Generosity may be its own reward, but it's even better when your gift garners a tax break. There are several tax-smart ways to help your kids or grandkids:
Feed a 529 plan. Money in a 529 plan may be used tax-free for college costs, and you may get a state income-tax break for your contributions. To qualify for a state tax break, you usually need to contribute to your own state's 529 plan (although five states -- Arizona, Kansas, Maine, Missouri and Pennsylvania -- allow a deduction for contributions made to any state's plan). Some states let anyone take a tax deduction for their contributions; others give the tax break only to the owner of the account. But there's no limit to the number of 529 accounts that may be opened for one child, so parents and grandparents, for example, can open separate accounts and deduct contributions (see details about each state's plan and tax rules).
Get a big gift-tax break. In 2011, you may generally give up to $13,000 per person without being subject to gift-tax rules. Or you may make five years' worth of 529 contributions in one year -- up to $65,000 per child, or up to $130,000 per child per married couple -- without triggering the gift tax. Caveat: If you give money to that person again within the next five years, you'll eat into your lifetime maximum of $5 million in tax-free gifts.
Take credit for tuition payments. The American Opportunity credit can cut your tax bill by up to $2,500 per student if you're paying tuition for the first four years of college. To qualify for the full credit, the student must be considered your dependent and you must spend at least $4,000 in tuition and qualified expenses (including fees, books and other course materials). Plus, your modified adjusted gross income must be below $160,000 if married filing jointly or $80,000 if single or head of household (couples earning up to $180,000 or singles earning up to $90,000 can get a partial credit).
Pay college tuition directly. Direct payments of tuition (but not room and board) to educational institutions are excluded from the $13,000 annual gift-tax limit. This rule applies to anyone making the tuition payment and is particularly popular with grandparents who want to give some extra money to their grandkids without running up against the gift-tax limits.
Help contribute to a Roth IRA. Kids of any age can open a Roth IRA as long as they have earned income from a job -- even if it's just babysitting or lawn mowing. They may contribute up to the amount of their earned income for the year -- with a $5,000 maximum in 2011 -- and you can give them the money to make the contributions. You won't get a tax break for your gift, but the kids will reap the benefits in the future -- by withdrawing all of the money (including the earnings) tax-free after age 59 1/2. And they can access the contributions at any time without taxes or penalties.
Open a custodial account. Open an account for your children or grandchildren at a brokerage firm or mutual fund company and make it a learning experience by making the investing decisions together. You can use the money for anything that benefits the child until he or she reaches the age of majority (21 in most states; 18 in a few) and takes over control of the account. Custodial accounts for children younger than 19 and full-time students younger than 24 are generally subject to the kiddie-tax rules: The first $950 of the child's investment income is tax-free; the next $950 is taxed at the child's own, low rate. Any investment income that tops $1,900 in 2011 is taxed at the parents' higher rate.