Finance

One of the most impactful ways to ensure your legacy is by investing in the education of your children or grandchildren. Various gifting strategies can help you provide for their educational needs while also offering potential tax benefits. Here are four education-specific gifting strategies and the pros and cons of each strategy:

1. Outright Payments Made Directly to the Educational Institution

One of the simplest and most effective ways to contribute to a child’s education is by making outright payments directly to the educational institution. Payments for tuition only are not considered taxable gifts and do not count against your annual or lifetime gift tax exemptions. Payments made for other educational expenses, such as room and board, books, fees, and equipment are considered taxable gifts, but they qualify for the annual gift tax exclusion—for 2024, the annual exclusion amount is $18,000 per recipient.

• PROS: Easy to implement. This cost-effective option allows you to significantly reduce the financial burden on the student, while reducing your taxable estate and avoiding gift taxes. This is the ideal strategy for those who want to make a substantial impact immediately.
• CONS: This strategy only covers present gifts; future gifts are uncertain.

2. UGMA/UTMA Accounts

The Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) accounts are custodial accounts held for the benefit of a minor beneficiary until they reach the age of majority (which varies by state). For example, in Ohio, UGMA/UTMA accounts can be held for the benefit of the minor beneficiary until they reach age 25. While contributions to UGMA/UTMA accounts are considered taxable gifts, they qualify for the annual gift tax exclusion.

• PROS: Better investment options than 529 plans; lower administrative costs than trusts; greater flexibility in how the funds can be used, including for education; and income is taxed to the minor beneficiary (i.e., likely a much lower tax rate than the donor).
• CONS: Higher administrative costs than outright payments; a countable asset for financial aid; and a potential windfall to the beneficiary at the age of majority, when they gain full control over the account and can use the funds as they desire.

3. Education Trust

An irrevocable trust created with the purpose of paying for the education costs of one or more beneficiaries. This type of trust can be tailored to fit specific needs and can cover a wide range of educational expenses, including tuition, books, and even living expenses. Extra care must be taken in drafting this trust to qualify any contributions for the annual gift tax exclusion. By creating the education trust as a grantor trust, the income taxes can be reported and paid for by the individual that establishes the trust (known as the grantor), allowing the education trust assets to grow income tax free and, thus, amplifying the gift(s) to the education trust.

• PROS: Flexibility at the drafting stage on the purpose of the trust; control over distributions for a longer period of time than UGMA/UTMA accounts; and grantor trust status amplifies gifts.
• CONS: Higher administrative costs than the other the other three options; more advanced estate planning is required; and extra care must be taken at the outset as the irrevocable trust, by its nature, is unable to be amended, restated, or revoked.

4. 529 Plans

A 529 Plan is a tax-advantaged savings plan designed specifically for education expenses. Contributions to a 529 Plan grow tax-free, and withdrawals used for qualified education expenses are also tax-free. These plans offer significant flexibility, allowing the funds to be used for a variety of education-related costs, including public or private K-12 tuition and higher education expenses. Additionally, 529 Plans have high contribution limits and offer potential state tax benefits, making them an excellent choice for long-term education savings.

• PROS: Very easy to establish; tax-free growth of assets; tax-deductible contributions for the donor at the state level; ability of the owner to change the beneficiary; and the ability for the donor to front-load 5 years’ worth of annual exclusion gifts.
• CONS: Limited investment options, compared to the education trust and UTMA/UGMA accounts; limits on ownership changes; lack of flexibility on the purpose of the funds; and can cause issues with financial aid depending on the owner.

Conclusion

Investing in your children’s or grandchildren’s education is a meaningful way to leave a lasting legacy. By understanding and utilizing one or more of these four gifting strategies, you can help secure their educational future while also taking advantage of potential tax benefits. Each strategy has its own set of pros and cons, so it is important to evaluate which one aligns best with your financial goals and family needs. Consulting with an estate planning attorney can provide personalized guidance to ensure your gifts are both impactful and tax efficient.

Understanding the basics of gifts and transfer taxes is an essential foundation for any discussion on wealth transfer strategies and effective estate planning. This article provides a basic overview of what gifts and transfer taxes are, how they work, and their implications for your estate plan.

What Constitutes a Gift?

A gift is any transfer of property or assets from one person to another without receiving something of equal value in return (known as consideration). Gifts can include money, real estate, stocks, or other valuable assets. With any discussion about gifts, it is important to distinguish between reportable gifts and those excluded from gift taxes:

• Reportable Gifts: These are gifts that exceed the annual exclusion amount set by the IRS. For 2024, the annual exclusion amount is $18,000 per recipient (i.e., the $18,000 is the sum of all your gifts to a specific individual during the calendar year). Any gift above this amount must be reported to the IRS on a federal gift tax return (IRS Form 709) and will count against your lifetime exemption (see discussion below).
• Excluded Gifts: Certain types of gifts are excluded from gift taxes and do not need to be reported. These include direct payments for qualified education expenses (such as tuition) and medical expenses made directly to the institution or provider. Additionally, gifts to your spouse, charitable organizations, and political organizations are also excluded from gift taxes.

Understanding these distinctions can help you make informed decisions about gifting and ensure compliance with IRS regulations.

What are Transfer Taxes?

Transfer taxes are levied by the federal government and by some state governments on the transfer of property from one person to another without consideration (or without adequate consideration). This includes transfers during a person’s lifetime (known as gifts) and transfers upon death (known as an inheritance).

Types of Transfer Taxes

The transfer tax system includes three separate taxes: gift tax, estate tax, and generation-skipping transfer (“GST”) tax. Here is a closer look at each tax:

Gift Tax

Gift tax is a federal tax imposed on transfers of property during life without consideration (or without adequate consideration). Key points to understand about gift taxes include:

• Annual Exclusion: Each year, you can give a certain amount to any number of individuals without incurring gift tax. For 2024, the annual exclusion amount is $18,000 per recipient.
• Lifetime Exemption: In addition to the annual exclusion, there is a lifetime exemption amount applicable to each person that applies to gift and estate taxes combined. For 2024, each U.S. citizen has a lifetime exemption of $13.61 million.
• Tax Rate: If your gifts exceed the annual exclusion and the lifetime exemption, the excess amount is subject to gift tax at a rate that can be as high as 40%.

Estate Tax

Estate tax is a federal tax imposed on the fair market value of all assets includible in your estate at the time of your death and the value of taxable gifts made during your lifetime. Key points to understand about estate taxes include:

• Estate Tax Exemption: The same lifetime exemption that applies to gift taxes also applies to estate taxes. For 2024, the exemption amount is $13.61 million.
• Estate Tax Rate: Similar to gift taxes, the estate tax rate can be as high as 40% on the value of the estate that exceeds the exemption amount.
• Portability: Married couples can take advantage of portability, allowing the surviving spouse to use the unused portion of the deceased spouse’s exemption.

Generation-Skipping Transfer (GST) Tax

GST tax is a federal tax imposed in addition to the gift and estate tax on direct or indirect transfers or bequests made to a “skip person.” A skip person is typically a grandchild or someone who is at least 37.5 years younger than the donor. The GST tax is designed to prevent individuals from avoiding estate taxes by skipping a generation when transferring wealth. Key points to understand about estate taxes include:

• GST Tax Exemption: For 2024, each U.S. citizen has a lifetime GST exemption of $13.61 million.
• GST Tax Rate: The GST tax rate is a flat 40% on the value of the transfer that exceeds the GST exemption amount.
• No Portability: The GST exemption amount is a use it or lose it exemption. Unlike the federal estate tax exemption, any GST tax exemption unused at one spouse’s death cannot be used by the surviving spouse.

Planning Considerations

Effective estate planning can help minimize the impact of gift and transfer taxes. Here are some strategies to consider:

• Annual Gifting: Take advantage of the annual exclusion by making regular gifts to family members or others. This can help reduce the size of your taxable estate.
• Trusts: Setting up certain types of trusts can help manage and reduce gift and transfer taxes. Trusts can provide control over how and when your assets are distributed.
• Charitable Contributions: Gifts to qualified charitable organizations are generally exempt from gift and transfer taxes. Charitable giving can be a valuable part of your estate plan.

Conclusion

By being informed about gifts and transfer taxes, you can take proactive steps to protect your assets and provide for your loved ones in the most tax-efficient manner possible. Consulting with an estate planning attorney can help you navigate these complex tax rules and create a comprehensive plan that meets your needs.