December 17, 2013

If you are a grandparent, opening a 529 plan with a grandchild as a beneficiary can have both direct and indirect tax benefits for you while providing a valuable benefit for your grandchild. Best of all, you shouldn’t hear any protests about how you’re spoiling your grandson or granddaughter again. Still, watch out for pitfalls associated with 529 plans imposed by the Internal Revenue Service and by individual states that can potentially ruin your gift.

Types of 529 Plans

There are two types of 529 plans: prepaid tuition and savings account assistance. Both types of plans are administered by individual states. Unlike in-state tuition rates, there are no residency restrictions imposed for purchasing either type of 529 plan. You or your grandchild can live in any state or even in two different states. You can also change beneficiaries for 529 plans as long as the new beneficiary is part of the same family. So when Jeanine finishes college, you can make her brother Billy the new beneficiary. However, some states place age restrictions on beneficiaries, which may be an issue if you intend to fund a plan for a grown grandchild.

Prepaid tuition plans provide funds that can be applied to pay tuition for colleges and universities located within the state. The growth rate for a prepaid tuition plan is pegged to the tuition rate of the particular educational institution to which it is linked.

If the tuition at a particular school quadruples by the time the beneficiary is ready to attend, the value of the 529 plan quadruples as well.

Financial aid assistance plans provide cash benefits that the beneficiary can use for qualified expenses at eligible financial institutions. Eligible educational expenses include all the usual suspects – tuition, fees, room and board. In addition, under the American Recovery and Reinvestment Act of 2009 (commonly called the stimulus), computer equipment, software, peripherals and the cost of Internet access also count as eligible educational expenses. So, purchasing accounting software for finance major is totally OK. That Wii Fit game console on the other hand, not so much, unless the beneficiary is majoring in physical therapy.

Both types of plans are administered by individual states. Unlike in-state tuition rates, there are no residency restrictions imposed for purchasing either type of 529 plan. You or your grandchild can live in any state or even in two different states. You can also change beneficiaries for 529 plans as long as the new beneficiary is part of the same family. So when Jeanine finishes college, you can make her brother Billy the new beneficiary. However, some states place age restrictions on beneficiaries, which may be an issue if you intend to fund a plan for a grown grandchild.

Establishing and Funding a 529 Plan

As a grandparent, you may fund a separate 529 plan and contribute as much as $14,000 (for 2013) to each 529 plan fund without incurring gift taxes. You and your spouse can contribute up to $28,000 in a 529 plan for each grandchild without incurring gift taxes. As an alternative, you an fund up to $65,000 (or $130,000 for married couples) in the first year of a five-year period without incurring the gift tax, as long as there are no other gifts made to that particular beneficiary within the same five-year window. If the cost to attend a particular educational institution is lower than the limit set by the IRS, though, you can only fund the plan to meet the lower amount.

State Tax Benefits and Federal Estate Tax Benefits

Some states allow grandparents to deduct contributions to 529 plans from their state income tax returns. Inquire with a plan administrator for the details. However, a prominent myth is that federal income taxes are also deductible. This is absolutely NOT true. But grandparents do receive indirect tax breaks from contributing to 529 plans – so long as the funds are used for qualified educational expenses by the beneficiary.

There are also no capital gains taxes on earnings. Plus, each contribution reduces the value of your estate, which may result in lower or no gift taxes for your heirs. But if the funds are use for non-qualified expenses, the owners of the funds are hit with income taxes plus a penalty of 10 percent on any investment gains.

The Gift That Keeps on Giving

Instead of braving the crowds trying to find that elusive gadget that happens to be the “it” gift this year, give the gift that keeps on giving – to you as well as your grandchildren. Even if you start off with a small cash gift now, by the time your grandchild is ready for college, he or she will have a tidy sum stashed away with no adverse affect on financial aid eligibility. You will save wear and tear on your nerves while providing a gift that can truly change your grandchild’s life for the better.

Photo: New York Times