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Prepaid Tuition Costs Can Save Thousands of Dollars in Gift and Estate Taxes

With education costs soaring to all time highs, making tuition payments for grandchildren and others can save lots of money in gift and estate taxes down the road – even if the donor is not alive when the tuition money is actually used.

By way of some background, the tax laws exempt tuition payments by grandparents or others from any gift taxes, provided certain requirements are met. First, the only educational costs that are gift-tax free are tuition costs. The cost of room and board, books, and other educational expenses are not exempt.

Second, the tuition costs must be paid directly to an educational organization that “normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.” Notice that there is no requirement that the tuition costs be paid to a college or university. In fact, tuition payments for nursery school, private elementary school, and private high school may also qualify. It’s possible, too, that tuition payments for part-time courses, such as dance, theater, music, cullinary arts, and the like will also qualify for the gift tax exemption.

So, how is this such a good deal? In the first place, these tuition payments are not treated as taxable gifts, so you don’t have to worry about having them come under the annual gift tax exclusion. In fact, you can make tuition payments for your grandchildren or others and still give each of them the annual exclusion amount ($12,000 for 2006) as a birthday gift or whatever.

Second, if your estate is large enough to be concerned about federal estate taxes (currently in excess of $2 million, $4 million for a couple), then the amount of the tuition payments will be excluded from your estate upon your death. In other words, your tuition payments will not be subject to a gift tax when the payments are made, nor will they be subject to an estate tax upon your death. In addition, they will not be subject to any generation-skipping taxes (GST) upon your death

That’s pretty good deal by itself, but here’s an added bonus. On July 9, 1999, the Internal Revenue Service issued Technical Advice Memorandum 199941013 stating that prepayment of tuition costs was also exempt from gift taxes under IRC Section 2503(3)(2). In that particular case, a set of grandparents had made payments to a private school to cover tuitiion costs for their two grandchildren from pre-school through grade 12. There was an agreement between the school and the grandparents indicating that the tuition payments would not be refundable even if the grandchildren failed to attend the school each of those years. The total payments made by the grandparents amounted to over $181,000 over a two-year period.

Recently, the Internal Revenue Service issued a private letter ruling that supports the Technical Advice Memorandum cited above. In that case, the IRS told a taxpayer that prepayments of many years of tuition costs for his grandchildren would not be considered a gift.

While Technical Advice Memorandums and private letter rulings only apply to the taxpayer’s who request them, they are a good indication of the IRS’ position on specific tax matters. Here, it appears fairly clear that prepayment of multiple years of tuition costs will not be treated as a taxable gift by the IRS.

Now, let’s sort of put all this into perspective. In the TAM discussed above, the grandparents pre-paid roughly $181,000 of tuition costs over a two-year period. The payments were not treated as taxable gifts and, since the money was removed from their estate, it was not subject to estate taxes upon their death. If the grandparents kept the money until they died and then gave it to their grandchildren under their will, it would have gone through probate first, then would have been subject to a federal estate tax and then, possibly, a generation-skipping tax – all before it could be used by the grandchildren.

If the grandparents had a fairly large estate, say larger than $4 million, then the estate taxes paid on that $181,000 would be roughly $83,260 (based upon a marginal tax rate of 46%). In that case, prepaying the tuition costs resulted in an estate tax savings of roughly $83,260. Plus, the grandparents didn’t have to use up their annual gift-tax exclusion to get the estate tax savings.

Still, there are some drawbacks that you should be aware of. First, you have to have a large enough estate to be concerned about estate taxes. Second, you probably should be concerned about dying before your grandchildren complete their education. Otherwise, you could just pay the tuition costs as they become due.

Finally, when you prepay your grandchildren’s tuition costs, you won’t be able to get the money back if your grandchildren drop out of school or decide to attend a different school. Some schools may allow the money to transfer to another school, but that would have to be agreed upon beforehand. Even so, there is no guarantee the IRS will go along with those types of arrangements.

One final point, tuition payments excluded from gift taxes under IRC Section 2503(e)(2) are not the same as payments under a 529 plan. First, gifts to 529 plans come under the annual gift-tax exclusion. Prepaid tuition gifts are in addition to the annual exclusion gifts.

Second, gifts to a 529 plan are excluded from the donor’s estate only if the donor survives during each year for which the pre-payment was made. Prepaid tuition gifts are excluded from the donor’s estate as soon as the prepayment is made.

Third, 529 plans apply only to higher education (college and beyond) whereas prepaid tuition gifts apply to all levels of education, including nursery schools, elementary and high school.

Fourth, 529 plans apply to all education costs, including room and board, books and supplies, as well as tuition. Prepaid tuition gifts apply only to tuition costs.

That is not to say, however, that prepaid tuition gifts cannot be used in tandum with 529 plans.

For wealthy grandparents who are inclined to help with their grandchildren’s education costs, a prepaid tuition gift under IRC Section 2503(3)(2) certainly should be considered.

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