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Families Can Prepay Tuition as a Way to Avoid Gift Taxes

The Internal Revenue Service recently ruled that individuals can prepay tuition of family members at private schools and colleges for a number of years as a way to cut their tax bills.

This wealth-transfer technique could be a wise move for people with large estates to deal with soaring education costs and trim their federal estate and gift taxes.  Prepaying tuition in large chunks reduces the value of an estate, which can save on future estate taxes. These payments don’t have to be reported to the IRS and are not subject to gift taxes.  The IRS case involved a taxpayer who prepaid private school tuition for all six of his grandchildren through the 12th grade.

A potential risk is if a child leaves a school before the prepayments are exhausted.  Prepayments of multiple years of tuition are nonrefundable, according to the IRS.  One way to deal with this potential problem is to arrange with a school to send unused prepayments to another school if a student transfers. The IRS hasn’t ruled on that particular strategy yet, so its uncertain it will pass muster if the IRS considers it down the road.

Another way to help avoid taxes is to establish a 529 college savings plan, which allows families to contribute money to an account, which grows tax-deferred.  Distributions are not taxed if they are used for college expenses. 

Another option is to establish a Health and Education Exclusion Trust (HEET), which pays for tuition and health expenses for multiple generations of heirs.  Money in the trust can grow free of “generation skipping” taxes, which are imposed when money moves from generation to generation.

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