Many grandparents have the luxury of helping their grandchildren pay for college. But what is the smartest way to give? You may think that an outright gift of money will most effectively accomplish your goal of providing your grandchild with an education, but you would be wrong!

The majority of grandparents assist grandchildren through outright gifts, which means that each grandparent can give up to $12,000 to a grandchild without having to pay estate or gift tax. This gift can be doubled to $24,000 if both grandparents give. The problem with an outright gift is that in today's dollars, $24,000 may not be enough to pay for a year's tuition. Compounding the problem, the gift may be considered income to the child, negatively impacting their ability to qualify for financial aid. And this method only works if you have a trustworthy grandchild who won't use the money to buy a new car or take a trip to follow their favorite rock band.

Another option you might consider is to pay the tuition directly to the college or university. This way, you can contribute as much as necessary without the money counting towards the $12,000 yearly gift exemption. Again, this option only applies to tuition and may reduce financial aid available to the student.

Coverdell education savings accounts are another option for grandparents with earned income. The grandparent can contribute up to $2000 per year to the account that was set up for a child under age 18. The catch here is that whoever opens the account must have earned income, so a grandparent without earned income might gift the money to the parent to open the account. The grandparent or parent can then control the investments. The funds in the account can be used for public or private elementary and secondary education.

The obvious drawback to a Coverdell is the $2000 per year limit. Also, if your income is too high, you may be barred from contributing. With a Coverdell, the funds in the account belong to the beneficiary, so you lose some control. The funds must be fully withdrawn by the time the beneficiary reaches age 30, or else it will be subject to tax and penalties. And not surprisingly, financial aid may be affected.

An excellent alternative to Coverdell savings accounts is a 529 plan. 529 plans are state-sponsored college savings plans that work like a mutual fund, investing money on behalf of participants. Earnings grow tax deferred from federal (and sometimes state) income tax. Withdrawals used for qualified education expenses are currently free of taxation. The grandparent controls the funds in the account, but contributions are removed from their estate for estate tax purposes (check with your tax and/or legal advisor as certain rules apply).

With 529 plans, you can donate five years worth of tax-free contributions into a single year, with a maximum of $60,000 per person or $120,000 per couple. The catch is that you cannot contribute any more money to the plan within that five-year period. If a grandparent contributes the lump sum up front, the time power of money is maximized which can lead to a substantial sum of money down the road. Most 529 plans allow for total investment of at least $200,000, and they are free of donor income limitations.

The downside to a 529 is that they can swing up and down, depending on the performance of the investments. Some critics warn about potentially high investment fees. Regardless, 529 plans are popular with parents and grandparents alike.

If your state still offers them, a prepaid tuition plan may be another option to consider. States and some groups of private colleges operate the plans. These plans allow investors to buy part or all of a future tuition at today's cost. A grandparent would buy units, which might equal a semester or a year of tuition at today's costs. The state or consortium guarantees that this unit will buy the same amount of education when it is time for the student to go to school, thus matching the inflation rate for that educational system's costs. Unfortunately, low market returns have caused some states to drop or freeze enrollment in these plans.

Giving to a grandchild's education is one of the most generous and important things a grandparent can do for their grandchild. Be smart about how you give so that your contribution is maximized for your grandchild and so your grandchild is not penalized when applying for financial aid.

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