Here is a detailed article by Elizabeth Bawden and Dina Nam of Withers Bergman, going through strategies for wealthy individuals seeking to gift education.
“An investment in knowledge pays the best interest” – Benjamin Franklin
The following guest article may be useful for wealth managers with clients that are thinking about the most strategic, tax-efficient ways that they can help a family member with costs related to education.
Bawden is a partner at Withers Bergman and focuses her practice on estate planning, planned giving and tax-exempt organizations. Nam is an associate at the firm.
According to the National Center for Education Statistics, the cost of a college education between 2002 and 2013 rose 39 per cent for public institutions and 27 per cent for private non-profit institutions. In light of these rising costs and the importance of education, clients often ask how they can help family members and friends pay for education without triggering any federal gift or estate taxes. There are a number of techniques, both simple and complex, to achieve these goals. They are discussed with reference to the person making the gifts for education as the “donor” and the recipient of the gifts, regardless of age, as the “student.”
Basic gift tax rules
Generally, gifts made to or for the benefit of a person other than a spouse are subject to federal gift or estate tax unless an exclusion or exemption applies. The most well known exclusion allows each donor to give $10,000, adjusted for inflation in 2015 to $14,000, per donee each year (the “annual exclusion”). The annual exclusion is separate from and in addition to the $5,000,000, adjusted for inflation in 2015 to $5,430,000, that each person is allowed to gift during lifetime or at death free from taxes (the “lifetime exemption”). A separate generation skipping transfer (GST) tax applies to gifts made to donees who are two or more generations younger than the donor (e.g. grandchildren); all of the options discussed below are suitable for grandparents and can be structured to avoid the GST tax.
Direct tuition payments
The simplest way to pay for education in a tax-efficient manner is to make tuition payments directly to an educational organization for the education or training of the student. Educational organizations for this purpose are broadly defined and include primary, secondary, and high schools as well as colleges and universities. As long as the tuition payments are made directly to the educational organization (and not to the student or student’s parents to later pay to the educational organization), they are excluded from gift and GST tax in an unlimited amount, separate and in addition to the annual exclusion or lifetime exemption.
While the ability to make direct tuition payments free of gift tax is both simple and powerful, it is only useful for a student with current (rather than future) education needs. Because direct tuition payments are separate from the annual exclusion, a donor can at the same time use annual exclusion gifts to save for the student’s future education or to pay for expenses like room and board, books and computers that don’t fall within this special exclusion.
UTMA or UGMA accounts
A simple way to make annual exclusion gifts for a student is via the Uniform Transfers to Minors Act (“UTMA”) or the Uniform Gifts to Minors Act (“UGMA”). Each state has its own version of UTMA or UGMA, which allow a custodian or guardian to hold property on behalf of a student until he reaches age 18 (unless a later age such as 21 or 25 is specified by the donor at the time of the gift and permitted by state law). The donor can choose the custodian and prior to the student reaching the designated age, the custodian controls the management and investment of the property and determines when to make distributions. There is no restriction on what the funds may be used for other than they must be used for the student’s benefit.
UTMA and UGMA accounts are very simple to establish and administer, and are flexible to satisfy both education and non-education expenses. However, they are not designed to last beyond a specified age, after which time the student will have complete access to any funds not previously spent. The donor cannot be the person to manage an UTMA or UGMA account he establishes it for a student without adverse estate tax consequences.
Qualified tuition plans, known as 529 Plans, are specifically designed to help families set aside funds for future college education. They have become one of the most common means of saving for education due to several distinct advantages. First, earnings in a 529 Plan grow free of federal income tax and will not be taxed when the money is taken out to pay for education. Second, a donor also has the ability to prefund the 529 Plan with up to $70,000 (or five years’ worth of annual exclusion gifts) without paying any gift or GST tax; this affords the gifted funds a greater ability to grow before they are needed for education. Finally, the donor can maintain control of the account, transfer unused funds to a 529 Plan for another qualifying student (such as the initial student’s siblings) and withdraw funds at any time for any reason (though earnings on non-qualified withdrawals will be subject to income tax and an additional 10 per cent penalty tax).
529 Plans are typically very easy to establish and administer. The primary disadvantage of a 529 Plan is its lack of flexibility to be used for anything other than post-secondary education (limited to tuition, books, certain fees, and, in some cases, room and board). In addition, 529 plans are typically operated by state or educational institutions and it can be challenging for donors to identify the plan that offers the best value and incentives. A donor can invest in any 529 Plan regardless of the state in which the donor lives, although certain states offer their residents tax breaks. Therefore it is important to do some research prior to making a decision.
Annual exclusion trusts
Donors who seek maximum flexibility may prefer to make annual exclusion gifts to a trust they create for a student’s benefit. There is no limit on what and how much can be gifted to the trust (though gifts in excess of the annual exclusion will use the lifetime exemption), so these trusts are suitable for gifts of non-cash assets. In addition, the donor has complete control to specify the purposes for which distributions may be made (limiting them to particular types of education only or including needs other than the student’s education) and to some degree how trust assets will be invested. The trust does not have to terminate when a student reaches a particular age and can last until particular milestones (obtaining a college degree), specified ages or even for the student’s entire lifetime.
While annual exclusion trusts are flexible, they impose a greater administrative burden than other options. There are several reasons for this. First, a separate trust must be created for the student. Second, there are special requirements that must be satisfied in order for gifts to the trust to qualify for the annual exclusion (and even further requirements to ensure annual exclusion gifts are GST exempt). Typically, gifts to trusts do not qualify for the annual exclusion because the student for whom the trust is created does not have a “present interest” in the gift such as the right to immediately use or enjoy it. Annual exclusion trusts (also known as “Crummey Trusts” after the case that established their effectiveness) are specifically designed to satisfy this requirement by providing that when a gift is transferred to the trust, the student will have the right to withdraw that gift for a limited time period (typically 30-60 days). If the student does not withdraw the gift, the withdrawal power lapses and the gift remains in the trust. Once the property is in the trust, the trustee may use it to pay for the student’s education as well as for health, support or other conditions named in the trust. While it is not common for withdrawal rights to be exercised by a student, the trustee is required to provide notice to the student of her withdrawal right each time a gift is made to the trust and the student may exercise that right (there can be no understanding or agreement, whether express or implied, restricting the student’s ability to exercise a right to withdraw).
Less common alternatives
Two less common alternatives for educational gifting are Minor’s Trusts and Coverdell Education Savings Accounts. Their use has largely been replaced by the options discussed above though they are available for use in the right situation.
A Minor’s Trust is a trust established to hold gifts but only until a student reaches age 21. Gifts to Minor’s Trusts qualify for the annual exclusion without giving the student a withdrawal right, and like an UTMA or UGMA account can be used for the student’s benefit for any purpose prior to termination. Typically, an UTMA or UGMA account can accomplish the same benefits of a Minor’s Trust without the administrative burden of establishing a separate trust.
A Coverdell Education Savings Account (“Coverdell ESA”), formerly known as the Education IRA, is similar to a 529 Plan in that it offers income tax-free investment growth and tax-free withdrawals when the funds are spent on qualified education expenses. Unlike 529 Plans, funds in a Coverdell ESA may be used for elementary and secondary education expenses in addition to higher education. The maximum contribution limit to a Coverdell ESA is $2,000 per student per year, regardless of the number of donors. In addition, if a donor’s income is between $95,000 and $110,000 for single filers (or $190,000 and 220,000 for joint filers) the contribution amount is gradually phased out. These limitations rule out Coverdell ESA contributions for many donors.
Each of these techniques have different pros and cons as well as different levels of flexibility. In order to make the best decision possible, it is important to consult with professional advisors to maximize the benefits to both the donor and the student.