3 Common Questions From Grandparents About Saving for College

Karen Wagener started a 529 college savings account when her granddaughter was four years old. She's n ow 15, and the two enjoy looking at the financial statements together to see how the money has grown.

"I knew that, with the cost of higher education being what it is today, that she was going to need help," say Wagener, who lives in California and has a Scholarshare College Savings plan. "Very likely, neither her parents nor we would be able to tote the whole note. So I thought, why not start now?"

A 529 is a state-sponsored savings account designed to help families save for college. Named after Section 529 of the Internal Revenue Code, the earnings grow on a tax-deferred basis and will not be taxed if used for qualified education expenses. Many states also offer a state tax deduction or credit.

Grandparents are in a unique position to help make a dent in saving for the ever-rising cost of college. They often have fewer financial obligations than parents, who may be bogged down by their own student loan payments, a mortgage, retirement contributions and day care costs.

"I find that for grandparents, they appreciate the fact that it's focused on education," says Liza Hanks, an attorney specializing in estate planning and a partner at Finch Montgomery Wright in Palo Alto, California. "They're worried about that for their grandkids."

But because 529s are relatively new, grandparents might have questions about the plans. Here are answers to some common ones.

[Learn four college savings myths grandparents should avoid.]

-- Should I open my own account or make contributions to an existing parent-owned account? For a grandparent who wants to be actively involved in how the money is invested, opening an account may be the way to go. If you'd rather let your grandchildren's parents handle the investment strategy, then you could always just write them a check.

However, there is another consideration: financial aid eligibility. Grandparent-owned assets are not considered in the Free Application for Federal Student Aid used by many schools to determine financial aid packages.

"They don't look at retirement accounts for parents , and they don't look at grandparent assets," says Michael Taylor, who writes syndicated financial column "The Smart Money" and is a financial blogger at Bankers Anonymous. "That fact alone, it seems to me, indicates you would always want to have a 529 from a grandparent rather than a parent if you were trying to get financial aid."

The catch is that distributions from a grandparent count as income to the student, which can harm a student's eligibility for need-based financial aid by as much as half the distribution amount.

"The natural defense against that is make the grandparent payments late in the student's career at college, as late as one could if you have other means of paying, if financial aid eligibility is the goal," Taylor says.

New FAFSA rules mean that financial aid is awarded based on a two-year-old tax return -- rather than the prior year's return -- meaning grandparents could take distributions when a grandchild still has two years left at college without affecting financial aid.

[Explore ways to ask for contributions to 529 plans.]

-- Will I have to pay taxes on a gift from a 529? Most likely not. A married couple can give $28,000 -- $14,000 for a single person -- per year without needing to report it on their taxes. Once they give more than that, they would need to report it, but they still would n't need to pay taxes until they hit a $5.45 million lifetime limit.

However, there is a unique rule for 529s that allows individuals -- including grandparents -- to "frontload" gifts to 529 plans, Hanks says. Grandparents could make five years' worth of annual gifts -- $70,000 for individuals or $140,000 for couples -- to a grandchild and not pay any gift tax or use up any of their lifetime exclusion.

"If you can afford to do it, what a beautiful thing to do when a kid is born or goes to kindergarten, because you get more time for that tax-deferred growth," Hanks says.

[Check out five smart moves for grandparents helping save for college.]

-- What sorts of limitations exist on the accounts? For grandparents, one benefit of 529s is that they have tax-advantages but no age or income limits. A grandparent may no longer be able to contribute to a 401K retirement account if they've already started taking out minimum distributions or to a Roth IRA if they exceed the income limit.

"Grandparents may have fewer tax-advantaged vehicles that they can access, either because they've aged out or because they're incomed-out," Taylor says. "And 529s don't have a limit on either one, which makes them seem more grandparent appropriate."

However, one limitation is that the money must be used for qualified higher education expenses. If taken out for something else, there is a 10 percent penalty on earnings. Qualified expenses include tuition, fees, books, computers and room and board for students who attend more than half time. It can also be used for graduate school and the beneficiary can be changed.

Trying to save for college? Get tips and more in the U.S. News College Savings 101 center.

Deborah Ziff is a Chicago area-based freelance education reporter for U.S. News, covering college savings and 529 plans. You can follow her on Twitter.