529 Gift a Great Idea, but First Do Your Homework

Question: My niece and nephew have every toy on the planet, so this year for Christmas, I was thinking of making a gift contribution to their college-savings accounts. Would I be better off sending the money to their parents to add to their existing 529s or opening a new 529 that I control?

Answer: Your niece and nephew are fortunate to have a member of the extended family who is thinking about their future. And I'm sure their parents will appreciate the gesture at least as much, if not more.

As you suggest, there are a few different ways to contribute to a 529 college-savings account for the benefit of someone who is not an immediate family member. (You could also consider other vehicles, such as a Coverdell Education Savings Account or UGMA/UTMA account, which I discuss more fully in this video.) In addition to sending the money to the parents for them to add to a 529 account that they control or opening a new 529 account that you control, another option would be to send the money directly to the parent-controlled 529 account.

But before deciding among these three approaches, let's take a closer look at the pros and cons of each.

Sending the Money Directly to the Parents
Pro: Sending the beneficiaries' parents a check or electronic funds transfer through your bank or through a service such as PayPal is a pretty straightforward process, so from a convenience standpoint, it's tough to beat. Once they receive the money, the parents can make a contribution of an equal amount to their existing 529 accounts for their children.

Cons: By sending the money directly to the parents, you are foregoing any potential state income tax deduction you might be entitled to, not to mention the fact that there's no guarantee the parents will use the money for the purpose you intended.

Sending the Money Directly to the 529 Plan
Pro: 529 plans typically make it easy for non-account owners--including friends and family members--to contribute directly to the plan via check or electronic funds transfer. Programs such as Ugift, which is available for plans affiliated with Upromise Investments, even encourage account owners to solicit such gift contributions from friends and family by helping them send out gift coupons with instructions for how to make a contribution to their account. Be aware, however, that some 529 gifting services charge fees either to the contributor or to the beneficiary (Ugift does not charge fees). It should cost you nothing to contribute directly to someone else's 529 plan.

Con: Some states allow those contributing to a 529 account that they don't own to take a tax deduction for their gift, but others don't. Therefore, you might miss out on a state income tax deduction by going this route.

Opening a 529 Account That You Control
Pro: Anyone can open a 529 account for any beneficiary--you don't need to be a family member--so establishing an account that you own would allow you to have complete control over how the funds are invested. Plus, owning your own account may be the only way for you to get a state income tax deduction for your contributions.

Cons: Here's where things get complicated, especially once it comes time to use the money from your 529 account to help cover the beneficiary's college expenses. That's because assets from multiple 529 accounts cannot be withdrawn to cover the same expenses--for example, if a beneficiary with two different 529 accounts owes $5,000 for tuition, the owners of those two accounts must be careful not to each withdraw $5,000 for this purpose (although withdrawing $2,500 apiece would be fine). So, you'll need to carefully coordinate 529 distributions with whoever else owns an account for the beneficiary. Also, you will be responsible for showing that the money was used to cover qualified college expenses if the IRS ever comes asking, which means you may need to ask the student and/or his or her family to provide documentation.

Second, while 529 assets owned by the beneficiary's parents have a minimal impact on need-based financial aid, distributions that come from 529 accounts owned outside the family count as student income on the following year's financial-aid application. So, while the 529 account you've established to help pay your niece and nephew's college costs won't cost anyone anything in taxes and may even get you a deduction on your state income tax, once you go and use the money to pay for their college expenses, it could end up costing them some financial-aid benefits.

One way around this problem: Coordinate with the student and his or her family to avoid tapping your 529 account until the student's final year of school, when applying for financial aid the following year won't be an issue. Another, simpler plan is to roll the assets from your 529 account into the account owned by the student and/or his or her parents, or to simply change ownership of the account over to the student or the parents. That way, distributions all come from the family-owned account and the impact on need-based financial aid is sharply reduced.

However, here, too, there are complications. Some states have what are called claw-back penalties for transferring in-state 529 assets to out-of-state plans. That means you could be forced to repay any state income tax deductions you've taken over the years if your 529 is from a different state than the one you're rolling the money into. Plus, some plans charge fees for rolling out of the plan. So, if you do think you'll open a 529 account with the intent of later rolling the assets into an account owned by someone else, you'd be well advised to do your research ahead of time so you don't get hit with a big tax bill or penalties.

The Bottom Line
To decide which of the above options makes the most sense for you, you'll have to answer a few key questions: Will you get a tax break for your contributions, and will it be enough to justify your decision? How important is it to you to have control over the assets? And how much of a hassle will it be to coordinate contributions and/or distributions?

If you don't expect to make any future college-savings contributions for your niece and nephew, the simplest thing to do is probably to send a check to the parents or directly to the accounts they own. If you plan to make repeat contributions, setting up a 529 you own may make more sense, keeping in mind the caveats we've already mentioned.

Opening a 529 college-savings account for someone who is not an immediate family member can become a rather complicated gesture requiring both research and coordination. That said, helping to cover your niece's and nephew's college costs and potentially helping save them from having to borrow more, is a true kindness. Just be aware that it's a kindness that may not be so simple.

Have a personal finance question you'd like answered? Send it to TheShortAnswer@morningstar.com.