Recent changes in federal tax law offer new opportunities to meet educational expenses of children and grandchildren while addressing an individual's own estate planning concerns.
Although the amount of the estate tax exemption gradually increases until the estate tax is eventually repealed, modified, or restored to its current status, the related exemption for lifetime transfers (the gift tax exemption) is slated only to increase to $1,000,000 in 2002, and to remain there indefinitely. The new law does not provide for any repeal of the gift tax. Instead, the rate of tax on gifts will gradually decline (like the estate tax rate), and will remain in effect after it reaches the same level as the maximum income tax rate in 2010.
That aspect of the new law may give incentive for families wishing to provide for descendants' educational expenses to look for some solutions. Here are some techniques that might be considered. As to which, if any, might be appropriate for your situation, you should check with your financial and tax advisors.
► Existing gift tax law allows a person to give present-interests of $10,000 per year free of gift tax to an unlimited number of individuals. It also allows that same person to make an unlimited number of gifts, of any amount, to an educational institution in payment of the tuition (only) of an unlimited number of individuals. These tuition transfers under Section 2503(e) of the Internal Revenue Code must be made directly to the educational institution, not to the individual student as advances or reimbursement for tuition, and they may be for tuition only - not for books, supplies, room and board or other related expenses.
Many grandparents have used this exclusion to make tuition payments for grandchildren, thereby (i) benefiting the grandchild, (ii) relieving the parent of some of the financial burden, and (iii) reducing the grandparent's estate and the appreciation that would otherwise be subject to estate tax at the grandparent's death.
However, there is no requirement in the law that the tuition be limited to "college" tuition. So long as the expense is for tuition at an educational organization that presents formal instruction, maintains a regular faculty and curriculum, and has a regularly enrolled student body, then the gift should be allowable. Tuition at private elementary or high schools, as well as nursery school and both public and private colleges would seem to qualify, whether the student is registered full-time or part-time. Tuition for extracurricular courses, should also qualify, where the primary purpose of the educational organization is to provide formal instruction, such as ballet, karate, or perhaps even sports clinics - so long as the payment is tuition.
►Can these transfers be made by way of trust, say for children in the future, for grandchildren and more remote descendants? That involves consideration of some gift planning techniques.
Remember that the gift tax law allows exclusions for gifts of "present interests," where the student receives a right to immediate beneficial enjoyment. A gift in trust, is a "future interest," the enjoyment of which the beneficiary may not see until some future date. Also, to constitute a gift, the donor must relinquish all control of the property. A transfer in trust often carries various terms and conditions that may negate the donor's intent to relinquish control. That means finding another way to avoid having to pay a gift tax
If the donor transfers property to an irrevocable trust (one in which he or she retains no beneficial interest or control), and if the trust includes authority for the beneficiaries to withdraw property currently, there is sufficient law to support the use of the annual gift tax exclusion.
But, won't the beneficiaries' authority to withdraw property undermine the very purpose of the trust? No, it is the exercise of that authority that would undermine the arrangement. The authority of the beneficiaries, if unexercised, would in itself not defeat the donor's plan.
This type of arrangement has been used by wealthier families for over 25 years now, surviving IRS scrutiny and court challenges. Often the gift to the trust is used to pay premiums for insurance on a grandparent's life. Properly structured and administered, the beneficiaries' rights of withdrawal can be limited to make effective use of the annual gift tax exclusion without interfering with the premium payments. Then, in the future, when the insurance policy matures, a fund will be available for payment of the health and educational expenses of descendants. Nor need these Health and Education Expense Trusts be limited to a single individual child, but it can be structured to receive gifts annually for many individuals, including grandchildren and great-grandchildren, whether mentioned by name or not, without complaint by the IRS.
► Another solution may also lie in existing law (Section 529 of the Internal Revenue Code), which permits State governments to establish Qualified State Tuition Programs, and enables individuals to create investment accounts to be used for "qualified" higher education expenses. Unlike the 2503(e) gift tax exclusion, discussed above, the Section 529 relief is not restricted to tuition. It extends to funds for: room and board (up to certain dollar limits, and only if the student is carrying at least half a full-time program), fees, books, supplies, and equipment.
Despite its limitations, the Section 529 account may be a nice complement to the Health and Education Expense Trust. However, note that these accounts are restricted to expenses associated with "higher education," unlike the Health and Education Expense Trust which can be used for tuition at all levels.
Under current law, contributions to these accounts are treated as gifts of "present interests," qualifying for the annual $10,000 exclusion, and the donor can "pre-fund" the account with up to five years' worth of gifts. There is an important trade-off, however, in that use of the annual exclusion to pre-fund one of these accounts reduces the tax-excludable amount that the donor might otherwise be able to give to the beneficiary. For example, some or all of a gift - perhaps insurance premiums scheduled for payment through a pre-existing irrevocable insurance trust or a Health and Education Expense Trust might not qualify for the annual exclusion, thereby requiring use of some of the donor's lifetime exemption to offset gift tax.
The earnings on the money in Section 529 accounts grow on a tax-deferred basis. Distributions from the accounts (which, by the way, need not be made directly to an educational institution, but may be made to the beneficiaries) are later taxed at the beneficiaries' income tax rates. Now, here's where the new tax law comes in -- starting in 2002, distributions from Section 529 Qualified State Tuition Program accounts will be tax-free.
Assuming a 10% annual rate of return, if a donor were to pre-fund one of these accounts with $50,000, and then contribute $50,000 every five years thereafter, there could be a fund of about $420,000 in 15 years - a significant fund for education.
There are other aspects of these accounts that may also be of interest. Since the funds added to these accounts qualify as gifts of present interests, they are not included in the donor's estate for estate tax purposes (except to the extent of any pre-funded contribution for a year after death). That is so, even if the donor retains the power to change the beneficiary, or withdraws funds himself. However, plans in some states impose restrictions upon who can transfer the accounts or change beneficiaries. Some, but not all, states also stipulate that only residents of their own state can establish the account.
There are, too, penalties that may apply if account funds are withdrawn or distributed for purposes other than higher education expenses, unless the beneficiary dies or becomes disabled. So, it may be worthwhile to compare plans used in various states and to select one that includes the terms most desired by you.