Financial Advice for Retirement, Social Security, IRAs and Estate Planning

How to Make Unlimited Tax-Free Gifts

How-To-Make-Unlimited-Tax-Free-Gifts

Anyone can make unlimited tax-free gifts. The strategy gets wealth out of your estate, and unlike many other gifts, you can be sure of how the money will be used. The strategy of maximizing tax-free gifts is growing in popularity, especially since the change in Congress makes it unlikely that elimination of the estate tax will be made permanent.

Longtime readers know that the tax law exempts gifts that are made to pay for education or medical expenses. The gifts must meet certain requirements to avoid the gift tax. They must be paid directly to the education institution or medical care provider. The education gifts must be for qualified education expenses. The medical expense gifts must be for expenses that fit the definition of deductible medical expenses (though the giver usually does not deduct them).

Most people who know about this provision assume that only the current year’s expenses qualify for the exclusion. In fact, the IRS has ruled that education expenses paid in advance also avoid gift taxes. In other words, a grandparent can prepay all future private school and college expenses for the grandchildren in one year and owe no gift or estate taxes on the payments. The money will be out of the grandparent’s estate and will benefit the grandchildren. The grandparent is sure of how the money will be used and will be able to see the benefits as long as he or she is alive. Prepayments also have the effect of locking in tuition costs and avoiding the uncertainty of tuition inflation. Giving a large sum now also avoids future taxes on income the money would have earned.

There are bonus benefits. The unlimited education and medical gifts do not reduce the annual gift tax exclusion amount ($12,000 per person in 2007) or the lifetime gift tax exclusion ($1 million per donor). The donor still can make tax-free gifts in these amounts to the same donee or to other people.

Because the strategy is growing in popularity, many private schools and colleges have policies in place to accept tuition prepaid many years in advance.

Prepaid tuition allows you to give away large amounts of money and have control over how the money is used. Yet, these goals are accomplished without the time, expense, and complications of setting up a trust and having a trustee manage the money for years.

To qualify for the gift tax exclusion tuition gifts must be paid directly to the education institution, and a tuition discount should not be received. The prepayments should not give any special rights or preferences to the giver or to the student that are not available to others. The payment also cannot guarantee admission of the student.

The tuition prepayments cannot be refundable. The payments are the sole property of the education institution to use as it wishes.

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Prepaying tuition does incur some risks. The grandchild might never attend the school. Or the student might attend but drop out, transfer, or be expelled. Some schools have policies that allow the transfer of prepaid tuition to another school when the student for which the money was paid transfers. But be advised that the IRS has not ruled whether prepayments with a guaranteed transfer to another school qualify for the exclusion.

Before making prepayments, a grandparent should have a tax advisor review the details of the plan to ensure that none of the provisions disqualify the payments from the unlimited gift tax exclusion. The donor must have a high certainty that the youngster will attend the school to which the tuition is prepaid, or not be concerned that the school would keep the money.

Of course, the strategy should be considered only by those who have enough wealth that they can afford to give the money without any possibility of its return. The strategy is most appropriate for those who are concerned that they will not live long enough to pay the tuition each year. Those in good health also will use the strategy because they want the wealth out of their estates and want to see how the wealth is used.

There are some alternatives to direct prepayment of tuition.

We have discussed 529 savings plans in past visits, and those discussions are available in the Archive on the members’ web site. The contributions to a 529 plan use the annual gift-tax exclusion, and no more than five years of exclusions can be used in advance. The donor can have the contributions returned if the 529 plan’s rules allow. Of course, there is no guarantee the savings plan will be enough to pay for all the tuition, and the plans can be used only to pay for higher education.

Another alternative is the 529 college prepayment plan. This plan does ensure the tuition will be paid, but also can be used only for higher education. Many states allow a tax deduction for contributions to their own plans.

Another alternative is to put the money in a trust that will be used only for qualified education or medical expenses. The trust provides more control than the other options and can apply to more than one beneficiary. The donor still cannot have the money returned, and setting up and maintaining the trust can be expensive.

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