If you want to help with a grandchild's college expenses, that's very nice of you. But please do it in a tax-friendly fashion. Here are three suggestions.
Contribute to 529 College Savings Account
The biggest advantage of 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 529 account will also reduce your taxable estate because they are treated as gifts to the grandchild. Contributions in 2012 are eligible for the $13,000 annual gift tax exclusion. Contributions up to the exclusion amount won't diminish your federal gift and estate tax exemption ($5.12 million for 2012).
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 2012 lump-sum contribution of up to $65,000 (5 x $13,000) to a Section 529 account set up for a grandchild. If you're married, you and your spouse can together contribute up to $130,000 (2 x $65,000). Lump-sum contributions up to these amounts won't diminish your federal gift and estate tax exemption as long as you choose to take advantage of 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 529 account, you will be happy to hear it's allowed under the tax rules. 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 You'll owe taxes on any withdrawn earnings plus a penalty equal to 10% of the withdrawn earnings.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.
Contribute to Coverdell Education Savings Account
If you're not such a high roller, you 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 in this case means your grandchild.
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 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.
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 (not room and board or other expenses) 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 federal gift and estate tax exemption ($5.12 million for 2012) 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 of $13,000, to help with other outlays like room and board, books, and transportation. If you're married, the annual gift tax exclusion is effectively doubled to $26,000. Gifts up to the annual exclusion amount won't reduce your federal gift and tax exemption ($5.12 million for 2012) even though they will reduce your taxable estate.