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What's the best way to transfer stocks to my granddaughter for her college fund?

August 4, 2011: 5:05 AM ET

I have quite a few stocks that I have owned for years in dividend reinvestment plans (DRIPs), and I want to give them to my two-year-old granddaughter to begin a college fund. I will probably add a 529 also. How do I best do this? -- Richard Gwinn, Columbia, S.C.

To help your granddaughter, you have two ways to go: transfer your stock to a custodial account or sell your shares and contribute the proceeds to a 529 state college savings plan.

If you decide to gift the stock, you should consolidate all your shares—your original purchases plus all the shares you bought with reinvested dividends—into an UTMA (Uniform Transfers to Minors Act) account at a brokerage firm. An advantage of doing this is that as a minor she can collect up to $950-a-year in unearned (investment) income tax free; the next $950 is taxed at the child's rate (zero, as long as she has no other significant income).

Keep in mind that as the shares appreciate, the tax liability is growing too—she'll owe taxes on the entire gain when she sells the stock to pay for college. Also, funds in an UTMA are considered the child's asset in financial-aid formulas, which could reduce any aid, and once the shares are gifted to an UTMA they are her property. There's no changing your mind.

The alternative is to sell the shares and invest the proceeds in a 529 plan, naming her as beneficiary (stocks can't be placed directly into a 529). You'll have to pay the taxes on any capital gains now, but all future growth will be tax-free. And withdrawals are tax-free as long as the money is used for post-secondary education expenses. "I would vote for the 529," says T. Rowe Price vice president and certified financial planner Stuart Ritter. "If the goal is to help with college, the best tool we have right now is a 529 plan."

Every state offers its own version of a 529 plan with a menu of investment options provided by the investment firm that manages the plan. In your state, South Carolina, Columbia Management runs the Future Scholar 529 plan, which offers a mix of Columbia funds. You can also pick a 529 plan from another state, but as a South Carolina resident your contributions to a Future Scholar 529 are deductible on your state tax return. You'll loose that benefit if you go out of state.

One final advantage is that you may change the beneficiary of a 529. So if 16 years from now your granddaughter decides to skip college, the funds can be used to pay for her sibling's education.

—Allan Chernoff

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