The tuition gift tax exclusion allows grandparents and other individuals to reduce their taxable estate while helping a child a child pay for college. Tuition payments made directly to an educational organization are exempt from gift taxes and the Generation-Skipping Transfer Tax. Grandparents do not have to file a gift tax form when money is paid directly to a college, even if the amount exceeds the $15,000 annual exclusion amount.
However, tuition payments made directly to a college can substantially reduce a student’s financial aid eligibility. One alternative is to contribute to a child’s 529 plan, which may have less of an impact on financial aid.
How the tuition gift tax exclusion works
Tuition payments made directly to a college are not considered gifts for tax purposes. By paying a school directly, grandparents can potentially move a significant amount from their taxable estate. Direct tuition payments are not counted toward the $15,000 annual gift tax exclusion amount and will not use up any of the individual’s $11.4 million lifetime gift tax exemption.
The tuition gift tax exclusion only applies to tuition payments. Money that is gifted to a child for other college expenses, such as books, supplies, room and board costs, do not qualify for the exclusion. According to the College Board’s 2018 Trends in College Pricing report, non-tuition expenses made up about 60% ($15,660) of the total budget for students who attended a 4-year in-state public college.
Financial aid impact
A tuition payment made directly to the college will reduce the student’s eligibility for need-based financial aid, but the actual impact will depend on the college. Most colleges treat a direct tuition payment as cash support, but some financial administrators argue that direct tuition payments fit the definition of estimated financial assistance.
Cash support is counted as untaxed income on the Free Application for Federal Student Aid (FAFSA). A student’s need-based financial aid eligibility is reduced by as much as 50% of the amount of their untaxed income.
Estimated financial assistance includes all scholarships, grants loans or other assistance the student receives that the college is aware of. These resources reduce a student’s eligibility for need-based financial aid on a dollar for dollar basis.
529 plans and gift taxes
One alternative to making tuition payments directly to a college is to contribute the money to a child’s 529 college savings plan. 529 plan contributions are considered gifts for tax purposes, and up to $15,000 qualifies for the annual gift tax exclusion.
Grandparents who want to make a larger 529 plan contribution may front-load up to $75,000 ($150,000 if married filing jointly) with 5-year gift-tax averaging, assuming no other gifts are made to the same child during that time period. With 5-year gift-tax averaging, or superfunding, individuals may contribute between $15,001 and $75,000 by treating the contribution as though it were spread evenly over a 5-year period.
With this strategy, grandparents who are 529 plan account owners may shelter a significant amount from their taxable estate while retaining control of the assets. However, if the grandparent dies within the 5-year period, the contribution is not considered a completed gift and a portion of the contribution will be added back to their estate.
Assets held in a grandparent-owned 529 plan are not reported on a student’s FAFSA, but distributions are counted as untaxed income to the grandchild. One way to reduce the negative impact on financial aid eligibility is to wait until January 1 of the student’s sophomore year in college to take a 529 plan distribution (wait until junior year if the student takes 5 years to graduate). By this time, the distribution should not affect financial aid eligibility, since the FAFSA uses the prior-prior year for income and tax information.