Best ways to boost godchild's college fund

By: Savingforcollege.com

Q:

Dear Joe, I have a goddaughter who is turning 8 in January. She is no biological relation to me. Each year, for her birthday, I have purchased savings bonds, first EE bonds and later I bonds. But her parents' income has increased well into the six figures and there is no way they will meet the means test for tax-free use of the money for college. What would be a better gift with an eye toward college savings? Should I open a 529 plan for her? An ESA? I'm thinking of a $250 gift every year. -- Kara

A:

Dear Kara,
If you've been registering the savings bonds in your goddaughter's name, you need not be concerned about the parents' income level, because the bonds are not going to qualify for the education exclusion in any event. One requirement for redeeming U.S. savings bonds tax-free is that the bond owner be at least 24 years old at the bond's issue date. Obviously, your goddaughter would not meet that test.

If, on the other hand, you are making one or both parents the owners of the bonds, the age test should not be an issue (assuming they are at least 24 years old at the relevant dates). Series I bonds and post-1989 EE bonds are eligible to be redeemed tax-free to the extent the bond owner or owner's spouse or dependent incur qualified higher education expenses (that is, tuition, fees, and contributions to 529 plans and Coverdell education savings accounts). Also, as you indicate, the bond owner must satisfy an income test in the year of redemption. For 2006, the bond exclusion phases out for single taxpayers with incomes between $63,100 and $78,100 and for joint filers with incomes between $94,700 and $124,700. These phase-outs are adjusted each year for inflation.

Whether or not the savings bonds qualify for the education exclusion, they still make an easy and attractive college savings vehicle.Even when registered in the child's name, a savings bond is a low- or no-tax investment when the child has little other income and makes an election to report the accrued interest each year on their tax return. See IRS Publication 550.

A 529 plan for your goddaughter is an excellent alternative to a savings bond. If you open the 529 account with yourself as the owner, you will remain responsible for tracking the 529 plan and requesting distributions as your goddaughter incurs college expenses. Instead, you may want to make contributions to a 529 account already owned by her parents. Just about every 529 plan -- New York is a notable exception -- accepts third-party contributions, and many even make "gift contribution" cards available for this purpose.

I advise most people in your situation to steer clear of Coverdell education savings accounts. They work best when the contributor is the child's parent. When grandparents and other relatives and friends start making their own contributions it becomes too easy to trigger penalties by inadvertently making excess contributions, either because aggregate contributions climb above the $2,000 annual limit, or because one of the contributors has income above the $190,000-$220,000 phase-out range ($95,000-$110,000 for single taxpayers).