Carrie Schwab Pomerantz

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!


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).

(set ital) The 529 plan (end ital): 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 In a 529 account, investment income is never taxed, as long as it's withdrawn for "qualified" higher education expenses.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 can give $130,000 in a single five-year period (this 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.

So what's not to like? Well, 529 plans offer fewer investment choices than custodial accounts or trusts, and trading and exchanges are often limited. Plus, 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.

Carrie Schwab Pomerantz

Carrie Schwab Pomerantz is a Motley Fool contributor.

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