The amount of money grandparents spend on their grandchildren's education is expected to multiply. According to Sallie Mae's "How America Saves for College 2013," the percentage grandparents are expected to contribute toward students' college costs is more than double for future college students versus current attendees.
However, grandparents don't qualify for the Lifetime Learning Credit or the refundable American Opportunity Tax Credit unless the grandchild is their dependent. The same rule applies to tuition and fees deductions.
According to the IRS, in order to claim either of these tax credits, the eligible student has to be "yourself, your spouse, or a dependent for whom you claim an exemption on your tax return."
However, there are other benefits that grandparents do qualify for, particularly at the federal income tax level.
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To benefit at the federal level, grandparents can give tuition directly to the university, says Dan Thomas, a California-based certified public accountant and personal financial specialist. Paying the school directly, instead of donating to a student's 529 plan, a tax-advantaged college savings account, would allow them to avoid potential gift taxes if they plan to make significant contributions.
Gift taxes are charged if grandparents donate more than $14,000 annually toward college savings accounts. Five years of this exempted amount can be gifted at one time to a 529 plan, meaning that anything in excess of a five-year donation of $70,000 could be taxed.
For instance, if tuition is $20,000 per semester, a grandparent could give that full amount every semester directly to the university without paying gift tax charges. The total for eight semesters, if tuition didn't rise, would be $160,000, an amount that is $90,000 over the five-year gifting limit for 529 plans.
Grandparents can also pay any health care expenses, including school health insurance, without worrying about gift taxes, Thomas says.
[Learn about changes to 529 plans this year.]
While direct tuition payments won't count against gift tax limits, they may count against future financial aid awards, says Chadderdon W. O'Brien, a New Jersey-based certified financial planner and certified financial risk manager with Lassus Wherley.
Schools don't take into account whether grandparents will be able to provide the same amount of money each year, O'Brien says. Similar to schools reviewing the prior year's income tax information on the Free Application for Federal Student Aid, financial aid officers review the previous year's tuition payments from other sources, including grandparents, he says.
"Grandparents making direct tuition payments on behalf of their grandchildren should be aware this may negatively affect the child's ability to obtain financial aid in the future," O'Brien says.
"Unless the grandparent intends to continue providing financial support, tuition payments should not be made on behalf of the child until the child is done applying for financial aid, typically in their last year of school," he says.
In general, a college senior whose grandparents are paying tuition directly to the school would not have to worry about filing another FAFSA because he or she is graduating the same year.
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Grandparents who can pay for all years of schooling may still need the student to add them to the list of allowed payers, according to Jim Brooks, financial aid director at the University of Oregon. At his school, students can electronically add five individuals' names to their authorized payer list.
However, each school's rules differ and grandparents who are considering making direct payments should check with the school's business office about the process, Brooks says.
For grandparents who can't afford to pay for all four years of tuition, O'Brien recommends they deposit the money in a 529 plan account instead. In many states, grandparents benefit from state income tax deductions on 529 plan contributions, he says.