Printer Friendly

School savings plans: prepayment option can avoid gift tax--but beware.

College costs are outpacing inflation, growing 9.8 percent at public four-year colleges and 5.7 percent at private four-year colleges in the 2004-05 school year, according to The College Board.

At this rate, new parents can expect average four-year college costs (including room and board) from $115,396 for public colleges to $221,562 for private colleges.

Given these escalating costs, CPAs often advise clients to use one of several options to help fund a child's college expenses, including 529 Plans, Educational IRAs and Custodial Accounts. While each strategy has its merits, each also has gift tax implications that can make them less desirable.

But a prepayment option, bolstered by a recent IRS Private Letter Ruling, may be an attractive alternative to such plans--and avoid gift taxes altogether.

Strategies for Saving

Before we dive into the prepayment option, here are the three most common education saving strategies:

529 Plans: Technically known as qualified state tuition plans, these allow users to contribute money into a tax-deferred account for higher education. Regardless of income levels, a donor may contribute $12,000 per year, per beneficiary, or $60,000 in a single five-year period ($120,000 for married couples) without triggering gift taxes.

The earnings in college savings plans grow tax-deferred from federal taxes. When funds are withdrawn, they are received federal income tax-free if used for qualified expenses, such as tuition, books, room and board.

If a child decides not to attend college, the deferred savings may be directed to an alternative beneficiary or the assets may be withdrawn. If the assets are withdrawn and not used for higher education, regular taxes and a 10 percent penalty may be imposed on the earnings.

Coverdell Education Savings Accounts: Formally referred to as Educational IRAs, these allow users to contribute cumulatively up to $2,000 a year for qualified elementary, secondary school and higher education expenses of a child. Withdrawals from Coverdell accounts are federal income tax-free if used for qualified expenses, such as tuition, room and board.

A beneficiary designation for a Coverdell can be transferred to another family member to pay for educational expenses. If the account is not used by age 30, or the funds are not used for higher education, regular income taxes and a 10 percent penalty may be imposed on the earnings.

Custodial Accounts: These accounts, from the Uniform Gift to Minors Act/Uniform Transfer to Minors Act, are created for a minor usually at a mutual fund company or brokerage firm. The accounts provide a simple way to transfer property to a minor without the complications of a formal trust. When the child reaches age 21, they then have full discretion over the account.

Note that earnings on these accounts are not tax deferred and that "Kiddie Tax" may apply.

The Prepayment Alternative

CPAs advising clients on selecting any of the above plans must consider the gift tax implications of each.

As an alternative, IRC Sec. 25.25036(b)(2) of the Gift Tax Regulations provides that a "qualified transfer" of tuition payments made directly to an educational institution on a student's behalf may avoid gift tax altogether, no matter how much is paid.

Also, IRC Sec. 2611(b)(1) provides that such transfers avoid "generation-skipping" tax. But users must wait until the student is ready to attend college to take advantage of this exclusion.

Rather than wait, wealthy taxpayers may elect to pay a student's tuition now to a college they may attend later. A recently released IRS Private Letter Ruling offers some assurance to those considering this strategy.

In PLR-200602002 (PLR-110328-05), the IRS informed a taxpayer that prepayments of multiple years of tuition for the taxpayer's grandchildren would not be considered a taxable gift. The taxpayer in question proposed prepaying tuition bills for each of six grandchildren through 12th grade.

Not For Everyone

One of the main attractions of the direct prepayment strategy is its simplicity. However, the requirements imposed upon a family may create hesitation.

In PLR-200602002, the taxpayer agreed that the prepaid tuition would be non-refundable and, once paid, became the sole property of the school. Finally, the prepayments did not afford the respective grandchildren any additional rights or privileges, and did not guarantee the child's acceptance and enrollment at the school.

Needless to say, there are some risks to this approach. The child may refuse to attend the school, not be accepted to the school, transfer out, get expelled or drop out.

In all, this education planning technique is best suited for those who:

* Are concerned they might not live long enough to pay each year's tuition as it comes up;

* Can afford to part with the money permanently;

* Are comfortable that the child will complete their education at the pre-selected school; and

* Are willing to allow the school to keep the money if the child doesn't complete their education at the school. Such requirements are obviously acceptable to only a select group.

By Philip R. Lieberman, CPA

Philip R. Lieberman, CPA is a director at Irvine-based Benevolent Planning & Financial Services. You can reach him at For more information on the CalCPA Estate Planning Committee, visit
COPYRIGHT 2006 California Society of Certified Public Accountants
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 2006, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
Printer friendly Cite/link Email Feedback
Author:Lieberman, Philip R.
Publication:California CPA
Geographic Code:1U9CA
Date:May 1, 2006
Previous Article:2006-07 CalCPA officer candidates.
Next Article:New faces on CBA: Petersen, Chi appointed to CBA; practice privilege modifications.

Related Articles
The consumption-based income tax.
Planning for college education.
Making the grade.
Qualified state tuition programs--sec. 529 plans.
College savings vehicles.
Thinking Ahead.
Plan for a comfortable retirement while you save for your children's education. (You Can ...).
Tuition prepayment by donor not subject to gift or GST tax.
Rating 529 college savings plans: use Morningstar ratings to determine the long-term performance of these programs.
The ABCs of QPRTs: a properly structured trust can freeze the value of a client's residence for estate tax purposes.

Terms of use | Copyright © 2018 Farlex, Inc. | Feedback | For webmasters