designed specifically for college. Investments can be withdrawn free of federal taxes when used for the beneficiary's qualified higher-education expenses. Most 529 plans offer a variety of investment options, including the types of investments you've mentioned.

The first step is to find out if your children have already opened up 529 accounts for your grandchildren. If they have, you typically can contribute directly into those accounts as long as you have the 529 plan's account number, name and address.

It's important to note that a few states do not accept contributions from anyone other than the account owner. If you find this to be the case, make your gift to the parents and request they deposit the funds into the 529 plan.

If your children have not already established 529 accounts for your grandchildren, perhaps asking for an account number will spur your kids to do so. Or, you can establish your own 529 accounts for the grandchildren.

The primary difference between the two approaches relates to the future ownership and control of the accounts. A grandparent making large contributions will often decide to retain control by being the account owner, while a grandparent making relatively small and sporadic contributions may decide it is easiest to use the parents' 529 accounts.

Grandparent-owned 529 accounts have a slight advantage when it comes to determining a student's federal financial-aid eligibility.

A Coverdell education savings account, or ESA, is another tax-free college savings vehicle offered by many banks, mutual fund firms and investment brokers. However, a child must pay a penalty tax if contributions to an ESA from all sources exceed $2,000 in a year. So, if someone else, such as the parents, makes ESA contributions, you should not.

Another common approach is to give your grandchildren direct gifts of cash along with a personal request that the money be invested and used for their future education. It will be up to their parents, as custodians, to establish a Uniform Transfers to Minors Act, or UTMA, and decide where to invest the money.

Although modest amounts in a UTMA may not cause any problems, large balances can create several concerns. These include the so-called kiddie tax (designed to prevent parents from sheltering income by hiding it in their child's name), the significant impact of student-owned investments on the child's ability to qualify for financial aid, and the risk that the child will take the money at age 18 or 21 and use it for less-than-desired purposes.

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