When Grandma offers tuition help

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(Money Magazine) -- Despite losses in their own investments, 65% of grandparents plan to help their grandkids pay for college, reports the College Savings Foundation. That may spell relief for parents squeezed by the economy. But handled incorrectly, such giving could hurt your child's chances for financial aid, says Joe Hurley of savingforcollege.com. Here are the best ways for Grandma to give.

Any money given to a kid could be considered income, and by law must be reported on the Free Application for Federal Student Aid (FAFSA). The aid award could then be reduced by up to 50% of the gift, says Mark Kantrowitz, publisher of FinAid.org. A check sent to the school can similarly cut into a student's award. (Yes, schools pay attention to who signs the checks.) Meanwhile, money given to the child's parent may be considered a parental asset, and that's far more favorable. There are significant exclusions on parental assets, and Mom and Dad are only expected to contribute up to 5.64% of the rest. Just advise Grandpa to keep his yearly contribution under the gift-tax exclusion - $13,000 per grandparent per beneficiary in 2009 - to avoid taxes.

Grandparents can stash up to the gift-tax exclusion annually in a 529 college savings plan, or put away a lump sum of up to $65,000 apiece using a special five-year election on the federal gift-tax form. As long as the grandparent is the owner and the child is still a dependent, the account value won't count against federal aid. But it could affect school aid. Also, distributions are considered student income, says Kalman Chany, author of "Paying for College." So it may make sense to hold off using the funds until senior year.

Still, the 529 has benefits: Grandparents may get a state tax write-off. Plus, if the kid doesn't go to college, the grandparent can change the beneficiary or even reclaim the cash - minus income tax and a 10% penalty on earnings. Visit savingforcollege.com for info on plans.

Another option: Grandma could promise to pay off the child's student loans upon graduation. That won't affect the student's aid eligibility. And it provides an incentive to finish school. The downsides? The student will have to accept loans - which, if the grandparent passes away before graduation, will be the child's responsibility. Also, if Grandma pays off more than the gift-tax exclusion in a year, she will owe the IRS.