Prepaid Tuition Costs Can Save Thousands of Dollars in Gift and Estate Taxes

With education costs soaring to all time highs,appears fairly clear that prepayment of multiple
making tuition payments for grandchildren andyears of tuition costs will not be treated as a
others can save lots of money in gift and estatetaxable gift by the IRS.
taxes down the road - even if the donor is notNow, let's sort of put all this into perspective. In
alive when the tuition money is actually used.the TAM discussed above, the grandparents
By way of some background, the tax lawspre-paid roughly $181,000 of tuition costs over a
exempt tuition payments by grandparents ortwo-year period. The payments were not treated
others from any gift taxes, provided certainas taxable gifts and, since the money was
requirements are met. First, the only educationalremoved from their estate, it was not subject to
costs that are gift-tax free are tuition costs. Theestate taxes upon their death. If the
cost of room and board, books, and othergrandparents kept the money until they died and
educational expenses are not exempt.then gave it to their grandchildren under their will,
Second, the tuition costs must be paid directly toit would have gone through probate first, then
an educational organization that "normally maintainswould have been subject to a federal estate tax
a regular faculty and curriculum and normally hasand then, possibly, a generation-skipping tax - all
a regularly enrolled body of pupils or students inbefore it could be used by the grandchildren.
attendance at the place where its educationalIf the grandparents had a fairly large estate, say
activities are regularly carried on." Notice thatlarger than $4 million, then the estate taxes paid
there is no requirement that the tuition costs beon that $181,000 would be roughly $83,260
paid to a college or university. In fact, tuition(based upon a marginal tax rate of 46%). In that
payments for nursery school, private elementarycase, prepaying the tuition costs resulted in an
school, and private high school may also qualify.estate tax savings of roughly $83,260. Plus, the
It's possible, too, that tuition payments forgrandparents didn't have to use up their annual
part-time courses, such as dance, theater, music,gift-tax exclusion to get the estate tax savings.
cullinary arts, and the like will also qualify for theStill, there are some drawbacks that you should
gift tax exemption.be aware of. First, you have to have a large
So, how is this such a good deal? In the firstenough estate to be concerned about estate
place, these tuition payments are not treated astaxes. Second, you probably should be concerned
taxable gifts, so you don't have to worry aboutabout dying before your grandchildren complete
having them come under the annual gift taxtheir education. Otherwise, you could just pay the
exclusion. In fact, you can make tuition paymentstuition costs as they become due.
for your grandchildren or others and still give eachFinally, when you prepay your grandchildren's
of them the annual exclusion amount ($12,000 fortuition costs, you won't be able to get the money
2006) as a birthday gift or whatever.back if your grandchildren drop out of school or
Second, if your estate is large enough to bedecide to attend a different school. Some schools
concerned about federal estate taxes (currently inmay allow the money to transfer to another
excess of $2 million, $4 million for a couple), thenschool, but that would have to be agreed upon
the amount of the tuition payments will bebeforehand. Even so, there is no guarantee the
excluded from your estate upon your death. InIRS will go along with those types of
other words, your tuition payments will not bearrangements.
subject to a gift tax when the payments areOne final point, tuition payments excluded from
made, nor will they be subject to an estate taxgift taxes under IRC Section 2503(e)(2) are not
upon your death. In addition, they will not bethe same as payments under a 529 plan. First,
subject to any generation-skipping taxes (GST)gifts to 529 plans come under the annual gift-tax
upon your deathexclusion. Prepaid tuition gifts are in addition to the
That's pretty good deal by itself, but here's anannual exclusion gifts.
added bonus. On July 9, 1999, the InternalSecond, gifts to a 529 plan are excluded from the
Revenue Service issued Technical Advicedonor's estate only if the donor survives during
Memorandum 199941013 stating that prepaymenteach year for which the pre-payment was made.
of tuition costs was also exempt from gift taxesPrepaid tuition gifts are excluded from the donor's
under IRC Section 2503(3)(2). In that particularestate as soon as the prepayment is made.
case, a set of grandparents had made paymentsThird, 529 plans apply only to higher education
to a private school to cover tuitiion costs for their(college and beyond) whereas prepaid tuition gifts
two grandchildren from pre-school through gradeapply to all levels of education, including nursery
12. There was an agreement between the schoolschools, elementary and high school.
and the grandparents indicating that the tuitionFourth, 529 plans apply to all education costs,
payments would not be refundable even if theincluding room and board, books and supplies, as
grandchildren failed to attend the school each ofwell as tuition. Prepaid tuition gifts apply only to
those years. The total payments made by thetuition costs.
grandparents amounted to over $181,000 over aThat is not to say, however, that prepaid tuition
two-year period.gifts cannot be used in tandum with 529 plans.
Recently, the Internal Revenue Service issued aFor wealthy grandparents who are inclined to help
private letter ruling that supports the Technicalwith their grandchildren's education costs, a
Advice Memorandum cited above. In that case,prepaid tuition gift under IRC Section 2503(3)(2)
the IRS told a taxpayer that prepayments ofcertainly should be considered.
many years of tuition costs for his grandchildrenAttorney Michael P. Pancheri is the founder and
would not be considered a gift.CEO of the Living Trust Network. You may
While Technical Advice Memorandums and privatecontact him by email at You may also contact
letter rulings only apply to the taxpayer's whohim at the Living Trust Network's web site. Its
request them, they are a good indication of theURL is
IRS' position on specific tax matters. Here, itCopyright 2005. LivingTrustNetwork, LLC.