EDITOR'S NOTE: This article was originally published in the March 2010 issue of Kiplinger's Retirement Report. To subscribe, click here.
Doting grandparents, take heed: If you have a grandchild or two headed for college, it could be time to lavish a little extra attention -- and cash. The double whammy of tuition increases and unemployment among parents means that many college kids are in a financial squeeze. In 2009, the percentage of students taking out loans was at its highest in nine years, at 53%, according to a UCLA survey of students entering four-year colleges and universities.
If you want to help a grandchild pay for college, you have various options, each with pros and cons. Before you make a move, coordinate with the parents. Otherwise, you could hurt your grandchild's eligibility for financial aid.
For grandchildren who are years away from college, consider a state-sponsored 529 college-savings plan. This is a good route "for people who have money they're not going to need, and a desire to help educate their grandchild," says Joseph Hurley, founder of SavingforCollege.com. The money grows free of federal income taxes, and it's generally not taxed when withdrawn to pay for college expenses.
Joan Richman of New York City opened 529 accounts for each of her five grandchildren when they were born. "Whatever I can accumulate for my grandchildren, even if it's a small amount, it will help," says Richman, 66.
Thirty-four states offer state income-tax deductions or credits for at least part of 529 contributions. There's also an estate-planning benefit. Each grandparent can contribute $13,000 a year for each grandchild without filing a gift-tax return or make a single contribution of $65,000, which the IRS treats as if it were paid out in $13,000 segments over five years. "It's a way they can get the money out of an estate," says Valerie Adelman, a certified financial planner with Financial Asset Management, in New York City.
If the grandchild doesn't go to college, you can switch the beneficiary to any family member. You can always liquidate the account, but if the money is withdrawn for a noneducation expense, "you would owe income tax and a 10% penalty on the earnings," says Mark Kantrowitz, publisher of FinAid.org.
Because the grandparent is the account owner, the 529 is not counted during the financial-aid application process. But when the money is withdrawn, some schools may reduce aid. "You'd have to ask the college what the policy is toward 529 plans," says Rick Darvis, a certified public accountant in Medicine Lake, Mont.
Hand Over the Cash
An alternative to a 529 is a custodial account at a bank or brokerage firm. The money is held under the grandchild's name. But the account could affect financial aid more than a 529 because the federal formula assumes that 20% of assets in a child's name can be used for tuition. And once the child turns 18 or 21 (depending on the state), it's the grandkid's money. "The grandchild could say, 'Thanks, Grandma,' and use the money for a trip abroad," says Adelman.
You can write a check to your kids to help pay the costs. The $13,000 gift can be multiplied by four if you and your spouse give to your son and daughter-in-law. There is no gift-tax limit if you send a payment directly to the university. But, "a check to the college would typically reduce financial aid dollar for dollar," says Deborah Fox, founder of Fox College Funding, in San Diego.
If you'd like to make a loan to your grandkid, treat it as a business transaction. The interest rate must be high enough so that the IRS won't consider the transfer a taxable gift. Draw up a promissory note, or consider using VirginMoney (www.virginmoneyus.com), which sets up loans between family members for a fee.
Also, if you want to give or lend money, it could be best to hand over the cash to the parent rather than the student. The financial-aid formula counts up to 5.6% of a parent's assets -- but 20% of a student's assets -- in determining resources available for college. To maximize aid, make the loans or gifts during the student's junior year of college after the final financial aid forms have been submitted for senior year.