For many older taxpayers, there is no greater pleasure in life than spoiling their grandchildren. When it comes to paying for college, grandparents can also reap substantial tax benefits on top of the enjoyment of watching their grandkids benefit from higher education. This article explores some of the tax-advantaged avenues available for older taxpayers who wish to help pay for their grandkids' college costs.

TUTORIAL: Personal Income Tax Guide

529 Plans - Qualified Tuition Programs
There are two types of qualified tuition programs, the college savings plan and the prepaid tuition plan.

College Savings Plan
College savings plans are established by a state or eligible educational institution, and allow individuals to make contributions in order to finance the beneficiary's (student's) higher education. The contributions are made to a college savings account and the balance in the account is determined by the performance of the underlying investments. This ultimately affects the amount of funds available to meet the beneficiary's eligible education expenses.

Prepaid Tuition Plans
Prepaid tuition plans, also known as prepaid education arrangements or prepaid tuition programs, provide a way for families to beat the cost of inflation by purchasing the future cost of tuition at today's rate. These plans are sold in units or by contract, and cover a given number of years of tuition or a certain number of credits. They are backed by the state and provide another low-risk alternative for estate-conscious donors who wish to shift large amounts of assets to heirs without reducing their unified credit. Drawbacks to these plans include stiff withdrawal penalties and a relatively low rate of return compared to other options such as college savings plans. Furthermore, prepaid tuition plans are generally only available for in-state residents and school alumni, and may also be limited to in-state public institutions. Some plans do not cover costs at private or out-of-state schools.

If used for qualified education expenses, all contributions accumulate on a tax-deferred basis and earnings are tax free. Most states offer a tax deduction for residents who use their state's plan, and a special tax break for wealthy taxpayers seeking to reduce their taxable estates. Qualified tuition program rules stipulate that contributors can stack up as many as five annual gift tax exclusions on top of each other in a single year. For example, an individual could contribute up to $70,000 to a single qualified tuition program in 2013 without creating any gift tax as long as the money does not exceed the amount necessary for the child to complete their higher education. Married couples can contribute twice that amount.

These limits are applicable on a per-plan basis. So, couples seeking a tax-efficient transfer of assets could contribute up to $130,000 to several different beneficiaries in a single year. Furthermore, the beneficiary does not have to be a biological grandchild. As a matter of fact, the beneficiary does not have to be related to the contributor. An older couple with no children can even choose to donate this amount to their neighbor's grandkids. (For more on qualified tuition programs, see Choosing The Right Type Of 529 Plan and Clearing Up Tax Confusion For College Savings Accounts.)

The primary drawback associated with qualified tuition programs is the penalty and taxation on the earnings included in any plan distribution that is not used for qualified education expenses. Nonqualified distributions are treated in the same way as early distributions from a retirement plan or annuity; they're both assessed a 10% early distribution penalty in addition to being counted as taxable income. However, the income and penalty is assessed only on the earnings. Any tax or penalty applies to the plan beneficiary and not to the contributor, which may be a major factor for donors to consider. (To learn more about these plans, see the 529 Plan Tutorial.)

U.S. Savings Bonds
Conservative investors can find another education tax haven in bonds that are backed by the full faith and credit of the U.S. government. The education bond program allows certain kinds of bonds to be exempted from taxation if the proceeds are used to fund higher education expenses. The interest generated from Series I bonds and EE bonds, zero-coupon bonds and STRIPS and Treasury inflation protected securities (TIPS), is eligible under this program, while Series H and HH bonds are not. However, several conditions must be met in order for this exemption to apply. Any eligible bond must have been issued after 1989 to an investor who was at least 24 years old at the time of issuance.

If the bonds are to be used to pay for a minor's higher education, the child must be the beneficiary on the bonds and cannot own them directly. Furthermore, the child must be claimed as a dependent on the parent's (or grandparent's) tax return. No more than $30,000 of savings bonds can be purchased by a single investor - or $60,000 per couple - in a given year to qualify for the exemption. If these conditions are met, savings bonds can provide a more flexible source of college funding than 529 plans, as there is no penalty if the funds are used for a different purpose. However, the interest on the bonds will then become taxable.

Coverdell Education Savings Account
Originally created as Education IRAs, these savings accounts were overhauled and expanded in 2002. They allow for an annual nondeductible contribution of $2,000 for each child up to the age of 18. The earnings grow tax-free, usually at the state and federal levels, as long as the IRA is used for qualified education expenses. However, the early distribution penalty and income tax are assessed on the earnings portion of any amount remaining in the account for 30 days or more after the beneficiary reaches age 30. The early distribution penalty does not apply to exceptions such as the death or disability of the beneficiary. The age 18 and age 30 limitations do not apply to beneficiaries with special needs. (Learn about these accounts by touring our Education Savings Account Tutorial.)

Education savings accounts differ from qualified tuition programs as contributions are aggregated per child in the same manner as IRA contributions. Four different family members cannot each make $2,000 contributions in the same year for the same beneficiary. Furthermore, contributions are counted toward the gift tax exclusion, which means that an individual who contributes $2,000 for tax year 2013 to these plans can only allocate another $12,000 as a nontaxable gift to a qualified tuition program for the same beneficiary.

Withdrawals from these accounts may also affect the taxpayer's ability to benefit from education tax credits. While the beneficiary may be able to claim the credit in the same year that the distribution is made from the education savings account, the distribution and the credit cannot be used to cover the same expenses.

The disadvantages inherent in these plans have made them much less popular than other avenues of saving, such as the qualified tuition programs. (Learn more about these accounts by reading Don't Forget The Kids: Save For Their Education And Retirement.)

The Bottom Line
There are several options for grandparents and other older taxpayers who want to reduce their income or estate tax while helping young ones pay for college. However, taxation is only one factor involved in choosing the right type of tuition assistance. Other issues, such as who controls the assets, and coordination with financial aid, must also be considered. (For more information about paying for college, see Pay For College Without Selling A Kidney, Pay For A College Education With Retirement Funds and Five Ways To Fund Your College Education.)

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