One of the most commonly asked questions we receive as estate and financial planners is how to make tax-efficient gifts to children, grandchildren and other family members for education purposes.
The use of 529 Plans, irrevocable trusts and IRAs are among the most valuable tools available for gifting for education purposes.
A 529 plan or “qualified tuition plan” is an education savings plan authorized under Section 529 of the Internal Revenue Code. Such plans are generally sponsored by a state or state agency and have numerous tax benefits. Earnings in a 529 plan accumulate federal income tax-free, and distributions on earnings from the plan for qualified education expenses are not subject to federal income tax.
The custodian of the 529 plan ensures that the distributions are used for qualified education expenses.
The annual limit for making a contribution to a 529 Plan that is not subject to the federal gift tax is generally equal to the gift tax annual exclusion amount, which is $15,000 per donee for 2018. An individual who is making gifts for education purposes should always take advantage of utilizing the gift tax annual exclusion, because such exclusion is only available on a “use it or lose it” basis. However, an individual may also contribute up to five (5) years of annual exclusion gifts per donee in one calendar year and elect to have such contributions qualify for the gift tax annual exclusion. For 2018, the five-year maximum gift is equal to $75,000 per donor ($15,000 multiplied by five years), or $150,000 per married couple ($75,000 multiplied by two donors). Gifts for the following four years to the beneficiary cannot be covered by the annual exclusion used by this five-year 529 plan gift.
This is a great way to start saving for education without incurring any federal transfer tax consequences.
Although there are limits to making contributions to a 529 plan that qualify for the federal gift tax annual exclusion, an individual always has the option to gift more than the gift tax annual exclusion amount by using a portion of his or her available lifetime gift tax exemption. For 2018, the lifetime gift tax exemption has increased from $5.49 million per person in 2017 to $11.2 million per person, or $22.4 million per married couple, as discussed in more detail below.
Aside from the transfer tax advantages, there are over 30 states, including the commonwealth of Pennsylvania, that currently offer a state income tax deduction or credit for 529 plan contributions. This makes the 529 plan an even more attractive tax planning mechanism since under the new tax laws, effective in 2018, the deduction for state taxes are limited.
The new tax laws also add more versatility to the use of 529 plans as a vehicle for gifting, because 529 plan distributions may now be used for educational needs outside of higher education. For example, distributions from a 529 plan can be used to pay for qualified K-12 expenses up to $10,000 per year for each student.
If a beneficiary does not use all of his or her 529 plan account, the custodian may change the beneficiary to another person who can then use the account for education purposes under the income tax exclusion for qualified distributions.
An irrevocable trust can be created for the primary (and sometimes sole) purpose of the trust beneficiary’s education. The trustee of the trust controls the investment of the trust assets and the distributions to the trust beneficiary
Although an irrevocable trust for education does not carry with it the advantages of tax-free earnings and distributions like the 529 plan, there are various other benefits associated with using an irrevocable trust to hold gifts for education.
An irrevocable trust can be structured as a grantor-trust for income tax purposes. This means that the grantor (the creator of the trust) will be treated as the owner of the trust assets for income tax purposes and will pay income tax on the earnings of the trust. The payment of the income tax by the grantor amounts to an additional transfer tax-free gift that serves to reduce the value of the grantor’s estate, and increase the value of the amount held in trust for the beneficiary since the trust will not have to pay income tax on its earnings.
Using an irrevocable trust for holding gifts for education also provides great flexibility, as the trust instrument can also allow distributions for other purposes outside of education, such as the beneficiary’s medical needs, maintenance and support. Additionally, the trustee can retain the assets in further trust for the next generation if the current beneficiary dies before the trust is exhausted.
As with 529 plans, an irrevocable trust can be funded with annual exclusion gifts or through the use of the donor’s lifetime gift tax exemption. The only difference being that the donor cannot apply five (5) years of annual exclusion to a contribution to an irrevocable trust as is allowed with the funding of a 529 plan. Although beyond the scope of this article, a donor can use multiple so-called crummy beneficiaries to exceed the annual exclusion limit for one person.
Because the provisions of the new tax law (providing for the increased lifetime exemption of $11.2 million per person) will sunset after 2025, when the exemption will revert back to the pre-2018 amount of $5 million (adjusted for inflation) per individual, a donor considering making gifts for education purposes or otherwise should take advantage of the increased exemption amount while it is available. Notwithstanding the possibility of a reduced exemption amount in the future, under most circumstances it is generally advisable to use the exemption “sooner rather than later” due to the time value of money and appreciation.
IRAs can also be used for making gifts for education.
A donor can make a gift to an IRA that generates an income tax deduction for the recipient by giving cash from the IRA to the recipient and allowing the recipient to fund his own IRA. While the gift and subsequent contribution by the recipient to an IRA does not provide the donor with an income tax deduction, it will generate an income tax deduction for the recipient as long as the recipient has earned income.
Although early withdrawals from an IRA are generally subject to a 10 percent penalty, there is an exemption from the early withdrawal penalty if the money is used for qualified higher education expenses. This means that the recipient of the donor’s gift can use the funds from his IRA to pay for such expenses.
Withdrawals from the IRA are subject to income tax, which is expected since the contribution went into the IRA through a tax deduction.
The limit on contributions to an IRA for 2018 is generally $5,500.
If the IRA account is a Roth IRA there is also an exception for distributions for qualified higher education expenses. In general, if you withdraw money from your Roth IRA before you have met the five-year holding period and/or before you reach age 59½, not only is the earnings portion of the distribution taxable, but you could be subject to a 10 percent penalty on those earnings unless the distribution is used for qualified higher education expenses for yourself and/or eligible family members.
Direct Payment of Education Expenses
In addition to making gifts for education through the use of 529 plans, irrevocable trusts and IRAs, donors also have the option of making payments directly payable to the educational institution. There is an unlimited gift tax exclusion for such payments, which makes this option attractive for those that want to fund the education of their loved-ones without using any annual exclusions or lifetime exemptions.
Estate planners have many tools at their disposal for clients who are interested in making gifts for education. Deciding upon the appropriate option will require the estate planner to examine the facts and circumstances of each client’s unique situation.
Jeanna Lam is a principal in the Philadelphia office of Offit Kurman. She utilizes sophisticated estate planning techniques to provide comprehensive estate planning services that address each client’s unique planning goals and objectives, including transfer tax, wealth preservation and asset protection concerns.
Herb Fineburg, a principal at the firm, is a business lawyer whose substantial knowledge of tax law provides clients with strategic and cost-saving benefits in connection with commercial transactions, taxation and wills, trusts and estates matters.