As the cost of college tuition continues to climb at significant rates, one of the biggest financial challenges facing parents today is saving for a child's college education. In the event that parents or even grandparents have funds that they wish to gift to a child, there are various methods available for making gifts to or for the benefit of a child for purposes of funding the child's education. The various methods discussed below may have differing gift tax or income tax advantages or implications. Also, there may be limits on the ability of the donor to control the funds and be sure they will be used for education purposes. The following is a brief summary of potential gift and/or income tax advantaged methods of planning for the funding a child's education costs.
1. Annual Exclusion Gifts. Under Section 2503(b) of the Internal Revenue Code of 1986, as amended (IRC), the first $14,000 per year of an outright gift by a donor to a child is excluded for gift tax purposes. An outright gift to a minor child if intended to be used for future college education is not desirable as the donor loses control of the funds and the child can use such funds as he or she wishes. Accordingly, most parents and grandparents wishing to use such funds for a child's education desire a different vehicle.
2. Gifts in Trust. IRC Section 2503(c) allows for transfers to children under the age of 21 in trust, which qualify for the annual gift tax exclusion. IRC Section 2503(c) provides that no part of a gift to an individual who has not attained the age of 21 years on the date of the gift shall be considered a gift of a future interest if the gift may be expended by, or for the benefit of, the donee (child) before attaining the age of 21 years, and any amounts not so expended will be paid to the donee (child) upon attaining the age of 21 years, or if the child dies before reaching age 21, the funds must be payable to the child's estate or as such child may appoint under a general power of appointment. This gifting format is also not ideal, if contributions to such a Section 2503(c) Trust are intended only to be used for education, as control is lost once the child turns 21 years of age.
The above funding mechanisms do not offer the potential income tax advantages of the following plans which are structured strictly for education costs, which gift and possibly income tax benefits are only limited to funds actually used for education purposes. The trade-off is that the above general gifting options provide greater flexibility in the use of the funds for the donee-child.
3. Gifts for Educational Expenses. IRC Section 2503(e) provides for an unlimited exclusion for amounts paid on behalf of a child or grandchild for tuition expenses if paid directly to an educational institution. Note that under Tax Advice Memorandum 199141013 prepayment of tuition payments can also qualify under IRC Section 2503(e).
4. Michigan Education Trust. To address the spiraling cost of education, many states created prepaid tuition programs which permit persons to prepay and guarantee college educations costs through lump sum or periodic payments. In exchange for the early payment, these programs typically allow purchasers to lock in current tuition rates. Michigan's prepaid tuition program is identified as the Michigan Education Trust (MET). The MET allows parents or others to pre-purchase undergraduate tuition for a child residing in Michigan at any Michigan public university or college, including 28 public community colleges. Under the MET contract, MET will pay future tuition and mandatory fees without additional charge. MET will pay in-state tuition at public four-year colleges and universities in Michigan or in-district tuition at public community colleges in Michigan. Students may also direct refund payments to any eligible university in the nation, both public and private. MET provides that students have 15 years to use tuition benefits. MET offers payment plans over 4, 7, 10 and 15 years. Benefits under a MET may be transferred to a sibling or first cousin in the event a child receives a full scholarship or does not attend college. If the child decides not to attend college, the monies are refunded. The total contract price is deductible for state income tax purposes. Also, the earnings under a MET plan are tax-exempt when the benefits are used for higher education.
5. Section 529 Savings Plans. In response to the many state-created prepaid tuition programs, the federal government adopted its own qualified tuition program under IRC Section 529 (now referred to as "529 Plans"). Given their tax benefits and flexibility the 529 Plan has become the vehicle of choice by most for saving for a child's or grandchild's education. A 529 Plan is operated by a state or educational institution. There are two basic types of 529 plans, a prepaid tuition plan (see the MET plan above), and a savings plans. The rest of this Section details the characteristics of a savings plan. With 529 Plans, an individual is not limited to the plan offered by the State of Michigan. The basic benefits of the Michigan 529 Plan (Michigan Education Savings Program (MESP)) includes: (1) earnings within the plan are not subject to federal or state income taxes when used for a child's qualified higher education expenses; (2) Michigan taxpayers (under the Michigan 529 Plan) may also be eligible for a Michigan income tax deduction on contributions up to $10,000 for married couples filing jointly ($5,000 for individuals filing single) (3) the funds can be used at any private or public college or university, in-state or out-of-state, trade or graduate school; (4) if a child does not want to go to college, you can roll the account over to another family member; (5) unlike the MET, which requires a certain lump sum payment or periodic payments to lock in tuition rates, the MESP offers greater flexibility in permitting minimum contributions of $25 per beneficiary, per investment option; (6) there are no income limitations related to the donor creating the account; and (7) a donor can contribute as much as $235,000 per beneficiary as long as the total balance of all accounts for that beneficiary does not exceed $235,000, including contributions to MET (see above). Most investment advisors offer assistance with 529 Plans.
This discussion of the various methods of funding a child's or grandchild's educational needs is very general in nature. There are significant income and gift tax issues associated with each method. Accordingly, any planning should be conducted with the assistance of a tax or legal professional or financial advisor.
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Mark E. Kellogg, an attorney and CPA, is a shareholder with Fraser Trebilcock. Kellogg has devoted his 28 years of practice to the needs of family and closely-held businesses and estate and succession planning. For more information or to discuss your estate planning needs, e-mail mkellogg@fraserlawfirm.com or call 517.377.0890.
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