The annual gift tax exclusion allows someone to give up to $16,000 (in 2022) to any person in a calendar year ($32,000 for a married couple) without having to file a federal gift tax return and without it counting toward your lifetime exemption amount.
Currently, no specific tax breaks exist for generous grandparents. However, grandparents and those who are looking to pay for a loved one’s education costs should consider how they can maximize their generosity while preventing unintended tax consequences.
How the Tuition Gift Tax Exclusion Works
The tuition gift tax exclusion allows you to pay an unlimited amount of tuition and is in addition to the $16,000 annual gift tax exclusion. Often overlooked, this exclusion is a great way to transfer wealth to children and grandchildren.
Generally, any transfers you make to other individuals are subject to gift tax. The IRS, however, considers payments for tuition made to a qualified educational organization on behalf of a student to be “non-gift” gifts, and gifts of this type are exempt from federal gift tax or federal generation-skipping transfer tax (GSTT). To be considered a qualified transfer, the payment must be: (1) for tuition, (2) made to a qualified educational organization, and (3) made directly to the educational organization.
Making Tuition Payments Directly to the College
Tuition payments to a qualified educational institution are exempt from the gift tax rules. To qualify, you must make the payment directly to the educational organization. Giving the payment directly to the student or to a trust on behalf of the student will not qualify. For example, consider if grandma transfers $100,000 to a trust with provisions stating that the funds are to be used for tuition expenses incurred by the grandchildren. In this example, grandma’s transfer to the trust is a completed gift for federal gift tax purposes and is not a direct transfer to an educational organization and, thus, does not qualify for the unlimited exclusion from gift tax.
This exclusion only applies to tuition payments. Money that is gifted to a child for other college expenses, such as books, supplies, room and board, do not qualify for the exclusion. However, the exclusion applies to tuition for any level of education and to both full-time and part-time students. Therefore, you can use it for payments for your younger child's private school tuition, as well as your older child's graduate school tuition.
You must make the payment to an educational organization that meets conditions set out by the IRS. To satisfy the requirements for a qualified educational organization, the organization must maintain a regular faculty, offer a regular schedule of courses, enroll students on a regular basis and have a place where it regularly carries out its educational activities. Unlike other types of charitable gifts that must be made to organizations located in the United States, a gift of tuition on behalf of another person can be made to a foreign educational institution as long as it meets the aforementioned requirements.
Paying for another's tuition can be a personally gratifying act. Individuals with the financial resources can also make good use of this tuition gift tax exclusion. The payment can be made on behalf of anyone. It does not have to be a relative as long as you make the payment directly to the educational organization.
Make sure you get a receipt that can prove that you made the payment directly to the educational organization in case the IRS audits you.
Strengths and Drawbacks
Making tax-free tuition gifts allows you to not only save your applicable lifetime exclusion amount but also stretches the annual gift tax exclusion. This can be a great way to transfer wealth to your children and grandchildren. Tuition payments made directly to a college do not count towards your lifetime gift tax exemption ($12.06 million in 2022). Making a gift of tuition also allows grandparents and other individuals to reduce their estate tax liability by removing the value of the payment from their gross estate. Because gifts of tuition are not considered gifts for gift tax purposes, you can still give the student up to $16,000 (in 2022) tax-free under the annual gift tax exclusion for other educational expenses.
However, it’s not just the gift tax exclusion for educational expenses that you should consider here. Tuition payments made directly to a college can substantially reduce the student’s eligibility for need-based financial aid, but the actual impact will depend on the college. Most colleges treat a direct tuition payment as cash support, but some financial administrators argue that direct tuition payments fit the definition of estimated financial assistance.
Superfunding a 529 College Savings Plan
One alternative to making tuition payments directly to a college is to contribute the money to a child’s 529 college savings plan. Money in a 529 plan grows tax free while in the plan, and distributions are also tax free if used for qualified education expenses.
While 529 plan contributions are considered gifts for tax purposes, grandparents who want to make a larger 529 plan contribution may front-load up to $80,000 ($160,000 if married filing jointly) with 5-year gift-tax averaging, assuming no other gifts are made to the same child during that time period. With 5-year gift-tax averaging, or superfunding, individuals may contribute between $16,001 and $80,000 by treating the contribution as though it were spread evenly over a 5-year period.
With this strategy, grandparents who are 529 plan account owners may shelter a significant amount from their taxable estate while retaining control of the assets. However, if the grandparent dies within the 5-year period, the contribution is not considered a completed gift and a portion of the contribution will be added back to their estate.
Additional Considerations
In addition to tuition payments, the gift tax exclusion also applies to any amount paid on behalf of an individual to any person who provides medical care with respect to that individual as payment for the qualifying medical expenses arising from such medical care. Qualifying medical expenses include expenses incurred for the diagnosis, cure, mitigation, treatment or prevention of disease as well as amounts paid for medical insurance on behalf of any individual.
Although the basic idea is simple, the implementation of gifting can be complicated. Speak with a financial professional at Busey Wealth Management to determine what is appropriate based on your individual goals and objectives. Learn more about our comprehensive services by visiting busey.com/wealth-management.
This is not intended to provide legal, tax or accounting advice. Any statement contained in this communication concerning U.S. tax matters is not intended or written to be used, and cannot be used, for the purpose of avoiding penalties imposed on the relevant taxpayer. Clients should obtain their own independent tax advice based on their particular circumstances.
This material is provided for educational purposes only and should not be construed as investment advice or an offer or solicitation to buy or sell securities.
This presentation is for general information purposes only. It does not take into account the particular investment objectives, restrictions, tax and financial situation or other needs of any specific client.
Investment products and services through Busey Wealth Management are:
Not FDIC INSURED | May lose value | No bank guarantee