You may not be aware of this, but you don't have to be a parent to open a 529 savings account or to contribute to a Coverdell Educational Savings Account. And whether the child's parents are already saving for college or not, with the rising costs of education, a contribution to college expenses will always be a welcome gift.
While opening a college savings account is a bit more complex than picking up the hottest toy from Wal-Mart, the long-term rewards are well worth it. But first, you'll need to decide how best to contribute to the child's future education.
The Options: 529 Plan v. Coverdell Educational Savings Account
There are two tax-advantaged college savings account options – the 529 plan and the Coverdell Educational Savings Account. Each option has its own advantages and disadvantages, which you'll want to understand before choosing to contribute to Johnny's or Sally's educational expenses.
The largest difference between the Coverdell ESA and the 529 is that the Coverdell can be used for private elementary and secondary school costs as well as college-related costs. On the other hand, 529 plans can only be used for qualified higher education expenses, including undergraduate and graduate expenses.
The differences between 529s and Coverdells are complicated, but the bottom line is that it's usually easier to open and contribute to a 529 account than to open or contribute to a Coverdell. This is partially because some Coverdell plans must be opened by a child's parent or guardian and also because a Coverdell ESA has a low $2,000 per year total contribution limit. No matter how many Coverdell accounts one beneficiary has, or how many individuals contribute to the account, you can never put more than $2,000 per year into Coverdell ESAs for one beneficiary.
However, if the child's parents have already opened a Coverdell account and aren't planning to max out the $2,000 contribution, you may want to put money into this type of account – especially if the child may attend private elementary or secondary school.
Make a Plan Together
Before you decide to contribute to a child's college savings, talk to the parents or guardians. Find out if they've already opened a college savings account or if they're planning to in the future. Some parents, understandably, prefer to keep control of all a child's assets.
In this case, they may prefer that you just add money to an existing 529 plan. Some 529 plans even let the account owners send electronic or paper invitations to those who wish to donate to the account, so they know exactly where to send a check or electronic payment.
In some cases, though, the child could benefit more from having a separate 529 account – outside of the main account run by his or her parents. You'll want to discuss this option with the child's parents and work as a team to find the best college savings solution.
While you're making these decisions, be sure to talk with the child's guardians about overall college savings goals. Above all, you don't want to save too much money in a 529 account. The goal is to have just enough to cover future college expenses. Otherwise, any money left in the account will either have to be rolled over to a new beneficiary or withdrawn for non-educational expenses. Distributions not used for qualified educational expenses are subject to heavy taxes and penalties, which you'll want to avoid.
A Gift that Gives Back
In some states, you can get a tax benefit from adding money to that state's 529 plan. If your state offers this tax benefit, you might want to start or contribute to an account run by your state. This way, the recipient will benefit, and you'll reap some tax savings for yourself.
So before you buy the kid who has it all a bunch of toys that will be played with twice, consider a gift that will keep giving through the years – a college savings account.
Abby Hayes is a freelance blogger and journalist who writes for personal finance blog The Dough Roller and contributes to Dough Roller's weekly newsletter.