Paying For College: Understanding the Tax on Gifts (page 2)

By — John Wiley & Sons, Inc.
Updated on Oct 26, 2010

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.

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