Susan E. Thomas CPA
Should I make tuition payments directly to my grandchild's college or should I contribute to a 529 plan instead?

Direct payment of tuition to an educational institution is not considered a taxable gift. Therefore, you're able to "give away" more than $15,000 per year (the annual federal gift tax exclusion) for your grandchild's college education and not worry about gift taxes. However, colleges may reduce a student's institutional financial aid by the amount of your payment. So before sending a check, ask the college how it will affect your grandchild's eligibility for college-based aid.

With 529 plans, all contributions are considered gifts, so the federal gift tax exclusion comes into play. This exclusion lets you gift up to $15,000 per year per person (in 2019) without any gift tax or estate tax consequences. There is one exception. Under special rules unique to 529 plans, you can gift up to five times the annual gift tax exclusion — $75,000 in 2019 — and avoid gift tax if you elect on your tax return to treat the gift as if it were made evenly over a five-year period. Married grandparents can gift up to $150,000 this way. (Keep in mind that even if you go over these limits, you won't necessarily owe gift tax. You must first use up your lifetime applicable exclusion amount before you'll have to pay gift tax out-of-pocket). Grandparents must also be cognizant of the generation-skipping transfer tax, or GSTT, which is a tax imposed on a gift made to someone who is more than one generation below you.

Regarding financial aid, grandparent-owned 529 accounts do not need to be listed as an asset on the federal government's financial aid application, the FAFSA. However, withdrawals from a grandparent-owned 529 plan must be reported as student income, which has the potential to cut a student's aid award in half the following year because student income is assessed at 50% by the FAFSA. To avoid having a withdrawal from a grandparent-owned 529 account count as student income, one option is for the grandparent to delay taking a withdrawal from the 529 plan until after January 1 of the grandchild's junior year of college because there will be no more FAFSAs to submit. Another option is for the grandparent to contribute to a 529 account owned by the parent.

529 plans offer an advantage over the direct payment of tuition: tax-free withdrawals from a 529 plan can be used to pay for items besides tuition, including room and board, books, and supplies.

You should also consider the possibility that you may not live long enough to pay your grandchild's tuition in the future. If such a case, any general funds will be part of your taxable estate, and the money your grandchild needs for education may not be available after settling your estate. But if you contribute to a 529 plan now, your contributions are considered present interest gifts and are generally taken out of your estate. (An exception exists if you elect to spread a lump-sum gift over five years and you die during the five-year period. In that case, the portion of the contribution allocated to the years after your death will be included in your gross estate.)

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.

Prepared by Broadridge Investor Communication Solutions, Inc, Copyright 2011