Gifts now that pay for education later

With the holiday season in full swing, many grand-parents and other relatives are wondering how to make gifts earmarked for education. There are myriad options, and selecting the best one for your family depends on your circumstances.

Section 529 Plans

Since 1996, families have been able to use these tax-advantaged savings plans that are operated by individual states or educational institutions. There are two types of section 529 plans: prepaid tuition plans, which lock in future tuition rates for eligible colleges at current prices; and college savings plans, which allow saving and investing for qualified higher education expenses, free from federal and (almost all) state taxation. Additionally, some states offer 529 plans that provide state income tax deductions for residents. If your state offers a specific deal for residents, use it! (For a list of the states that provide such deals for residents, check out the wonderful finaid.org website.)

New York's 529 plan is called the New York College Savings Program. Qualified withdrawals are exempt from federal and New York state income taxes and contributions (up to $5,000 single filers, $10,000 joint filers) are deductible for New York income tax purposes. The cumulative contribution limit per beneficiary is $235,000.

In general, 529 plans offer a variety of investment vehicles, ranging from low-risk fixed options to aggressive stock funds, as well as age-based investment plans, where portfolio managers invest based on when the student will attend college. Most plans do not require that you be a resident of the state to use the plan, nor do most require that the student attend school in that state. To compare state plans, go to savingforcollege.com.

Savings bonds

These bonds are the lowest risk education funding vehicle, because they are backed by the U.S. government. The Education Bond Program allows qualified taxpayers to exclude all or part of the interest earned from all I Bonds and EE Bonds issued after Dec. 31, 1989, when paying for qualified higher education expenses. To qualify, there are income phase-outs based on the year you redeem the bonds, not the year you buy them. The 2012 limits haven't been announced, but for 2011, the income phase-outs were $70,100 to $85,100 for single filers and $105,100 to $135,100 for married taxpayers filing jointly.

Bonds must be issued in the name of a taxpayer age 24 or older at the time of issuance. Grandparents can purchase bonds for their grandkids, but the bonds must be registered in the grandparents' or parents' names. The child cannot be listed as a co-owner but may be listed as a beneficiary. There is an annual purchase limit of $30,000 per owner for Series EE and Series I Bonds. As of Jan. 1, 2012, paper savings bonds are no longer sold at financial institutions. Investors can buy the bonds at treasurydirect.gov.

Coverdell Education Savings Accounts (ESAs)

These accounts were previously known as Education IRAs and can be opened at most financial institutions (banks, mutual fund companies, brokerage firms). Contributions to a Coverdell ESA are not deductible, but amounts deposited in the account grow tax-free until distributed, if the funds are used for qualified education expenses. The ability to use ESAs for private elementary and secondary education makes them different from both savings bonds and section 529 plans. The downside of ESAs is that the total contributions for the beneficiary of this account cannot be more than $2,000 in any year, no matter how many accounts have been established. Coverdell accounts can be owned by the student or the adult opening the account, and the beneficiary must be younger than 18.

UGMA & UTMA Accounts

The Uniform Gifts to Minors Act (UGMA) and the Uniform Transfers to Minors Act (UTMA) allow adults to establish accounts on behalf of a minor, but do not offer any special tax treatment. All of the money and investments in these accounts are turned over to the beneficiary's control between the ages of 18 to 21 (depending on the state in which the account was opened), and the beneficiary can use the funds in any way he or she chooses. For this reason, UGMA and UTMA accounts are risky, because if the student decides against college and instead wants to take a cross-country motorcycle trip, there is nothing the custodian can do.

It's also important to know that all of these plans can potentially affect financial aid applications. For details, go to finaid.org/savings/ and accountownership.phtml.

Jill Schlesinger is the editor at large for CBSMoneyWatch.com and writes this column for Tribune Media Services.