Indeed, grandparents can use these gifts to reduce their taxable estate. And by channeling the money to certain college-savings plans or accounts, they can avoid paying gift taxes on amounts to one beneficiary exceeding $10,000 a year. They can also limit the capital-gains and income-tax burden on themselves--and on their grandchildren.
From an estate-planning perspective, the state-sponsored, tax-deferred 529 savings plans are the best way to go. Each grandparent can contribute up to $50,000 in one year, free of gift tax, to an account for each grandchild. "It gets the future growth out of the estate fast," says Joseph Hurley, a certified public accountant who runs SavingForCollege.com, a 529 Web site.
The Internal Revenue Service treats the $50,000 as if it were paid out in $10,000 segments over five years. After those five years are up, you can give again. If a grandparent dies before five years, the estate will be taxed on a prorated basis. For instance, if the grandparent makes the $50,000 contribution in May, 2001, and dies in August, 2002, the estate pays taxes on $30,000.YOUR CHOICE. Another advantage is that the grandparents remain the account owners. They can change the beneficiary or even liquidate the account if they later need the money. If they cash out, though, they'll have to pay income tax and a 10% penalty on the appreciated amount.
You can also open an UTMA (Uniform Transfer to Minors Act) custodial account at a bank or brokerage. You may give as much as you want in a given year--but only up to $10,000 per person escapes gift tax. Unlike 529 plans, which are run by a investment manager picked by the state, UTMA accounts let the custodian choose the investments.
The accounts aren't tax-deferred, but they do offer some breaks. Every year, for a child under 14, the first $700 of earnings is tax-free and the second $700 is taxed at the child's rate. The rest is taxed at the parents' rate. When the child turns 14, earnings above the first tax-free $700 are taxed at the child's rate. Funding the UTMA with stock ensures that any appreciation is ultimately taxed at your grandchild's lower capital-gains rate.
But a UTMA account can affect your grandchild's financial-aid eligibility to a greater extent than a 529 because the federal formula assumes that 35% of assets in the student's name can be used to fund tuition and other costs. Remember, too, that once you put money into the account, it's your grandchild's, and not yours. You can take money out only to pay for expenses benefiting the child. When your grandchild turns 18 or 21, depending on the state, he or she can choose to blow the cash on a car or a trip to Europe, and "there is legally nothing you can do to stop it," says Martin Kawadler, a certified financial planner in Waltham, Mass.
Another option: Grandparents can make a direct tuition payment to the college. No matter how big the amount, the payment "is not subject to the gift tax," says Judy Miller, a certified financial planner in Alameda, Calif.
Education IRAs, which can be used to pay for certain education costs, allow tax-free withdrawals. But they offer few other benefits. Yearly contributions are limited to just $500, and even that starts phasing out at an adjusted gross income of $95,000 for single filers and $150,000 for joint filers. Nor can you fund an Education IRA in the same year donations are made to a 529 plan for the same person. Otherwise, your grandchild must pay an excise tax on the money in the account. Still, with the many tax-advantaged plans around, grandparents should have no trouble finding one that will work for them--and pay off many times over in their grandchild's future. By Susan B. Garland