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What's The Best Way to Invest for Your Grandchildren's College Education?


October 19, 2011

Dear Carrie,

I have $85,000 to invest for my grandchildren's education. Where would you suggest I invest it?

—A Reader

Dear Reader,

I applaud your idea wholeheartedly, with just one caveat. Before you move ahead, make absolutely sure you won't need that money for your own retirement. Err on the cautious side, and proceed with this gift to your grandkids only if you're confident you'll have the financial resources you'll need for yourself. You are being incredibly generous, but when it comes to retirement, it's hardly selfish to think of yourself first!

Accounts: lots of choices

That said, let's get to the meat of your question. Essentially, you're looking at four options: a 529 plan, a custodial account, a trust account, or simply investing using your own account (with the plan to make gifts to your grandchildren later).

529 Plan: The most obvious answer (but not necessarily the right one) is a 529 plan, the popular tax-deferred vehicle for college investing (a Coverdell; Education Savings Account can offer even greater benefits, but is limited to annual contributions of no more than $2,000 and then only if you qualify based on your adjusted gross income). In a 529 account, investment income is never taxed, as long as it's withdrawn for "qualified" higher education expenses ("qualified" means about what you'd expect: tuition and fees, room and board, and books and supplies).

Some additional benefits of 529 plans:

  • You can make substantial contributions without triggering gift taxes: an individual can contribute $65,000 and a married couple $130,000 in a single five-year period (requires a special election on your gift tax return).
  • You control the assets. The child is the beneficiary, but the assets are in your name; your grandkids cannot access the money directly.
  • You can transfer unused assets to a wide range of family members, which could be important. Say one grandchild was college bound, but the other wasn't; 529 plan assets could be shifted to the one headed for college without penalty.
  • You might get a state tax break. Some states offer tax credits for 529 contributions.

What's not to like? Well, 529 plans offer fewer investment choices than custodial accounts or trusts and trading and exchanges are often limited. And the funds can only be used for higher education; if you withdraw them for some other reason, you'll pay federal and state taxes on any investment income plus a 10 percent penalty.

A Custodial Account: If you're sure your grandkids will go to college, a 529 plan makes sense. But if your goal is simply to give them some financial assistance later in life, you might consider a custodial account. It's more flexible than a 529 in terms of what you can invest in and how your grandkids can use the money.

That can be a double-edged sword. You would control the investment now, but the assets must be given to the beneficiary when he or she turns 18, 21, or 25 (depending on your state and your wishes). Theoretically, your grandchild could reach the legal age and cash out the account to buy a Ferrari, and there'd be nothing you could do about it.

Earnings don't grow tax-free as they do with a 529 plan, but a custodial account may offer a tax benefit: Under the current tax code, the first $950 of investment earnings are tax-free and the next $950 is taxed at the child's (usually quite low) rate; after that the marginal tax rate goes up to the parents' rate.

A Trust Account: If you want more control over the money, look at a trust account, either a Crummey Trust (the odd name comes from the first person who successfully set one up) or a 2503(c) Minor's Trust. These are more complex and more expensive than your other options; if they sound appealing, consult a trust expert to see if one of these structures would be right for you. With either a custodial account or a trust account, you will be limited to the annual gift tax exclusion of $13,000 per year per recipient ($26,000 for spouses electing to “split” their gifts).

Keep It In Your Own Account: One final option is simply to earmark that money for your grandchildren and keep it in your own name and your own account. Of course you would need to stipulate your intentions in your will (or set up a trust), and potentially have part of it eaten up by estate tax. But the pluses are that you'll have complete control over how the money is invested and how and when it's disbursed. In addition if you should happen to need the money yourself, it'll be available.

So you have a lot of options, though given the amount of money you plan to invest and assuming you are very confident you won't need it yourself, the 529 plan may make the most sense. Pick a plan with low expenses and a wide range of investment choices, and then make investment choices that match the time horizon you need and offer plenty of diversification. Target funds, which rebalance automatically as the date of matriculation grows nearer, offer a simple solution, so check them out.

Good luck--and I am sure your generosity will be remembered for years and years to come.

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