4 College Savings Myths Grandparents Should Avoid

Contributions to 529 plans will rarely be subject to gift tax, experts say.

By + More

Gifts from relatives can often make or break college savings. Grandparents considering saving for their grandchildren's education often hear about tax breaks, gift tax limits and how 529 plan money is used.

These tax-advantaged college savings accounts can be started by a parent, but are also frequently started or contributed to by other family members such as grandparents or aunts and uncles.

Experts debunk some commonly held myths regarding grandparents and these college savings plans.

Myth 1: The money will be subject to gift taxes. This is rarely true.

In 2013, gifts up to $14,000 are excluded from the possibility of federal gift tax. One of the big benefits for grandparents – or for anyone – of contributing to 529 plans is the ability to give a lump sum of up to five times the annual amount of money excluded from the possibility of gift tax, says Jason Washo, an Arizona-based certified public accountant and personal financial specialist.

The grandparent would then have to wait five years before gifts would again fall under the exclusion.

"A grandparent could make a $70,000 contribution to a grandchild's 529 account in 2013 and avoid gift tax as long as the grandparent does not make any other gifts until 2018 and survives until 2018," he says.

Grandparents who give more than this amount may still never pay any gift tax. Amounts given as gifts over the annual excluded amount are added to a giver's lifetime tally, which would only incur taxes after that total reaches a certain amount, currently at $5.25 million for tax year 2013, says Kelley Long, an Illinois-based certified public accountant and personal financial specialist.

Lifetime limits are subject to change. Gift taxes are charged to someone's estate in the year of their death.

If grandparents reach the maximum lifetime giving limits, then the gift tax rules do apply.

Whether or not gift taxes are ever paid, gift tax forms will need to be filed for amounts above the annual limit. This is only so the Internal Revenue Service can keep tally of how close someone is to the lifetime limit mark, Long says.

[Learn who can benefit most from 529 plans.]

Myth 2: Grandparents can claim state tax benefits. This is partially true.

If grandparents are still working, being able to deduct some or all 529 plan contributions on state tax returns is a nice perk. However, each state sets its own rules on who can claim the tax deduction and for how much, Long says.

Grandparents need to verify what their state allows, which can typically be found on their state treasury's website. It may be a requirement for the grandparent to own the account or have an account in the same state to claim the deduction.

"For example, if Grandpa lives in Illinois and opens a 529 plan account for his grandchild who lives in Michigan, Grandpa must use an Illinois state-sponsored plan," Long says.

A student doesn't have to attend school in the state where the plan is located for the grandparent to claim a state income tax deduction. In this example, the grandfather could deduct up to $10,000 per year from his Illinois state tax return.

[Find out why another state's 529 plan may be right for you.]

Myth 3: Grandparents can claim federal income tax deductions. This one is false.

Long says that there are no federal income tax benefits for contributions to 529 plans, except that 529 plan earnings are not subject to income and capital gains taxes – taxes on investment account earnings – as long as the funds are used for qualified education expenses. Qualified education expenses include tuition and fees and books.

This myth tends to be believed by grandparents who live in states where 529 plan contributions are deductible on state tax returns, experts say.

The good news is the federal tax benefit that does exist, tax-free growth on savings, can add hundreds to thousands of dollars to 529 plan savings over the course of a decade of consistent savings.

[Understand how college savings can be part of estate planning.]

Myth 4: Grandparents give up control over money in 529 plans. This is partially true.