Gift Tax Exclusion for Transfers for Educational Expenses
Payments made directly to an educational institution, either elementary or high school or college, for a child’s tuition are exempt from measurement as a gift and do not reduce the annual $14,000 gift exclusion. The gifts must be made directly to the educational institution. They cannot be made to a trust which will pay for the beneficiary’s future tuition. The child does not have to be currently enrolled at the school when the payment is made. If a tuition payment is a legal obligation or parental support item, the gift tax would not be applicable. The gift for tuition will reduce the donor’s estate. This estate reduction technique is often utilized by grandparents who are motivated by the estate tax savings, and wish to make gifts in excess of the $14,000 per donee annual limit.
- Gifts in excess of the annual $14,000 exclusion can be made without incurring a gift tax liability.
- The generation-skipping transfer tax (GST) does not apply to lifetime gifts made directly to an educational institution for tuition expenses. Therefore, gifts made directly to an educational institution by a grandparent for the grandchildren are not generation skipping transfers and not subject to GST.
Example: Grandma Lucy makes a cash gift of $14,000 to her granddaughter, Lil, during February Grandma Lucy also makes a payment of $17,200 for Lil’s tuition directly to Minnesota University during 2013. Because the tuition was paid on behalf of Lil directly to the educational institution, the transfer is exempt from gift taxation. Additionally, because Grandma Lucy’s other gifts to Lil during the year were $14,000 or less, no gift tax return is required to be filed by Grandma Lucy for the year 2014.
Note: The “needs analysis formula” treats payments made directly to a college by grandparents as a “resource” of the student, resulting in a direct reduction in the financial aid eligibility of the student.
Note: IRC Sec. 25A regulations hold that any direct payments of tuition by a third party, such as grandparents, are treated as payments made directly by the student for purposes of the American Opportunity Credit or Lifetime Learning Credit. Thus, the strategy of having the grandparents make direct payment of tuition still preserves eligibility for these tax credits on the student’s tax return.
Advance Tuition Payments
The IRS has privately ruled that the IRC Sec. 2503(e) gift tax exclusion applies to a grandparent’s advance tuition payments on behalf of a grandchild (TAM 199941013).
- Under an arrangement with the educational institution, a grandparent made a total of over $180,000 of current payments to cover tuition over the next ten years to a K-12 school that two of her grandchildren were attending. The amounts were nonrefundable; if either grandchild did not attend the school for any year that tuition payments were made, the tuition for that period was forfeited.
- In concluding that the payments were subject to the gift tax exclusion of IRC Sec. 2503(e), the IRS cited Reg. 25.2503-6(b)(2), which provides that the unlimited gift tax exclusion is permitted for tuition expenses of full-time or part-time students paid directly to the qualified educational institution attended by the student.
Observation: By affording these payments the gift tax exclusion of IRC Sec. 2503(e), the grandparent also accomplished the removal of the amounts from her taxable estate.
Use of Qualified Tuition Plans to Fund Grandchild’s College Cost
If a grandparent wants to reduce the size of an estate and help pay for grandchildren’s college educations, the grandparent should consider the use of QTPs to accomplish these goals.
If the grandparent is young and in good health and anticipates living for quite awhile longer, the grandparent wants to make sure that there is enough funds available for retirement needs. Also, the grandparent wants to make sure that the grandchildren will not grow up to be spendthrifts and not use the money for college. Accordingly, the grandparent may not like the idea of trusts or custodial accounts to accumulate funds for the grandchildren’s college educations. If a grandparent uses these types of vehicles to accumulate funds, the grandparent will lose control of the money and it will not be available for retirement needs, and the grandchildren may not use it for college.
Because of the above concerns, funding grandchildren’s college educations with a QTP may be the best option. The grandparent can establish an account for each grandchild and fund it with annual tax-free gifts, if the gift is less than the annual gift exclusion.
The advantages of a QTP to fund a college education are:
- the grandparent can withdraw the funds from the QTP if needed for retirement,
- the funds need not be distributed to a grandchild who might use the funds for non-college purposes,
- if a grandchild falls from favor with the grandparent, the plan funds can be rolled over to another beneficiary, and
- the grandchildren will benefit from the deferral of income tax on the plan earnings; this benefit is unavailable for custodial accounts and some trusts.
If a grandparent’s primary goal is to reduce an estate in the most tax-efficient manner possible, a QTP may not be the best option. If the grandparent anticipates being alive during the grandchildren’s college years, the best way to reduce a grandparent’s estate may be for the grandparent to make gifts directly to the grandchildren’s colleges. In this situation, the grandparent will not waste the annual gift exclusion on gifts to a QTP. If part or all of the annual gift exclusion is used to offset gifts to a QTP, the grandparent is not reducing the estate in the most tax-efficient manner. The grandparent could make gifts directly to colleges and also make additional gifts that could be offset by the annual gift exclusion.
Using a Grandparent’s Retirement Accounts to Fund College
If a grandparent’s retirement accounts are left entirely to the parents, it is probable that the parents will take substantial distributions from the accounts to meet the grandchild’s projected college expenses. In this situation, the grandparent should consider naming the grandchild as a beneficiary of that portion of the retirement accounts that will be sufficient to meet the child’s anticipated college expenses.
The distributions will be taxed to the grandchild. If the distributions are used to provide more than half of the grandchild’s support, the grandchild, not the parents, will be able to claim the personal exemption. Because the income is taxed to the grandchild, this strategy will help maximize the grandchild’s tax capacity. The grandchild will likely pay very little or no income taxes on the distributions because of the grandchild’s personal exemption, standard deduction, and eligibility for the education tax credits.
Grandparents that are under age 59½ may withdraw funds from a traditional or Roth IRA to pay for a grandchild’s qualified college expenses without incurring the 10% early withdrawal penalty. Paying for a grandchild’s college education by withdrawing funds from an IRA will reduce the value of the IRA in a grandparent’s estate. Since IRAs are considered “income-in-respect-of-decedent,” IRD, assets in a grandparent’s estate and receive adverse tax treatment, it may be best for the grandparent to use IRAs, rather than non-IRD assets to pay for a grandchild’s college education.
However, it may be better to name a grandchild as the beneficiary of an IRA. Instead of the grandparent taking the minimum distribution from an IRA at age 70½, which is based on the joint life expectancy of the grandparent and the beneficiary named to the IRA account, the grandparent can minimize the annual distribution by naming a younger grandchild as the beneficiary of the IRA. The grandchild has a longer life expectancy than the grandparent and therefore, the payout period will be longer and the distributions will be less than if the grandparent’s spouse or child is the beneficiary. When the grandparent dies, the balance of the IRA will be distributed over the grandchild’s life expectancy.
By minimizing the IRA annual payout, the account will compound tax-deferred over a longer time period. In addition, because of the grandchild’s tax capacity and availability of education tax credits, the grandchild may pay little or no income taxes on the distributions.
In order for charitable gifting to be a viable college funding strategy, the client must have a charitable desire. The donor will not receive more tax or college benefits from a donation than the monetary cost of the donation. The effective tax rate would have to be 100% in order for the donor to receive full tax value for the donation. Therefore, the donor must have a desire to give to a charitable cause for reasons other than monetary gain.
It may make sense for the donor who has a charitable desire to combine the estate and tax benefits of a charitable donation with a desire to help pay for a grandchild’s college education. Consider the scenario where a grandparent, who has appreciated assets, sells those assets, pays capital gain tax, re-invests the assets, pays income tax on the assets’ current earnings, and then gives the remaining assets to a grandchild to pay for college. If the grandparent has a charitable intent, one strategy would be to use the charitable trusts to accomplish the grandparent’s goal of reducing income and estate taxes, gift to a charity, and fund a grandchild’s college education. This could be accomplished through the use of a Charitable Remainder Trust (CRT) or a Charitable Lead Trust (CLT). These trusts can be created during the donor’s lifetime, inter vivos trust, or at death, testamentary trust.
- The client receives a current tax deduction.
- The donated asset is not included in the donor’s estate.
- Future income generated by the asset is not subject to income tax.
- The asset’s appreciation is not subject to estate tax.
- The donor loses the lifetime financial benefits generated by the donated asset.
Charitable Remainder Trusts
If a CRT was used, a donor/grandparent could donate a remainder interest in the asset to the charity. The donor would receive a current charitable tax deduction, remove the asset from the estate, and retain an income interest in the asset to help fund current or future college costs. A grandparent could gift the income interest to a grandchild. In this case, the grandparent is treated as having made a taxable gift of the income interest. If the income is immediately payable to a grandchild, the annual gift tax exclusion is available. The income interest for the non-charitable beneficiaries’ (children or grandchildren) can be paid over a fixed period of up to 20 years. At the end of the period, the remaining trust assets are transferred irrevocably to the designated charity.
A “pooled income fund” may be an inexpensive alternative to a CRT. The website www.charitable-gift.com contains more information on these funds.
Example: The parents have stock worth $50,000 with a tax basis of $5,000. The parents contributed the stock to a 4-year term CRT and gifted the annual income interest of $6,000 (12% annuity) to their child. The income interest proceeds were to be used for the child’s college expenses.
The income interest of $6,000 is taxable to the child. In addition, the parents have made a gift, of approximately $20,000, to the child of the present interest in the CRT income interest. At the end of the trust, the named charity would receive the trust principal. The parents will receive approximately a $30,000 charitable income tax deduction.
There are two types of Charitable Remainder Trusts, CRTs:
- the charitable remainder annuity trust (CRAT), and
- the charitable remainder unitrust (CRUT).
A CRAT’s annuity payments to the donor are fixed; such payments will not fluctuate with the performance or value of the assets.
A CRUT’s annual payments will fluctuate with the performance or value of the assets.
- The client receives a charitable donation tax deduction for the charitable gift.
- The client avoids paying income tax on the appreciation of the asset that was gifted.
- The value of the asset plus any future appreciation is removed from the client’s estate.
- The client will receive income during the term of the trust.
- The client loses the future benefit of the asset.
- The amount of inheritance left to the client’s heirs is reduced.
Charitable Lead Trusts
A charitable lead trust, CLT, pays income to a charitable organization for a given period or the life or lives of individuals (there is no 20-year term limit), after which the remainder interest either reverts back to the grantor or passes to a non-charitable beneficiary such as a child or other family member.
A CLT may either be:
- a charitable lead annuity trust, CLAT, where the income interest is in the form of a guaranteed annuity whereby a specified dollar amount is paid to one or more charitable beneficiaries each year for a specified term of years, or for the life or lives of an individual or individuals; or
- a charitable lead unit-trust, CLUT, where the income interest is based on a fixed percentage of the fair market value of the trust’s assets, determined annually. The trust can be created during the donor’s lifetime or at death.
The most common form of CLT is the non-grantor CLT. The typical non-grantor CLT is drafted so that the grantor is eligible for a gift, or estate, tax charitable deduction. The value of the remainder interest passing to the non-charitable beneficiary is subject to gift or estate tax at the time the trust is funded.
Lifetime transfers to a CLT are not eligible for the annual $14,000 gift tax exclusion because they are not present interests of property.
A grantor CLT differs from a non-grantor CLT in that the grantor is the remainderman, or the grantor retains such powers for the trust to be considered a grantor trust. As such, the grantor receives a charitable income tax deduction for the actuarial value of the charitable interest in the year the trust is established, limited to 30% of the donor’s adjusted gross income. As the trust earns income and satisfies its charitable obligation during the trust term, the donor, treated as owner of the income interest, is taxed on this income even though it is paid to charity.
- The value of the gift to the non-charitable beneficiary is limited to the value of the remainder interest.
- Grantor receives a charitable income tax deduction for the actuarial value of the charitable interest in the year the trust is established.
- The CLT may be used as a means of bypassing the charitable deduction percentage limitations for individuals.
- The donor is taxed on the CLT income even though it is paid to the charity.
- Lifetime transfers to a CLT are not eligible for the annual $14,000 gift tax exclusion.
A non-grantor charitable lead trust (CLT) may be useful as a means of bypassing the charitable deduction percentage limitations for individuals. A non-grantor CLT can claim a charitable deduction for up to 100% of its income donated to charity. Transfer tax can also be saved with a non-grantor CLT.
When a charitable lead trust is established and a child is named as the beneficiary, a taxable gift occurs.
Life Insurance to Replace the Gift Value
Donors are sometimes reluctant to make gifts to CRTs because they do not want to reduce the size of the estate that will be left to their heirs. One way to solve this problem is to use the increased cash flow from a CRT and the income tax savings generated by the charitable gift to purchase life insurance on the donor’s life to replace the assets gifted to the CRT.
- Replaces the asset that was transferred to the CRT.
- If the life insurance is placed in an irrevocable life insurance trust, the proceeds will not be included in the donor’s estate.
- The cost of the life insurance may be high, depending on the age of the donor.
Testamentary Trust for Funding College
A client can provide funds for a grandchild’s college education through a will with a testamentary trust.
A provision in the testamentary trust could be made for general living expenses: typical support, maintenance, education and health expenses, until the grandchild reaches the age of 18. Once the grandchild reaches age 18, only the grandchild’s education and health expenses could be defined to include the reasonable living expenses of the grandchild. In essence, the grandparent would be “ruling from the grave.” If the grandchild wished to have living expenses continued to be paid by the trust, the grandchild would have to be satisfactorily engaged in the pursuit of a college education.
A testamentary trust could benefit either one grandchild or two or more grandchildren. To prevent an older grandchild from pillaging the fund down at the expenses of a younger grandchild, “equalization provisions” in the trust should be considered. In the alternative, the trust document should contain provisions mandating or allowing the breaking of the original trust for the benefit of two or more grandchildren into separate trusts for the benefit of each separate grandchild.