Whenever you, your child's grandparents, or any other relatives make any contribution toward your child's education, a gift is being made to your child. And, because the IRS never leaves any good deed unpunished, that gift becomes subject to the Gift Tax and/or Generation-Skipping Transfer Tax (GSTT). Yep — right when you think you've done something nice for someone, the IRS has to slap some kind of tax on it. There is good news, however, and you can find it in the following sections, where I show you how to make the most of your goodwill by explaining the rules surrounding the Gift Tax and the GSTT.
If ever a topic defied easy explanations, it's the transfer tax, which is the slice the government takes when money is given from one person to another, either in a lifetime gift or an after-death inheritance, and which includes the Gift Tax and GSTT. You can easily go wrong when trying to figure out these taxes, and mistakes are costly to repair. If, after you read what follows, you have some gift tax or GSTT questions, please run, don't walk, to a qualified tax advisor, whether an accountant, a lawyer, or an enrolled agent (a person qualified by the IRS to advise clients on tax issues). The relatively small amount you may spend upfront for advice is peanuts in comparison to the amounts you may have to cough up if you don't play by the IRS rules.
Understanding The Gift Tax
If you, and your extended family and friends, are planning and plotting ways to see your child, or children, through college and beyond, you may begin a gifting program early in your child's life. Every year, every person is entitled to make gifts, tax free, to as many other people as he or she wants, up to the annual exclusion amount. This amount is adjusted periodically to reflect inflation. (The amount was $13,000 in 2009.) So, for example, if you have three children, you, your spouse, your parents, and anyone else who has the means and the desire, can each transfer $13,000 (or the current exclusion amount) to each of the deserving people on your list, without incurring any gift-tax consequences. Next year, you can do the same thing again.
Now, the IRS, in its infinite wisdom, realizes that handing a 7-year-old a check for $13,000 probably isn't a wise move, and this is one time (and maybe the only time) that you probably agree with the IRS. Accordingly, the IRS allows you to make gifts into financial vehicles, such as in trust, in UGMA/UTMA accounts, in Section 529 Plans, and in Coverdell Savings Accounts, for your children (or grandchildren, or anyone else you want to make gifts to), that hold and maintain that money either for a specific period of time or a for specific purpose. No matter whether you gift cash, stocks or bonds, jewelry, or anything else, if you give up your interest in the property, the gift qualifies as a completed gift, and you can deduct the annual exclusion amount ($13,000) from the total value of the gift. Any amount you've gifted over and above the annual exclusion amount is now subject to the gift tax rules.
For example, if Auntie Elizabeth gives your child $20,000 in 2009, $13,000 is excluded from that gift, and $7,000 is subject to the gift tax. If Auntie Elizabeth and Uncle Bob (who are married to each other) each give your child $20,000, then $26,000 of their total gift qualifies as annual exclusion gifts (2 x $13,000), with $14,000 subject to the gift tax.
Checking Out The Exceptions
You found this out in grammar class, and the same holds true for the gift tax — for every rule, you can find an exception. In the case of the gift tax, I discuss two exceptions below.
Section 529 Plan Exception
Section 529 plans, a relatively new item in the arsenal of college savings, are designed to harbor enough money to put a child all the way through college without any other assistance. Consequently, the amounts that are allowed in them are quite large. And, because you may have kids who are creeping up in age and approaching college far more rapidly than you may like, you may want to superfund your plan, pushing as much money into your Section 529 plan as fast as you can. And you can, without incurring a gift tax.
An exception to the annual exclusion rules has been made for Section 529 plans. You, or anyone you know, may put up to five years' worth of annual exclusion gifts into a Section 529 plan for the benefit of a specific person in one year, which means you can put $65,000 (5 x $13,000) in Junior's Section 529 plan in 2003 without being subject to any kind of gift tax. But wait — it gets even better. Gift-splitting rules still apply, so you can put $130,000 into a Section 529 plan for any beneficiary in 2003 without any gift tax consequences, split the gift with your spouse, and then file gift tax returns for the next five years, allocating one-fifth of the total gift (which equals $13,000 per donor) to each year.
However, during that five-year period, any additional gifts made to the same beneficiary are subject to gift tax treatment (remember, you've used up your annual exclusion amounts for five years). It probably would be a good idea if you didn't die during this period, either; any amounts gifted in anticipation of years that haven't happened yet will be pulled back into your estate and become subject to federal estate tax rules.
If your baby has just been born, and your crystal ball shows ample savings for his college education using normal methods, you probably don't need to worry about superfunding a Section 529 account. However, if you've waited until almost the last minute and still want to take maximum advantage of this savings plan, this gives you the opportunity. Likewise, if you have the money available now (perhaps you've just received an inheritance), but wonder if you might squander some or all of it if you wait, superfunding Section 529 plans for your children may make sense.
Qualified Education Expenses Paid Exception
Your children may be some of the fortunate ones. Maybe you, your extended family, and/or your friends can afford to just whip out your checkbooks when the time comes and write that check for Harvard, Notre Dame, or your local community college. If you have that luxury, you may be hesitating just a bit now because you suspect there may be gift tax consequences; but think again.
Tuition for another person which is paid directly to an educational institution, whether for primary, secondary, or postsecondary education, does not constitute a taxable gift, does not affect your annual exclusion amounts (you can still give that lovely, large birthday gift you were planning), and does not cut into your lifetime unified credit.
A word to the wise. If your child will be applying for need-based financial aid, tuition payments made on that child's behalf will count as untaxed income to the child on the next year's FAFSA application. If Grandma can afford to pay for only one year's tuition and you want to maximize need-based financial aid, ask her to postpone her tuition gift until your child's last year of college.
Figuring Out The Generation-Skipping Transfer Tax (GSTT)
The Generation-Skipping Transfer Tax (GSTT) is yet another transfer tax (like the gift tax) that Congress devised to close a particular tax loophole: one generation (the grandparents, for example) bypassing their children in favor of their grandchildren when making a gift. That makes sense, but to Congress, it meant that they could only collect gift tax once on the value of that property, rather than twice — grandparents to parents, and then parents to children. The GSTT was instituted to deal with that problem.
The GSTT is, essentially, a tax calculated by figuring out how much the government would have collected had the transferred amounts gone first to your children, and then transferred subsequently to your children's children, and so on.
The GSTT is designed for the very wealthy; accordingly, you are entitled to a lifetime exclusion of transfers from this tax (over and above annual exclusion amounts, which are the same for the GSTT as they are for the gift tax), totaling $2,000,000 per donor in 2008 and indexed annually for inflation.
Because of the high GSTT exemption amount and the availability of annual exclusion gifts, for most of you, the GSTT will remain very far out on the radar. If, however, you're one of those grandparents who has undertaken to provide college education for your grandchildren (and you have more than a few of them), and if you've also decided to take advantage of various college savings plans that are now available, you may run up against this tax. If you plan to make large gifts into these plans (or into trust or any other financial vehicle), you need to contact your legal and tax advisors.
You should never ignore tax advice, but, in this case, missteps in the GSTT can cost you especially dearly — the top tax rate in 2003 was 45 percent in 2007. Because the GSTT is assessed in addition to any gift tax you may have to pay, the combined gift tax and GSTT on a gift to your grandchild can approach almost 100 percent of the total gift!