The Generation-Skipping Transfer tax (GST) is a federal tax applied to 529 plan contributions and other property transferred to a beneficiary who is at least 37 ½ years younger than the donor. The GST was introduced in 1976 to prevent wealthy grandparents from avoiding taxation by “skipping” their own children and leaving inheritance directly to their grandchildren.
Contributions to a grandchild’s 529 plan will count against the grandparent’s GST lifetime exemption of $11.2 million if they exceed the $15,000 per beneficiary annual exclusion amount .
How the Generation-Skipping Transfer Tax works
Gifts made to a “skip person”, typically a grandchild, are subject to a flat 40% GST in addition to gift taxes. 529 plan contributions are considered gifts for tax purposes, and 529 plan contributions made on behalf of a grandchild may be subject to the GST. The GST does not apply if a grandchild’s parents are deceased at the time of the transfer.
The GST exemption amount is the same as the lifetime exemption amount for gift and estate taxes, $11.2 million ($22.4 million if married) in 2019. The annual GST exclusion amount is also the same as the annual gift tax exclusion amount, $15,000 per beneficiary ($30,000 if married).
Most taxpayers will never have to pay the GST because the lifetime exemption is so high. However, if a grandparent gives more than $15,000 worth of gifts to a grandchild in a given tax year the gifts must be reported on IRS Form 709. The excess amount above $15,000 will count against the grandparent’s lifetime exemption. The grandparent will only be subject to the GST when the total amount of gifts exceeds $11.2 million.
For example, if a grandparent contributes $25,000 to a grandchild’s 529 plan in 2019, they would report $10,000 on IRS Form 709. The $10,000 is subtracted from their lifetime exemption amount.
529 Plans and the Generation-Skipping Transfer Tax
Grandparents who contribute to a 529 plan on behalf of a grandchild are subject to the GST. However, grandparents may contribute more than the $15,000 annual exclusion amount without affecting their lifetime exemption by using 5-year gift-tax averaging.
With 5-year gift-tax averaging, a taxpayer may contribute up to $75,000 per beneficiary when the contribution is treated as if it were made over a 5-year period. If a grandparent contributes more than $75,000 to a grandchild’s 529 plan, only the excess amount will count against the grandparent’s lifetime exemption limit.
Taxpayers must report 20% of the total 529 plan contribution for each of the 5 years. If the grandparent dies within the 5-year period, a pro-rata portion of the 529 plan contribution will be added back to the grandparent's estate. For example, if the grandparent dies in year 3, the contributions corresponding to years 4 and 5 will be included in the grandparent's estate.
Gift taxes and the GST do not apply if a grandparent pays for a grandchild’s tuition and the payment is made directly to a qualified educational institution. However, in most cases a grandparent would be better off funding a 529 plan to pay for a grandchild’s education than paying the college directly:
- The educational exclusion for gift tax and GST only applies to tuition expenses. Qualified 529 plan expenses include tuition, books, supplies, room and board if the student is enrolled at least half-time, computers, internet access and related technology
- Paying the college directly may reduce the student’s eligibility for need-based financial aid. Grandparents can avoid the financial aid impact by making contributions to a 529 plan owned by the student’s parent.
- A 529 plan gift grows tax-deferred and distributions are tax-free when used to pay for college
- Many states offer state income tax deductions or credits for 529 plan contributions
- Grandparents who contribute to a grandchild's 529 plan are subject to gift taxes and GST only if their total gifts exceed the lifetime limit of $11.2 million