Question: I intend to make tuition payments directly to my grandchild's college, and I know this will reduce my estate. But would it be better to contribute to a 529 plan instead?
Answer :
Direct payment of tuition to an educational institution is not considered a taxable gift. Therefore, you're able to "give away" more than $13,000 per year (the amount of the annual federal gift tax exclusion) for your grandchild's college education and not worry about gift taxes. The money used to pay the tuition also will not be part of your estate.

With 529 plans, all contributions are considered gifts, so you want to use your annual federal gift tax exclusion. This exclusion lets you give to another person, like your grandchild, up to $13,000 per year without any gift tax or estate tax consequences. If you contribute more than $13,000 to the same beneficiary during a given year, though, you can avoid the gift tax if you elect to treat your contribution (up to $65,000) as if made evenly over a five-year period. However, informational gift tax returns must be filed. In any case, no gift tax must be paid out of pocket until you've used up your applicable exclusion amount ($1 million) and your lifetime exemption from the generation-skipping transfer tax (tentatively $1 million in 2011).

Section 529 plans offer certain advantages over the direct payment of tuition. First, withdrawals from 529 plans can be used to pay for tuition, fees, books, and even room and board for college and graduate school. The exclusion for direct payment of educational expenses, on the other hand, applies only to tuition. Your grandchild might need significantly more financial assistance.

You should also consider the possibility that you may not live long enough to pay your grandchild's tuition in the future. In such a case, nothing will be removed from your taxable estate (and the money your grandchild needs for education may not be available). If you contribute money to a 529 plan now, though, your contributions will be considered present interest gifts, and the value of your gifts to the plan will be taken out of your estate. (That is, unless your total gifts in one year are more than $13,000, you elect to treat the gifts as if made over a five-year period, and then you die within the five years. In such a case, the portion of the contribution allocated to the years after your death will be included in your gross estate.)

Note: Investors should consider the investment objectives, risks, charges, and expenses associated with 529 plans before investing. More information about 529 plans is available in each issuer's official statement, which should be read carefully before investing. Also, before investing, consider whether your state offers a 529 plan that provides residents with favorable state tax benefits.