Giving Money to Your Grandchildren

by Ben Alper

Grandboomers are like their own grandparents. They often express their love for their grandchildren by giving presents, especially on holidays and other occasions. Giving gifts such as toys or candy can be very gratifying since the joy and pleasure the child experiences is so immediate. As children grow older, however, it often becomes more difficult to select an appropriate gift for a grandchild. After all, if understanding the musical and fashion tastes of your children was challenging, it's probably not going to be much easier with your grandchildren.

Grandparents also want to give their grandchildren a gift that is more practical and longer lasting. Giving money, if done correctly, can be one of the most helpful and important things they can do for their grandchildren, particularly when it comes to helping with their education.

If done wisely and regularly, contributing even a small amount of money, starting when your grandchildren are young, can have a great and long-lasting impact on their lives. The key is to understand the options available to you and, when needed, seeking advice from a reliable financial planner.

If you are just beginning to think about how you can contribute financially to your grandchildrens future, you might want to ask yourself the following questions:

* How much money do you want to give?

* Do you want your grandchildren to have access to the money immediately to spend as they see fit? Or would you rather specify that the money cannot be accessed until the child reaches a certain age? Should the money be used solely for educational purposes?

* If the money is being invested, should the investment tool be one that is safe and yields small to moderate growth, or should it be more aggressive with the potential of both greater growth and higher risk?

* How will your gift affect your taxes as well as your grandchildrens?

Here is some basic information about giving money to help you get started.

How Much Can I Give?

An individual donor can give up to $10,000 a year tax-free to any individual family member or friend. A husband and wife can give up to $20,000 per individual. Any amount over that limit is subject to a gift tax paid by the donor. You can, however, give more than $10,000 just as long as it doesnt exceed $10,000 per individual. For example, an individual donor can give $30,000 a year tax-free if $10,000 is given to three individuals.

Custodial Accounts

What if your grandchild wants to spend your $5000 gift on Pokemon cards? Thats why there are custodial accounts. Although your newborn granddaughter may be a shoo-in to eventually win Nobel prizes in a variety of categories, she may not yet be ready to select a good mutual fund.

A custodial account allows a parent, relative, or friend to give money to a minor but also maintain control over the account. A person, usually a parent or close family friend, is then designated as the custodian of the account until the child reaches his or her legal age of maturity. It is the custodians responsibility to manage the account and choose how the money will be invested. It is the custodians responsibility to administer the account until the beneficiary reaches a specified age (between 18 and 21 in most states).

Another advantage of a custodial account is that if the money is in the childs name, it will probably be less of a tax burden since it will be taxed at the childs lower rate. Also, unlike setting up a trust fund, which is a complicated task usually requiring a lawyers assistance, setting up a custodial account is very simple and inexpensive.

Different Ways to Give

The following are some of the more popular options available to grandparents for giving money to their grandchildren:

Savings Bonds

Giving savings bonds has long been one of the most popular ways of giving money as presents, particularly since they can be purchased in small denominations. Series EE savings bonds come in denominations of $50, $75, $100, $200, $500, $1000, $5000, and $10,000. The purchase price for each is half the face value. Interest is paid out when the bonds are cashed. Since the federal government guarantees a return of the original cost as well as a set amount of interest, savings bonds are always a very reliable investment. Keep in mind, though, that in times of high inflation they can be a very bad investment (as anyone who bought savings bonds in the seventies can attest). There is no guarantee that they will keep up with the rate of inflation. Thus, it is even possible you could lose money.

In recent years the government has made savings bonds a better investment for education by allowing the income from Series EE savings bonds to be tax exempt if the income on bonds purchased after January 31, 1989 is used solely to pay college tuition.

Mutual Funds

Mutual funds have been the rage with baby boomers. So why not buy some for your grandchildren? Particularly, if they are intended to help pay for a big ticket item such as college tuition. They allow you the flexibility of investing in aggressive growth funds when the child is young (up until junior high school), and then switching over to more conservative funds as the child gets closer to graduating from high school. You can set up a custodial account and designate yourself, your grandchildren's parents, or a friend of the family as the custodian of the account.

Zero Coupon Bonds

U.S. Treasury zero coupon bonds are popular among parents and grandparents. Zero coupon bonds are discounted Treasury bonds that, unlike regular bonds, do not pay semi-annual interest. You collect the interest when the bond matures. The advantage to this is that you can purchase a bond that matures the same year your grandchild graduates from high school. Or, for example, you could purchase four bonds, one each maturing during a students four successive years in college. Though the yield on zero coupon bonds may be nowhere as great as an aggressive mutual fund, they are great way to protect your investment as your grandchild gets closer to graduating from high school.

Pre-paid Tuition

Many states now offer pre-paid tuition programs. While each program has its own rules, they all work basically the same way: They allow you to start saving for tuition to a state college or university at todays tuition costs. It's then up to the state to invest your money and make sure it will be enough to cover the costs when your grandchild eventually enrolls.

What happens if the student decides that he or she would like to attend a state college in another state or an expensive private institution? Some states will cover the additional cost of non-resident tuition at another state school, but don't expect them to pick up the tab for four years at Harvard.

Also, the states will invest your money very conservatively. Do you think you can do better? If so, you could end up with more money and a greater deal of flexibility when it comes to your grandchild choosing a college. If, however, you are like a lot of people, you may value peace of mind over the potential risk that always comes with more aggressive investing.

Education IRA

The Education IRA was recently created by congress. Its name (Education Individual Retirement Account) is confusing since its purpose has nothing to do with retirement. It does, however, work like an IRA. A parent, grandparent, or friend can set up an account and contribute up to $500 a year for any child under the age of 18. The money in the account grows tax-free until it is withdrawn for college expenses. Only the amount that exceeds qualified college expenses can then be taxed. You can set up an Education IRA in addition to the IRA to which you normally contribute $2000 annually.

There are a few strings attached, however. You cannot contribute to an Education IRA if your adjusted gross income reaches $150,000 for married taxpayers or $95,000 for single taxpayers. Also, you cannot contribute to an Education IRA if you are already contributing to a pre-paid tuition program.

529 Plan

A 529 Plan is a newly created state-sponsored college saving plan. (529 is the section of the Internal Revenue Code by which it was created.) Currently, only a few states have 529 Plans, but that will change shortly.

A 529 Plan is allows parents or grandparents to set up an account in the name of a child who becomes the beneficiary of the account. The earnings grow federal income tax-deferred until the money is withdrawn to pay for qualified college expenses such as tuition, books, room, and board. At this time, the beneficiary is taxed at his or her rate, which will usually be much lower than that of the parent's or grandparent's. Since the money is not in the childs name it has less impact on their eligibility for financial aid.

Unlike pre-paid tuition plans, the money can go towards paying expenses at any accredited post-secondary institution in the United States.

Although the participant does not have any say in how the money is invested, each state invests differently. North Carolina, for example, tends to be more conservative than New Hampshire and Massachusetts.

In the case of Massachusetts and New Hampshire (both funds managed by Fidelity Investments), the money is invested in one of eight portfolios, depending on the age of the beneficiary. The younger the beneficiary, the more aggressive the investments. As the age increases, the invested portfolios become more conservative.

If the beneficiary receives a scholarship, the funds can be withdrawn without penalty. If the beneficiary doesn't use all the money in the account or even chooses not to attend college, the money can be transferred to another beneficiary without penalty.

Any U.S. resident can establish a 529 plan. An individual can contribute up to $50,000 ($100,000 per couple) just as long as the individual makes no additional contributions during the next five years. Family and friends can open up accounts for a beneficiary, just as long as they don't exceed a total of $100,311 per beneficiary.

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